FIRPTA and the Benefits of a Section 897(i) Election

By Anthony Diosdi

Foreign investors actively invest in U.S. real estate by speculating on land and developing homes, condominiums, shopping centers, and commercial buildings. Many foreign investors own recreational property in popular U.S. beach and ski destinations. Any foreign investor in U.S. real estate should consider the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”) or the effects of Section 897 of the Internal Revenue Code. Section 897 was designed to counteract the use of the various techniques that had been developed to avoid income tax on the disposition of U.S. real property. Section 897 provides that gain or loss realized by nonresident aliens or foreign corporations on the disposition of U.S. real property. Section 897 provides that gain or loss realized by nonresident aliens or foreign corporations on the disposition of U.S. real property interests will be treated generally as if such gain or loss were effectively connected with a U.S. trade or business. In some instances, the tax will also apply to gains on the sale of stock in U.S. corporations that hold 50 percent or more of specified assets in the form of U.S. real property. While gain from the sale of stock in a foreign corporation will not be taxed, the foreign corporation is taxed if and when it sells U.S. real property interests or distributes such interests to its shareholders.

Tax on Gain From U.S. Real Property Interests

Section 897 imposes a tax on gain realized upon the disposition of a “U.S. real property interest.” A U.S. real property interest is defined to include “an interest in real property located in the United States.” See IRC Section 897(c)(1)(A)(i). It also includes certain leasehold interests, options to acquire real property and “associated personal property,” such as movable walls. A U.S. real property interest does not include an “interest solely as a creditor in real property.” See Treas. Reg. Section 1.897-1(d)(1). A loan in which the lender has a direct or indirect right to share in the increase in value or the proceeds of the disposition of property will not be regarded as an interest solely as a creditor.

Withholding Requirement

To ensure collection of FIRPTA, generally any transferred acquiring a U.S. real property interest must deduct and withhold a tax equal to 15 percent of the amount realized on the disposition. A transferee is any person, foreign or domestic, that acquires a U.S. real property interest by purchase, exchange, gift, or any other type of transfer. See Treas. Reg. Section 1.1445-1(g)(4).

Tax On Sale of Stock in U.S. Corporation

U.S. real property interest is also defined to include any interest (other than an interest solely as a creditor) in a U.S. corporation unless the foreign person holding such interest establishes that the U.S. corporation was at no time during the five years ending on the date of the disposition a U.S. real property corporation. See IRC Section 897(c)(1)A(ii). A “U.S. real property holding corporation” is defined to include any corporation (whether domestic or foreign), the fair market value of whose U.S. real property interests equals or exceeds 50 percent of the sum of the fair market value of 1) its U.S. real property interests, 2) its interests in real property located outside the United States and 3) any other of its assets that are used or held for use in a trade or business. See IRC Section 897(c)(2).

U.S. real property interests will not include any class of stock of a corporation that is regularly traded on an established securities market, except in the case of a person owning more than five percent of such a class of stock during the relevant time period. Constructive ownership rules are prescribed by Section 897(c)(6)(C) in applying the five-percent test. If a foreign investor owns, directly or indirectly, more than five percent of such stock, the stock of the corporation may be a U.S. real property interest.

Gains realized from the disposition of an interest in a U.S. corporation that constitutes a U.S. real property holding corporation are generally taxed at the same rate and under the same rules as the disposition of direct holdings in U.S. real property. The entire amount of the gain realized from the sale of stock in a domestic U.S. real property holding corporation is subject to tax, regardless of the portion attributable to the U.S. real property interests that it holds. However, Section 897 withholdings will not apply to the sale or other disposition of the stock if the corporation holds no U.S. real property interests at the time of the disposition and if all U.S. real property interests held by the corporation during the five years prior to the disposition have been transferred by the corporation in transaction in which the full amount of gain has been recognized. A foreign corporation may be a U.S. real property holding corporation. However, stock in a foreign corporation will not be classified as a U.S. real property interest unless it elects to be treated as a U.S. corporation.

Disposition of Interests in Foreign Corporations

Ordinarily, the sale or other disposition of shares in a foreign corporation that owns a U.S. real property interest is not subject to U.S. taxation. Instead, the foreign corporation must recognize gain and pay U.S. tax when it distributes U.S. real property interest to any of its shareholders, whether by way of dividend, liquidation or redemption of stock. The foreign corporation is generally obligated to pay tax on the amount equal to the excess of the fair market value of the U.S. real property interest at the time it is distributed over its adjusted basis. See IRC Section 897(d)(1). Such a gain will be taxed as if it were effectively connected with the conduct of a U.S. trade or business.

Withholding of FIRPTA

The purchaser of a U.S. real property interest from a foreign investor is, in general, required to withhold 15 percent of the purchase price, which can be claimed by the foreign investor as a credit against U.S. federal taxes. If there is an installment sale, the withholding amount is still based on 15 percent of the total price and not the amount of installments. In some circumstances foreign investors can apply to the Internal Revenue Service (“IRS”) for a certificate authorizing a reduced amount of withholding tax (for example, if the 15 percent withholding tax exceeds the maximum amount of tax payable on disposition). Also, no withholding is required on the disposition of a partnership interest, unless 50 percent or more of the partnership’s gross assets are U.S. real property interests and 90 percent or more of its gross assets are U.S. real property interests, cash, or cash equivalents.

Nonrecognition Provisions

Under Internal Revenue Code nonrecognition provisions, there are some FIRPTA exceptions for transactions involving an exchange of property interests. If a U.S. corporation owns U.S. property, it may be advantageous to sell the property and pay U.S. property. Once the corporation has no real estate and has recognized all real estate gains, it would no longer constitute a real property holding corporation and it would be possible to liquidate the corporation with no FIRPTA tax consequences to the shareholders. This would potentially allow a foreign corporate shareholder to avoid U.S. tax on a distribution from the U.S. corporation. If the property is not appreciated over its tax basis, there would be no FIRPTA withholding, although it will be necessary to apply for a FIRPTA withholding certificate to avoid FIRPTA withholding. It may be possible to overcome this obstacle, by having the foreign corporation elect to be treated as a U.S. corporation for FIRPTA purposes under Section 897(i) of the Internal Revenue Code. 

The benefit of this election is that the deemed contribution of U.S. real property to the corporation would now be afforded nonrecognition treatment under FIRPTA regulations because the transferred corporation itself would be considered a U.S. real property interest. In addition, a Section 897(i) election only causes the foreign corporation to be treated as a domestic corporation for FIRPTA purposes, not for estate tax purposes. Once a foreign corporation has elected to be treated as a domestic corporation, a transfer of the real estate to the corporation will be eligible for nonrecognition under Sections 351 and 897(e) of the Internal Revenue Code. In order to qualify for the Section 897(i) election, the corporation must be entitled to nondiscriminatory treatment under a U.S. treaty. The foreign corporation must also demonstrate it has met the requirements of a Section 897(i) election. The election becomes effective on the date on which it is made or on such an earlier date as specified in the election.

To successfully make an election, the foreign corporation must show that it has met the requirements of Section 897(i). This includes forwarding the following documents to the IRS:

1) A general statement signed by a responsible corporate officer under penalties of perjury indicating that a Section 897(i) election has been made. The election should include the following: a) the electing corporation’s name, address, identification number, and place and date of incorporation; b) the treaty and article number under which the electing corporation is seeking nondiscriminatory treatment; c) description, acquisition dates, adjusted basis, and fair market value of the property held by the corporation; and d) certain information regarding related parties.

2) A binding waiver of treaty benefits that may apply to any gain or loss from the disposition of any U.S. real property interest during the period in which the Section 897(i) election is in effect.

3) A binding agreement to pay income tax like a domestic corporation on any gain that is recognized upon the disposition of the U.S. real property interest or any property acquired in exchange for a U.S. real property interest in a transaction to which nonrecognition treatment applies under Section 897(e) during the time of the Section 897(i) election.

4) Unless the shareholder is a shareholder of a publicly traded corporation whose stock ownership satisfied the exception to U.S. property interest on the date of the election each shareholder has to file a signed consent to the making of the election and a waiver of U.S. treaty benefits with respect to gain or loss from the disposition of any interest in the foreign corporation. Along with the shareholder’s consent to the election, a list identifying and describing the interests held by each shareholder in the foreign corporation has to be submitted to the IRS.

5) The electing corporation must state that no interest was disposed of during the longer of the last ten years before the date of the Section 897(i) election.

Conclusion

A Section 897(i) election permits foreign corporations to be treated as a domestic corporation to potentially avoid FIRPTA withholding. A Section 897(i) election can also be utilized as part of a plan to avoid the U.S. federal estate and gift tax.

The foregoing discussion is intended to provide a basic understanding utilizing multi-tiered structures to avoid FIRPTA. It should be evident from this article, however, that this is a very complex subject. As a result, it is crucial that a foreign investor in U.S. real estate review his or her circumstances with a qualified international tax attorney.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.

He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.