Tax Implications Applicable to Foreign Persons Investing in U.S. Real Property Key Considerations
With the devaluing of the U.S. dollar and the increase of foreign wealth, the U.S. real estate market is becoming more attractive to foreign investors. For foreign persons considering investing in U.S. real estate, the knowledge of how to hold U.S. real property from a legal and tax perspective is extremely important. The way in which foreign persons choose to hold U.S. real property can have a significant effect on the tax implications and U.S. tax filing requirements. The following is a brief summary of the tax law applicable to foreign investment in U.S. real property and U.S. tax implications of specific investment structures that may be considered by foreign investors.
SUMMARY OF TAX LAW
Prior to 1980, a foreign person could hold and dispose of U.S. real property and may be exempt from U.S. tax on passive U.S. real estate investments. In 1980, in an attempt to control foreign ownership of U.S. real property, Congress enacted the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”) to ensure that any foreign persons disposing of U.S. real property interests would be subject to U.S. taxation. Under FIRPTA, any foreign person disposing of a U.S. real property interest (“USRPI”) is deemed to conduct a U.S. trade or business and the gain or loss would deemed to be effectively connected with a U.S. trade or business and therefore subject to taxation on a net basis. To ensure that taxes are paid by the foreign sellers, the IRS requires the purchaser to withhold tax equal to 10% of the amount realized upon disposition of any U.S. real property interest by a foreign person. Since withholding is on a gross basis, this often would result in an overpayment of tax and any excess taxes withheld may only be recovered when a foreign person files a U.S. income tax return.
TAX IMPLICATIONS ON SPECIFIC INVESTMENT VEHICLES
One of the most simple methods is to own U.S. real property through direct ownership. The major advantage to a foreign individual owning property directly is the favorable long term capital gains tax rate available to individuals as well as the absence of double taxation that would otherwise be applicable if held through a corporation. Today, long term capital gains are either taxed at a 20% or 23.8% rate for individuals. Disadvantages include an unlimited liability exposure, personal tax return filing requirement and the absence of anonymity of the foreign investor with the IRS. Estate taxes would also likely be assessed upon death of a non-resident alien individual owning U.S. real property.
Ownership through a U.S. Corporation
When a U.S. corporation holds a real estate investment, one major concern is double taxation, which is the taxation of the corporation itself and taxation on the dividend income when earnings are repatriated. Corporations are generally subject to a tax rate of 35% and state and local income taxes would also be applicable. Since the corporation is a U.S. person, any dispositions of U.S. real property by the corporation are not subject to FIRPTA withholding. However, the disposition by a foreign person of shares in a U.S. corporation primarily holding U.S. real property would constitute a U.S. real property interest and would be subject to the FIRPTA withholding requirements. The corporation itself has a tax filing requirement, however this eliminates the need for the foreign investor to personally file a U.S. income tax return. Repatriation of earnings from the corporation to the foreign investor give rise to double taxation and any dividends paid may be subject to 30% withholding tax absent a treaty reduction or exemption.
Ownership through a Foreign Corporation
Foreign corporations owning U.S. real property are generally taxed on a net basis on effectively connected income (“ECI”) and on a gross basis on any non-ECI U.S. source income. Repatriation of earnings in the form of a dividend paid by the foreign corporation generally is not subject to further taxation in the United States. Stock of the foreign corporation can also be sold without the application of FIRPTA since the stock does not constitute USRPI. One major concern, however, is the 30% branch profits tax that may be assessed on foreign corporations doing business in the United States.
Ownership through a Partnership
A partnership is generally viewed as a transparent entity for U.S. tax purposes and the partnership itself does not pay taxes. The income and losses of the partnership flow to its partners and the partners are taxed directly on their share of the partnership’s income annually regardless of whether any income is distributed in the current year. A foreign partner may be subject to taxation on its share of allocable U.S. source income and would be withheld upon under the FDAP and ECI rules. Gain from the sale of USRPI is generally considered ECI and is therefore subject to withholding at the maximum rates applicable to the partner (35% for corporate foreign partners and 39.6% for individual foreign partners). Each foreign partner allocated ECI would generally be required to file a U.S. income tax return. When a foreign partner sells a partnership interest, the gain from the sale may also be treated as ECI to the extent the gain is attributable to the partnership’s ownership of U.S. real property.
Ownership through a Real Estate Investment Trust (“REIT”)
REITs are special investment vehicles that are otherwise taxable as a U.S. corporation. The main difference between a REIT and a corporation is that a REIT is allowed a tax deduction for dividends paid to its shareholders. In order to qualify, a REIT must annually distribute at least 90% of its net income to its shareholders. To the extent that a REIT makes a distribution to a foreign person attributable to gain from the sale of U.S. real property interest, the distribution would be taxable as ECI to the foreign person. The disposition of REIT shares are also subject to tax when the REIT is foreign controlled (greater than 50% of REIT stock is owned by foreign persons). However, if the REIT is publicly traded and the foreign investor owns 5% or less, no tax is imposed. Also the disposition of shares of a domestically controlled REIT is not subject to U.S. tax to the foreign seller.
ESTATE AND GIFT TAX IMPLICATIONS
One often overlooked area with respect to foreign ownership of U.S. real property is the estate tax implications upon death of a foreign person. Generally, absent an applicable estate tax treaty, foreign persons owning U.S. real property at time of death are subject to U.S. estate tax at a rate of up to 40% (2014 rate) with only a $60,000 exemption. Depending on the location of the U.S. property, the estate may also be subject to additional State estate tax. Though a majority of states have repealed the estate tax, a handful of states still impose estate taxes.
A gift of U.S. real property by a foreign individual is subject to U.S. gift taxation. Foreign persons are eligible for the annual gift tax exclusion ($14,000 in 2014) and spousal exclusions may be available depending on the resident status of the spouse. In 2014, the gift tax rate is 40%
The U.S. tax laws surrounding foreign ownership of U.S. real estate is complex. The ideal investment vehicle for a foreign investor would vary depending on each foreign person’s facts and circumstances. It is important that careful consideration and planning is taken in the initial steps of acquisition to ensure that the method of investment meets the particular needs of the foreign investor. Each foreign investor should seek tax advice in order to efficiently structure their investment.
To learn more about the FIRPTA rules and tax planning opportunities applicable to your investment, please contact Curt Giles firstname.lastname@example.org (714) 361-7670 or Michele Carter email@example.com (714) 361-7627.