FIRPTA Planning and U.S. Real Property Holding Corporations

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”). FIRPTA is designed to ensure that a foreign investor is taxed on the disposition of a U.S. real property interest, which includes an interest in U.S. reality and an interest in a U.S. corporation that was a U.S. real property holding corporation (“RPHC”) at any time during the five-year period before the disposition. A corporation is deemed an RPHC if the value of its U.S. real property interests equals or exceeds the value of all its real property interests plus its business assets. Similarly, the disposition of an interest in a partnership that holds U.S. real property is treated as a disposition of a U.S. real property interest to the extent that is attributable to the underlying U.S. real property interests.

The FIRPTA rules do not apply if the transferor is not a foreign person, if the disposition involves a sale of publicly traded stock in a U.S. corporation in which the foreign investor owns 5 percent or less, or if the disposition relates to the sale of shares in a U.S. company that has not been an RPHC during the last five years or that has disposed of all of its U.S. real property interests and recognized all the gain therefrom.

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. Under Internal Revenue Code nonrecognition provisions, there are some FIRPTA exceptions for transactions involving an exchange of property interests.

A distribution of a U.S. real property interest by a foreign corporation, a foreign partner of a U.S. partnership, or U.S. trust with a foreign beneficiary are taxed under FIRPTA. The FIRPTA withholding may be greater than 15 percent in certain cases.

Effects of FIRPTA

In 1980, Congress enacted Section 897 of the Internal Revenue Code (in legislation called “FIRPTA”). 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 987 provides that gains 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.

Tax on Sale of Stock In U.S. Corporation

U.S. real property interest includes 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 holding 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 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). Since the test depends on comparative asset values, a corporation could become a U.S. real property holding corporation, even though it did not modify its asset holdings, simply as a result of fluctuating property values.

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. See IRC Section 897(c)(3).

Gains from the disposition of an interest in a U.S. corporation that constitute a U.S. real property holding corporation is 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 gain realized from the sale of stock in a domestic U.S. real property holding corporation is subject to tax, regardless of the portion attribution to the U.S. real property interests that it holds. However, Section 897 will not apply to the sale or other disposition of the stock if the corporation holds no U.S. real property interest 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 (which made the corporation itself a U.S. real property holding corporation) have been transferred by the corporation in transactions in which the full amount of gain has been recognized. See IRC Section 897(c)(1)(B)

Exceptions to FIRPTA Withholding Requirements

As discussed above, the purpose of FIRPTA withholding is to assure tax compliance. However, there is a FIRPTA withholding exception for U.S. corporations that cannot be classified as “U.S. real property holding corporations.” In such cases, withholding is not required:

1. By the transferee of property if the transferor furnishes an affidavit stating that the transferor is not a foreign person and setting forth the transferor’s taxpayer identification number. See IRC Section 1445(b)(2).
2. On the disposition of an interest in a U.S. corporation if the corporation furnishes an affidavit stating that it is not and has not been a U.S. real property holding corporation during the five-year or shorter base period specified in Section 897(c)(1)(A)(ii). See IRC Section 1445(b)(3).
3. If the transferee receives a “qualified statement” from the IRS that the transferor is exempt from tax or that adequate arrangements to secure payment of the tax or acceptable arrangements to pay the tax have been made. See IRC Section 1445(b)(4).
4. If the transferee is going to use the property as a residence and the amount realized by the transferor on the disposition does not exceed $300,000. See IRC Section 1445(b)(5).
5. On a disposition of shares of a class of stock regularly traded on an established securities market. See IRC Section 1445(b)(6).

As noted above, there is an exception for the FIRPTA withholding requirements on the disposition of a U.S. corporation that holds U.S. real property if the entity cannot be classified as a U.S. real property holding corporation for the relevant time discussed above. This means, with property planning, foreign investors can hold U.S. real property in a corporate structure and avoid the FIRPTA withholding rules. That is, as long as the U.S. corporation cannot be classified as a U.S. real property holding company.

FIRPTA Withholding Procedures

If FIRPTA withholding is required, there are a number of procedures that must be followed. As with withholding taxes in general, a transferee that fails to withhold is liable for any uncollected taxes. Along with withholding, a transferee or buyer has an obligation to file with the IRS Form 8288, U.S. Withholding Tax Return for Dispositions by Foreign Persons of U.S. Real Property Interests, and Form 8288-A, Statement of Withholding on Dispositions by Foreign Persons of U.S. Real Property Interests for each foreign investor disposing of real property located in the U.S. These forms must be filed with the IRS no later than the 20th day after the date of the transfer.

From the foreign seller’s perspective, the withholding amount is usually greater than its U.S. federal income tax liability. The foreign seller has two options. First, the nonresident can have the transferee or buyer withhold the 15 percent. The nonresident can then file a U.S. federal tax return and request a refund for any overpayment of taxes. The foreign investor’s other option is to file a Form 8288-B with the IRS on or before the date of the transfer. Although the transferee or buyer will still need to withhold 15 percent of the amount realized in escrow, the purchaser does not need to report or pay over these monies to the IRS until the 20th day following the sale or transfer of the real property. In the meantime, the transferor or seller of the property can file a Form 8288-B and request a withholding certificate to reduce or eliminate withholding on the disposition of the real property. A transferor or seller can request a reduction in the FIRPTA withholding based on:

1. A claim is made that the transferor is entitled to nonrecognition treatment or is exempt from tax (i.e. a tax treaty reduces or eliminates the U.S. tax on the disposition of the real property);
2. A claim is made solely on a calculation that shows the transferor’s maximum tax liability is less than the tax otherwise required to be withheld; or
3. A claim is made that special installment sales rules which are described in Section 7 of Rev. Proc. 2000-35 are permitted in the disposition of the real property to reduce withholding. In the past, the IRS would normally act on a Form 8288-B submission within 90 days of receipt of all information. These days, the processing time of a Form 8288-B can be much longer. In order to avoid unnecessary withholdings, the Form 8288-B should be submitted to the IRS as early as practically possible. The Form 8288-B must be accurately completed in order to avoid a rejection of the application. At a minimum, the following information will be necessary to properly complete the Form 8288-B:

1. 1. The name of the transferor of the property and the identification number of the transferor.
   2. The name or names of the party or parties transferring the property and the identification number.
   3. A full description of the property being transferred (for example, “10-story, 100 unit apartment building).
   4. The sales price of the property being transferred and the adjusted basis in the property.
   5. It is necessary to tell the IRS whether or not tax returns for the three preceding tax years were filed. The definition of U.S. income tax returns includes Form 1120-F that is required to be filed by foreign corporations that have a direct or indirect interest in the U.S. property.
   6. It is necessary to state on the Form 8288-B the maximum U.S. tax liability for the sale of the property. The maximum U.S. tax liability can be determined through the contract for the sale of the property, invoices for improvements to the property, and depreciation schedules on previously filed tax returns. Special rules apply under Rev. Proc. 2000-35, Section 4.06 for net operating losses. Documents used to determine the maximum U.S. tax liability may also need to be submitted to the IRS with the Form 8288-B.
   7. If a reduction in the withholding is requested under a U.S. income tax treaty, the provision and an explanation must be submitted with the Form 8288-B.

The Form 8288-B must be signed under penalties of perjury by the nonresident transferor or a responsible corporate officer. The Form 8288-B may also be signed by an authorized agent such as an attorney admitted to practice before the IRS.

Conclusion

This article attempts to briefly summarize how the FIRPTA rules apply to U.S. real property holding companies. No portion of this article should be taken as a comprehensive or exhaustive treatment of the subject matter. Foreign investors should consult with a qualified international tax attorney regarding planning opportunities to mitigate their exposure to U.S. income, estate and gift tax associated with U.S. real estate ownership.

If there is a Form 8288-B filing requirement in connection with the sale of U.S. real property, the completion of the form requires careful and detailed attention to details. Failure to submit an accurate Form 8288-B will result in either a rejection of the application or a delay in the processing of the Form 8288-B. Buyers and sellers of U.S. real estate should also be aware that some states (such as California) have withholding requirements similar to FIRPTA. These withholding requirements should also be considered when transferring or selling U.S. real property.

We have substantial experience advising clients ranging from small entrepreneurs to major multinational corporations in foreign tax planning and compliance. We have also  provided assistance to many accounting and law firms (both large and small) in all areas of international taxation.

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.