By Anthony Diosdi
U.S. real estate has become a popular investment with foreigners. However, few foreign investors fail to consider the U.S. tax implications of holding U.S. real property. There are significant income, gift and estate tax consequences that may result when U.S. real property is sold or transferred. This article discusses the withholding requirements of the Foreign Investment in Real Property Tax Act of 1980 (or “FIRPTA”) and how the FIRPTA withholdings may be reduced or eliminated.
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 exceeds 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.
New IRS Proposed Regulations Regarding REITs
Under FIRPTA, 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. REIT stands for “Real Estate Investment Trust.” 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 REIT must also: 1) invest at least 75 percent of total assets in real estate, cash, or U.S. Treasuries; 2) derive at least 75 percent of gross income from rents, interest on mortgages that finance real property, or real estate sales; 3) pay a minimum of 90 percent of taxable income in the form of shareholder dividends each year; 4) be an entity that is taxable as a corporation; 5) be managed by a board of directors or trustees; 6) have at least 100 shareholders after its first year of existence; and 7) have no more than 50 percent of its shares held by five or fewer individuals.
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. Foreign investors frequently acquire U.S. real estate through a domestically controlled REIT and structure 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. Therefore, 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.
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.
Final Regulations Issued for Qualified Foreign Pension Funds
In final regulations published December 29, 2002, the Department of Treasury and the IRS addressed the qualifications for the exemption from taxation under Internal Revenue Code Section 897(l) for gain or loss attributable to the disposition of U.S. real property interests held by qualified foreign pension funds (QFPFs) and their wholly owned subsidiaries. See T.D. 9971. The final regulations also address gain from distributions described in Internal Revenue Code Section 897(h), as well as related withholding requirements under Sections 1445 and 1446 of the Internal Revenue Code.
Section 897 treats gain recognized by a foreign person from the disposition of a U.S. real property interest as income that is effectively connected with a trade or business, and therefore, is subject to net basis tax at the graduated, regular U.S. federal income tax rates. In 2015, Congress amended Section 897 to create a new exemption under Section 897(l) for U.S. real property interest held by QFPFs or an entity wholly owned by a QFPF (qualified controlled entity or QCE). Section 897(l) provides that a QFPF is not treated as a nonresident alien individual or foreign corporation for purposes of Section 897 and that an entity, all the interests of which are held by a QFPF, will be treated as such a fund. As a result, QFPF’s (and their wholly owned subsidiaries are trusts) are exempt from tax on certain dispositions of, and distributions with respect to, USRPIs. The final regulations limit the exemption under Section 897(l) to gain or loss that is attributable to one or more qualified segregated accounts (“QSA”) that the qualified holder maintains.
The final regulations define a QSA as an identifiable pool of assets maintained for the “sole purpose” of funding “qualified benefits benefits” (generally retirement, pension and ancillary benefits) to “qualified recipients” (generally, plan participants, and beneficiaries).
To qualify as a QFPF, Section 897(l) requires the entity to be a trust, corporation, or other organization or arrangement (i.e., an eligible fund”) that satisfies five requirements. The fund must:
1) Be created or organized under the law of a country other than the United States;
2) Be established by either: i) The foreign jurisdiction or one or more of its political subdivisions to provide retirement or pension benefits to participants or beneficiaries who are current or former employees or persons designated by these employees (including self-employed workers) or these employees (government-established fund) or ii) One or more employees to provide retirement or pension benefits to participants or beneficiaries that are current or former employees (including self-employed workers) or persons designated by those employees in consideration for services rendered by the employees to the employers (employer fund);
3) Have no single participant or beneficiary with a right to more than 5 percent of the fund’s assets or income;
4) Be subject to government regulation and provide annual information about the amount of qualified benefits (or this information must otherwise be available) to the relevant tax authorities in the country in which it is established or operates;
5) Be eligible for certain tax treatment under the laws of the country in which the fund is established or operates (e.g., contributions to the eligible fund that would otherwise be subject to tax under the foreign law are deductible or excluded from gross income of the eligible fund or taxed at a reduced tax rate.
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.
Shared Appreciation Loan an Exception to the FIRPTA Withholding Rules
As stated above, Section 897 imposes a gain realized upon the disposition of a “U.S. real property interest.” A potential strategy to avoid FIRPTA is the use of a shared appreciation mortgage. A typical shared appreciation mortgage is a loan secured by a lien upon real property in which the currently payable interest rate is fixed below the prevailing market rate for a standard fixed-rate mortgage. In exchange, the lender receives, as “contingent deferred” interest, a predetermined share of the property’s appreciation between the time the loan is made and the time the property is sold or the loan otherwise is paid. See Friend, Shared Appreciation Mortgages, 34 Hastings L.J. 331 (November 1982).
The appreciation portion of the interest is “contingent” because it is payable only to the extent the property appreciates in value. It is “deferred” because it is not payable until the maturity date of the loan or the sale of the property. There are a number of ways a shared appreciation mortgage can be structured. For instance, many shared appreciation mortgages are 30-year loans with the lender receiving payment of principal and deferred contingent interest upon the sale of the secured property or maturity of the note.
Internal Revenue Code Section 897 was designed to counteract the use of various techniques that had been developed to avoid income tax on the disposition of U.S. real estate. Section 897 provides that gain or loss realized by nonresident aliens or foreign corporations on the disposition of U.S. real property interests will generally be treated as if such gain or loss were effectively connected with a U.S. trade or business. Section 897 imposes a tax on gain realized upon the disposition of a “U.S. real property interest.” 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. See Treas. Reg. Section 1.897-1(d)(2).
Treasury Regulation Section 1.897-1(d)(2)(i) discusses the phrase “an interest other than an interest solely as a creditor” by stating it includes “any direct or indirect right to share in the appreciation in the value, or in the gross or net proceeds or profits generated by, the real property.” Section 1.897-1(d)(2)(i) states that a “loan to an individual or entity under the terms of which a holder of the indebtedness has any direct or indirect right to share in the appreciation in value of, or the gross or net proceeds or profits generated by, an interest in real property of the debtor or of a related person is, in its entirety, an interest in real property other than solely as a creditor.” Accordingly, a shared appreciation mortgage that is tied to U.S. real estate is not a U.S. real property interest for purposes of the FIRPTA withholding rules.
Holding a U.S. real property interest will not necessarily trigger a U.S. tax obligation. However, when the foreign investor liquidates the U.S. real property interest, the foreign investor will be subject to U.S. tax under that Section 897 to the extent that the U.S. real property interest is disposed of.” Treasury Regulation Section 1.897-1(g) provides that disposition “means any transfer that would constitute a disposition by the transferor for any purpose of the Internal Revenue Code and regulations thereunder.” In regards to shared mortgage sharing agreements, Treasury Regulation 1.897-1(h), Example 2 outlines a tax planning opportunity for foreign investors investing in U.S. real estate.
Example 2 found in Treasury Regulation Section 1.897-1(h) provides as follows:
Foreign corporation Y makes a loan of $1 million to domestic individual Z, secured by a mortgage on residential real property purchased with loan proceeds. The loan agreement provides that Y is entitled to receive fixed monthly payments from Z, constituting repayment of principal plus interest at a fixed rate. In addition, the agreement provides that vY is entitled to receive a percentage of the appreciation value of the real property as of the time that the loan is retired. The obligation in its entirety is considered debt for federal income tax purposes. However, because of Y’s right to share in the appreciation in value of the real property, the debt obligation gives Y an interest in the real property other than solely as a creditor. Nevertheless, as principal and interest payments do not constitute gain under Section 1001 and paragraph (h) of this section, and both the monthly and final payments received by Y are considered to consist solely of principal and interest. However, Y’s sale of the debt obligation to foreign corporation A would give rise that is subject to Section 897(a).
Example 2 states that, because of the foreign lender’s right to share in the appreciation in the value of the real property, the debt obligation gives the foreign lender an interest in the real property “other than solely as a creditor.” Nevertheless, the example concludes that Internal Revenue Code Section 897 will not apply to the foreign lender on the receipt of either the monthly or the final payments, because these payments are considered to consist solely of principal and interest for U.S. federal income tax purposes. Example 2 conclude that the receipt of the final appreciation payment that is tied to the gain from the sale of the U.S. real property does not result in a disposition of a U.S. real property interest for purposes of Section 897, because the amount is considered to be interest rather than gain under Internal Revenue Code Section 1001. The example does note, however, that a sale of the debt obligation by the foreign corporate lender will result in gain that is taxable under Internal Revenue Code Section 897. See Using Shared Appreciation Mortgages to Avoid FIRPTA, Florida Bar Journal, Volum. 80, No. 3 March 2006, Pg 40 Jeffrey L. Rubinger.
Example 2 points out that the use of a shared appreciation mortgage does not avoid U.S. tax. Rather, a shared appreciation mortgage requires the lender to treat the receipt of contingent deferred interest as interest rather than capital gain. This is demonstrated in Dorzback v. Collison, 195 F.2d 69 (3rd Cir. 1952). In Dorzback, a debtor/creditor relationship was amended to provide that, in lieu of interest at the rate of 5 percent per annum, the creditor would receive 25 percent of the net profits of the debtor’s business. The court quoted the United States Supreme Court in defining interest as being “the amount which one has contracted to pay for the use of borrowed money.” The court also noted that payments made in lieu of interest were in fact to be treated as interest, and that it was not a requirement that the interest be computed at a stated or fixed rate, but only that it be an ascertainable amount. The taxation of a shared appreciation mortgage is also discussed in Kena, Inc. v. Commissioner, 44 B.T.A. 217, 219-20 (1941). In Kena, a borrower and lender entered into an agreement in which the borrower received a sum of money as a “loan. The borrower agreed to repay the principal and to pay a further sum “in lieu of interest” equal to 80 percent of the net profits of the borrower’s business. The court held that the agreement was one creating a relationship of creditor and debtor, and that the amount paid for the use of the borrowed money was interest.
In order the contingent interest of a shared appreciation mortgage to be recognized by the IRS, at a minimum, the debt instrument must contain the following terms: 1) the terms of the loan should contain a definite maturity date as well as a cap on interest participation; 2) the loan should not be convertible into an equity interest for the borrower; 3) the lender should not have effective control over the borrower or the borrower’s assets exceeding that which a lender ordinarily would have; 4) there should be sufficient security for the debt; 5) the loan should be recourse under in nature, rather than nonrecourse; 6) there should not be a provision in the loan under which the purported lender is obligated to subordinate to some or all the borrower’s gross receipts rather than on its net income.
Although interest received by a foreign investor through a shared appreciation mortgage is not typically subject to FIRPTA withholding, the interest received as a result of a shared appreciation mortgage would be subject to a flat tax of 30 percent on the gross amount of the income received. (Section 871(a) (for nonresident aliens) and Section 881(a) (for foreign corporations) impose a 30-percent tax on U.S. source interest).
Tax treaties generally provide for the reduction or elimination of withholding taxes on U.S.-source interest. Treaty benefits will typically depend upon the residence of the foreign investor.
Currently, there are a significant number of countries that have income tax treaties with the United States that contain articles which entirely eliminate withholding tax on interest paid from the U.S. Some of these countries include the United Kingdom, France, Germany, Czech Republic, Finland, Hungary (The Department of Treasury announced that Hungary was notified on July 8, 2022, that the United States would terminate its tax treaty with Hungary. In accordance with the treaty’s provisions on termination, termination will be effective on January 8, 2023. However, with respect to taxes withheld at source, the treaty will cease to have effect on January 1, 2024. In respect of other taxes, the treaty ceases to have effect with respect to taxable periods beginning on or after January 1, 2024), Iceland, Norway, Poland, the Russian Federation, the Slovak Republic, Sweden, and Ukraine. A number of other treaties reduce withholding to only 5 percent. This means that residents of a country that has entered into a bilateral income tax treaty with the United States that eliminates or significantly reduces the withholding on interest income can potentially utilize a shared appreciation mortgage to avoid the harsh consequences of FIRPTA.
In certain cases, even foreign investors that are not residents of a country that the United States has entered into a tax treaty with can still completely exempt the U.S. withholding tax on contingent interest received from a shared appreciation mortgage. In order for a foreign investor who is not a resident of a treaty jurisdiction listed above to obtain a complete exemption from U.S. withholding tax on contingent interest payments, the investor must rely on a treaty that has no limitation on benefits (“LOB”) provision.
Most modern U.S. tax treaties contain a LOB provision. Under most LOB provisions, a foreign person will be considered a resident for treaty purposes and permitted to benefit from the treaty if such person is liable to tax therein by reason of its domicile, residence, or citizenship. LOB provisions contained in many modern U.S. treaties also deny corporations the benefits of a treaty. Thus, even if a corporation qualifies as a resident of a treaty country, that corporation is not entitled to treaty benefits unless the corporation is a resident of the treaty country if the corporation meets one of the following requirements: 1) more than 50 percent of the corporation’s stock is regularly traded on a recognized stock exchange (i.e., the corporation is a publicly traded company) and the corporation’s primary place of management is in its country of incorporation; 2) the corporation is a 50 percent or more owned by 5 or fewer companies entitled to treaty benefits, or 3) the corporation meets both a stock ownership test (at least 50 percent of the corporation’s stock stock is owned by residents who are entitled to treaty benefits), and a base erosion test (less than 50 percent of the corporation’s gross income is used to make deductible payments to persons who are not residents of either treaty county.
It is important to note that not all U.S. tax treaties contain LOB provisions. There are a limited number of treaty countries that provide an exemption from withholding on payments of U.S. source interest, including contingent interest, and do not have LOB provisions. Please see the illustration below which demonstrates how a foreign investor was able to fund a shared appreciation mortgage through a Hungarian company.
Illustration
A resident of Singapore wishes to participate in the appreciation of a real estate development project in the United States. Singapore does not have a tax treaty with the United States. Therefore, the investor establishes a Hungarian company that owns 100 percent of the units of a U.S. limited liability company (“LLC”) that elects to be treated as a disregarded entity under the “check-the-box” rules. With this chosen structure and under the U.S.-Hungary Income Tax Treaty, no U.S. withholding tax would be imposed on the shared appreciation mortgage payments.
It should be noted that there are a number of provisions in the Internal Revenue Code and its regulations which curtail planning discussed in the illustration above. Any such planning should be approached with extreme caution.
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. 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 shared appreciation loans can be used by a foreign investor for U.S. federal income tax planning. 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.