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.
To ensure collection of the FIRPTA tax, any transferee or buyer acquiring a U.S. 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. The amount realized is the sum of the cash paid or to be paid, the market value of other property transferred or to be transferred, the amount of liabilities assumed by the transferred, and the amount of liabilities to which the transferred property was subject. Withholding requirements also apply to distributions made by a domestic or foreign corporation, partnership, estate, or trust, to the extent the distribution involves a U.S. real property interest, as well as to dispositions of interests in a partnership, trust, or estate that has a U.S. real property interest.
If the buyer is an individual person who will acquire the real property for personal use as a “personal residence,” there is an exception to the FIRPTA withholding rules. If the sales price is $300,000 or less, then the tax withholding is not required. To qualify under the personal residence exemption, the transferee or certain members of the transferee’s family (including brothers, sisters, spouses, or lineal descendants) must intend to reside at the property 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 acquisition of the property. The “personal residence” exception to the FIRPTA withholding rules is dangerous for transferees of U.S. real estate. If the property is not used as a “personal residence,” the transferee may be liable for the foregone withholding tax.
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
From a U.S. federal income tax perspective, the primary obstacle facing foreign persons who invest in U.S. real estate is FIRPTA, more specifically Internal Revenue Code Section 897. Internal Revenue Code Section 897 treats any gain recognized by a foreign person on the disposition of a USRPI as if it were effectively connected to a U.S. trade or business. 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.
Effects of Internal Revenue Code Section 897
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). However, 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) elaborates on 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.” The Income Tax Regulation goes on to state 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 a United States real property interest (“USRPI”) for purposes of Internal Revenue Code Section 897.
Holding a USRPI will not trigger a U.S. tax obligation. However, when the foreign investor liquidates the USRPI, the foreign investor will be subject to U.S. tax under that Section 897 to the extent that the USRPI 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. In Example 2, a foreign corporation lends $1 million to a domestic individual, secured by a mortgage on residential real property purchased with the loan proceeds. Under the loan agreement, the foreign corporate lender will receive fixed monthly payments from the domestic borrower, constituting repayment of principal plus interest at a fixed rate, and a percentage of the appreciation in the value of the real property at the time the loan is retired.
The example 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 concludes 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 USRPI 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.
Consequently, foreign investors may attempt to use debt instruments with contingent interest features to avoid Internal Revenue Code Section 897. This does not mean that using a shared appreciation mortgage avoids U.S. tax. Instead, a shared appreciation mortgage requires the lender to treat the receipt of contingent deferred interest as interest rather than capital gain. In Dorzback v. Collison, 195 F.2d 69 (3rd Cir. 1952), 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. In Kena, Inc. v. Commissioner, 44 B.T.A. 217, 219-20 (1941), the 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 Internal Revenue Service (“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 is not subject to Section 897 and the FIRPTA provisions of the Internal Revenue Code, Sections 871(a) (for nonresidents aliens and 881(a) (for foreign corporations) impose a 30 percent withholding tax on “interest.” In other words, the contingent interest received by the foreign investor through a shared appreciation mortgage is generally subject to 30 percent withholding tax. However, the withholding tax is often eliminated or reduced by treaty. However, tax treaties generally provide for a reduction or elimination of withholding tax on interest income. 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, Germany, 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.
Because tax treaties provide lower withholding tax rates on interest income, individuals and foreign corporations like to establish residency in a country that has a favorable tax treaty with the United States. This practice is known as “treaty shopping.” Anti-treaty shopping provisions known as LOB provisions restrict an individual’s or corporate structure’s ability to engage in treaty shopping. Under most U.S. tax treaties that contain a LOB provision, 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. Under most LOB provisions, 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 Illustration 1 which demonstrates how a foreign investor was able to fund a shared appreciation mortgage through a Hungarian company.
Illustration 1.
A resident of Taiwan wishes to participate in the appreciation of a real estate development project in the United States. Taiwan 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.
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.