How a REIT May be Utilized to Minimize FIRPTA Taxation

When U.S. real estate became a popular investment with foreigners in the 1970s, the favorable tax treatment accorded foreign investors in U.S. real property became a domestic political issue. Congress responded in 1980 by enacting the Foreign Investment in Real Property Tax Act of 1980 (or “FIRPTA”), which tried to equate the tax treatment of real property gains realized by domestic and foreign investors. Prior to FIRPTA, foreign persons generally were not taxed on gains from the disposition of a U.S. real property interest. Under FIRPTA, gains or losses realized by foreign corporations or nonresident alien individuals from any sale, exchange. Or disposition of a U.S. property interest are taxed in the same manner as income effectively connected with the conduct of a U.S. trade or business. This means that gains from dispositions of U.S. real estate interests are taxed at the regular graduated rates, whereas losses are deductible from effectively contracted income. To ensure the collection of the FIRPTA tax, any transferred acquiring a U.S. real property interest generally must deduct and withhold a tax equal to 15% of the amount realized on the disposition. Foreign investors in U.S. real estate commonly utilize real estate investment trusts (“REIT”) to invest in U.S. real estate. A REIT may offer unique advantages for foreign investors. This article discusses the potential advantages REITs offer foreign investors in U.S. real estate.

U.S. Taxation of Foreign Investors Generally

The way in which foreign persons are taxed in the United States depends generally on whether income derives from U.S. sources and whether the income that is taxed derives from the conduct of a U.S. trade or business or from passive investment arrangements. As a general rule, a nonresident alien or foreign corporation that conducts a U.S. trade or business will be subject to the usual (individual or corporate) U.S. tax rates on net income “effectively connected with the conduct of a trade or business within the United States. Tax treaties generally provide, however such income will not be taxed unless attributable to a “permanent establishment” maintained by the foreign person in the United States.

Most of the forms of U.S.-source income received by foreign persons that are not effectively connected with a U.S. trade or business will be subject to a flat tax of 30 percent on the gross amount of the income received. Sections 871(a) (for nonresident aliens) and 881(a) (for foreign corporations) of the Internal Revenue Code impose the 30 percent tax on interest, dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, and other fixed or determinable annual or periodical gains, profits, and income.” This type of income is often referred to as “FDAP income.” As in the case of U.S. trade or business income, tax treaties may reduce or eliminate FDAP withholding tax.

U.S. Taxation of the Foreign Real Estate Investor

Under FIRPTA, gains or losses realized by foreign corporations or nonresident alien individuals from any sale, exchange, or other dispositions of a U.S. real property interest are taxed in the same manner as income effectively connected with the conduct of a U.S. trade or business. This means that gains from dispositions of U.S. real property interests are taxed at the regular graduated rates, whereas losses are deductible from effectively connected income.

A U.S. real property interest includes interests in any of the following types of property located within the United States:

1. Land;
2. Buildings, including a personal residence;
3. Inherently permanent structures other than buildings;
4. Mines, wells, and other natural deposits;
5. Growing crops and timber; and
6. Personal property associated with the use of the real property.

For this purpose, an “interest” in real property means any interest (other than an interest solely as a creditor), including fee ownership, co-ownership, a leasehold, an option to purchase or lease property, a time-sharing interest, a life estate, remainer, or reversion interest, and any other direct or indirect right to share in the appreciation in value or proceeds from the sale of real property. A U.S. property interest also includes interest (other than an interest solely as a creditor) in a domestic corporation that was a U.S. real property holding corporation at any time during the five-year period ending on the date of the disposition of such interest or, if shorter, the period the nonresident held the interest. This prevents foreign persons from avoiding the FIRPTA tax by incorporating their U.S. real estate investment and then realizing the resulting gains through stock sales which may be exempt from U.S. tax.

Who is a U.S. Person for Purposes of FIRPTA that is Not Subject to Withholding

An individual is deemed a U.S. person” for purposes of FIRPTA if he or she is either a U.S. citizen or a resident of the U.S. In other words, a U.S. citizen or U.S. resident seller of U.S. real property is not subject to FIRPTA withholding. Under Internal Revenue Code Section 7701(b), an alien may be classified as a U.S. resident under either the “green card” or “substantial presence” tests. Under the green card test, a lawful permanent resident (green card holder) for any part of the calendar year for U.S. immigration purposes is a U.S. resident until the green card is administratively or judicially rescinded or has been abandoned. Under the substantial presence test of Internal Revenue Code Section 7701(b)(3), an alien is a U.S. person for purposes of FIRPTA if he or she is present in the United States for 183 days or more in a single year, including partial days, in the U.S. for that year. This is known as the substantial presence test. The test can be met if an alien is present within the United States during the tax year on at least 31 days and was present within the United States for 183 days during the tax year and two preceding years, as determined under the following formula:

Current year……………………………………………one day is one day
First preceding year……………………………………one day is ⅓ of a day
Second preceding year……………………………….one day is ⅙ of a day

Becoming a U.S. Purpose for FIRPTA Purposes by Making a “First-Year Election”

Another way for an alien to be treated as a resident of the United States is for the alien to make a so-called first-year election to be treated as a resident of the United States. An alien may make this election if the five requirements are satisfied:

1. The alien individual is not a resident of the United States under either the green card test or for the calendar year immediately after the election year; See IRC Section 7701(b)(4)(A)(iii).
2. The alien individual was not a resident of the United States under the green card test, the substantial presence test or the first-year election provision for the calendar year immediately before the election year; See IRC Section 7701(b)(4)(A)(ii).
3. The alien individual is a resident of the United States under the substantial presence test for the calendar year immediately after the election year; See IRC Section 7701(b)(4)(A)(iii).
4. The alien individual is present in the United States for a period of at least 31 consecutive days in the election year; See IRC Section 7701(b)(4)(A)(iv)(I).
5. The alien individual is present in the United States for at least 75 percent of the number of days in the “testing period.” The testing period starts with the first day of the 31-day period and ends with the last day of the election year. See IRC Section 7701(b)(4)(A)(iv)(II).

Corporations

The definition of a “U.S. person” includes a domestic corporation. The definition of a “U.S. corporation,” is defined by Section 7701(a)(4) to be corporations organized under the laws of the United States, any state or the District of Columbia. Any corporation not organized under the laws of the United States, any state or the District of Columbia is a “foreign corporation” under current law, regardless of the location of its head office or place of management. U.S. real property interest is 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 that U.S. corporation was at no time during the five years ending on that date of disposition a U.S. real property holding corporation. See IRC Section 897(c)(A)(ii). A “U.S. real property holding corporation” is defined to include any corporation, the fair market value of whose U.S. real property interests equal or exceed 50 percent of the sum of the fair market value of (1) its 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. Since the test depends on comparative asset values, note that 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.

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 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 interest 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.

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. 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 a U.S. real property interest to any of its shareholders, whether by way of dividend, liquidation, or redemption of stock.

Partnerships, Trusts, and Estates

U.S. partnerships, trusts, and estates are required to withhold tax in respect of the share of gain attributable to a foreign partner or foreign beneficiary of any amount realized by the entity a disposition of a U.S. real property interest. The withholding will generally be 37 percent. However, the withholding rate may be reduced to reflect the lower applicable long-term capital gains rates.

Withholding Requirements

To ensure collection of FIRPTA, any transferred acquiring a U.S. real property interest must deduct and withhold a tax on 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). The amount subject to withholding is the sum of cash paid, the market value of the property transferred, or the amount of liabilities to which the transferred property is subject. See Treas. Reg. Section 1.1445-1(g)(5). The withholding rate is generally 15 percent of the sales price of the real property.

If the real property being sold or transferred is commercial property, the foreign seller or transferor is subject to a 15 percent withholding tax. If the real property being sold or transferred is residential real estate is $300,000 or less, then the withholding tax is not required. If the sales price is equal to or greater than $300,001, but equal to or less than $1 million then the seller may qualify for a reduced withholding in the amount of 10 percent. If the sales price for the residential real estate is greater than $1 million, then the withholding rate is 15 percent. To qualify under the personal residence exemption, the transferee or certain members of the transferred’s family (lineal descendants) must intend to reside at the real property at issue for more than 50 percent of the number of days that the property is used by any person for residential purposes during each of the two years following the purchase. See Treas. Reg. Section 1.1445-2(d)(1).

If the sales price of U.S. real estate is equal to or greater than $300,001, but equal to or less than $1 million then the seller would qualify for reduced withholding in the amount of 10 percent (instead of 15 percent). If the sales price is greater than $1 million, then no exception applies, and the buyer is responsible for withholding 15 percent of the amount realized by the seller.

 Importance of REITS to Mitigating FIRPTA Taxation

A REIT introduces an option for foreign investors to invest in U.S. real estate and may provide the benefits of a so-called “blocking structure’ for U.S. tax purposes. REITs are corporate entities (corporation, trust, or association) that invest in real estate. The investment may be equity (ownership and operation) or debt (direct lending or investment in mortgage backed securities). As with mutual funds, investors buy shares in REITs, which can be publicly-traded or privately-traded. By pooling the investors’ capital and investing in real estate assets, REITs enable individuals and entities to invest in liquid, diversified, professionally managed, income-producing real estate. REITs are exempt from corporate-level U.S. taxes (and thus avoid double taxation), if they meet certain conditions. The exemption arises because REITs can deduct ordinary dividend and capital distributions paid to shareholders from taxable income, leaving the sole taxation at the shareholder-level.

To qualify as a REIT, a company must meet ownership, income, and distribution tests. First, REITs must have at least 100 different shareholders (the “100 Shareholder Test”) and more than 50% of the value of the REIT’s stock (the “5/50 Test”) cannot be owned by five or fewer investors. To ensure compliance, most REITs limit ownership, e.g., provisions may limit a single shareholder from owning more than a certain percentage of outstanding shares. Second, at least 75% of a REIT’s annual gross income must be real estate related (rents from real estate, interest on mortgages, gain on sale), and 95% of its gross income must be either real estate related or from some limited passive investments. Quarterly, at least 75% of a REITs’ assets must be in real estate. Third, REITs must distribute at least 90% of its annual ordinary taxable income to shareholders; else the REIT must pay tax on its income.

For foreign investors, investing in U.S. real estate through a REIT can offer a number of benefits. Recall that under the FIRPTA regime, foreign investors are generally taxed on gain or loss upon disposition of U.S. real investments in the same manner as if the foreign investor were engaged in a trade or business within the United States and if such gain or loss were effectively connected with a trade or business. One of the exceptions to the applicability of FIRPTA frequently relied on by foreign investors is the sale of stock in a domestically controlled REIT. 2015 legislation known as Protecting Americans from Tax Hikes Act of 2015 included a number of provisions that impacted REITs. Under the 2015 Act, foreign investors owning 10 percent or less of a publicly traded REIT were determined not to be subject to FIRPTA taxation upon the sale of the REIT’s stock. The 2015 Act also provides for a first-time exemption for small portfolio investors to interests in REITS held through certain widely held, publicly traded “qualified collective investment vehicles” such as Australian property trusts and certain publicly traded partnerships. Under the 2015 Act, a Canadian limited partnership that invests in a U.S. corporate subsidiary may also qualify as a REIT in which its investors avoid FIRPTA withholding tax in certain cases.

Domestically Controlled Determination

A REIT is organized as a partnership, corporation, trust, or association that invests directly in real estate through the purchase of properties or by acquiring mortgages. REITs typically issue shares that trade on stock exchanges and are bought and sold like stocks. To qualify as a REIT, a company must comply with certain provisions of the Internal Revenue Code. These requirements include to primarily own income-generating real estate for the long-term and distribute income to shareholders. A domestically controlled REIT is an entity in which non-U.S. persons hold directly or indirectly less than 50 percent of the interests in the REIT. A five-year testing period for REITs to determine if the 50 percent interest test is satisfied. The testing period looks at the shorter of the 5-year period ending on the date of disposition or the entire period the entity was in existence. If a foreign investor acquires U.S. real estate through a domestically controlled REIT and structures their exit in U.S. real estate as a sale of shares in such domestically controlled REIT instead of a sale of a free simple interest in order to avoid the FIRPTA tax, the determination of whether a REIT is domestically controlled is often critical to a foreign investor’s investment decision.

Section 897(h)(4)(B) generally provides that a domestically controlled REIT is which less than 50 percent in value of the stock is held “directly or indirectly” by foreign persons. The Internal Revenue Code does not provide specific guidance interpreting the words “directly or indirectly.” In the past, the Internal Revenue Service or (“IRS”) has considered whether a foreign-owned U.S. corporation should be viewed as a U.S. person for purposes of determining whether a REIT is domestically controlled. According to the fact pattern in Private Letter Ruling 200823001 (June 5, 2009), a REIT was held by two domestic corporations that were owned in part by foreign shareholders. The IRS determined that the REIT was considered to be “domestically controlled” despite the fact that the REIT was indirectly owned by a foreign corporation. The Ruling refers to Treasury Regulation Section 1.897-1(c)(2)(i), which provides that “the actual owners of stock, as determined under Treasury Regulation Section 1.857-8, must be taken into account.” Treasury Regulation Section 1.857-8(b) provides that the actual owner of stock of a REIT is the person who is required to include in gross income any dividends received on the stock. The proposed regulations do not retain the reference to Section 1.857-8 in Section 1.897-1(c)(2)(i).

The proposed regulations introduce a new concept of look-through persons and non-look-through persons that will dramatically impact REIT planning. Under the proposed regulations, in order to determine if a REIT is domestically controlled, it is necessary to review each look-through person until you reach a non-look- through person. A look-through person is any person other than a non-look-through person and includes a regulated investment company, a REIT, an S corporation, a non-publicly traded partnership (domestic or foreign) and a trust (domestic or foreign). A public REIT is treated as a foreign person that is a non-look-through person. The final regulations effective April 25, 2024 governing REITs maintain the look-through approach to determine if a REIT is domestically controlled. See Treas. Reg. Section 1.897-1(c)(3).

Under the final regulations, a non-public domestic C corporation is treated as a look-through-person if it is a foreign-owned domestic corporation. A foreign-owned domestic corporation is any non-public domestic C corporation if foreign persons hold directly or indirectly 25 percent or more of the fair market value of the non-public domestic C corporation’s outstanding stock. This means that, contrary to prior guidance, a REIT shareholder that is a private taxable domestic C corporation is a look-through person if 25 percent or more of the value of its outstanding stock is held by shareholders which are foreign persons. The Treasury Department and the IRS intend this new foreign-owned domestic corporation rule to prevent the use of intermediary domestic C corporations to create domestically controlled REITs. While the proposed regulations import this new concept of look-through persons and non-look-through persons, they continue to rely only on actual chains of ownership and do not import the attribution or constructive stock ownership rules found in other parts of the Internal Revenue Code such as Sections 267 and 318. Look through persons also include regulated investment companies (“RIC”), S corporations, REITs (non-public), non-publicly traded partnerships, and domestic or foreign trusts.

Non-look through persons include individuals, domestic C corporations (unless foreign controlled), publicly traded REITs, nontaxable holders, foreign corporations, foreign governments entities, publicly traded partnerships (domestic or foreign), estates (domestic or foreign), international organizations, qualified foreign pension funds (“QFPF”), or qualified controlled entities.

Conclusion

Established correctly, a domestically controlled REIT can eliminate or significantly mitigate the FIRPTA tax. However, a REIT does not guarantee to reduce the burden of all U.S. tax associated with U.S. real estate. A REIT does not distribute real estate rental income to its shareholders. Instead, a REIT issues ordinary dividends to its shareholders from accumulated earnings and profits (“E&P”). Ordinary dividends paid to foreign investors are classified as FDAP for U.S. tax purposes and subject to a 30 percent withholding tax. In some cases, a tax treaty can be utilized to reduce or avoid the 30 percent withholding tax. However, even if a foreign investor cannot utilize a tax treaty to reduce withholding taxes, a foreign investor may make an election to be subject to U.S. tax on U.S. effectively connected income and can claim a Section 199A deduction, provided the investor files a U.S. tax return. The Tax Cuts and Jobs Act allows individual investors to claim a 20% Section 199A pass-through deduction on REIT dividends.

Anthony Diosdi is an international tax attorney at Diosdi & Liu, LLP. Anthony has advised various Fortune 500 companies and large privately held businesses in their cross-border tax planning. Anthony is a frequent author and speaker on international tax topics.

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.