By Anthony Diosdi
Foreign investors actively invest in U.S. real estate by speculating on land and developing homes, condominiums, shopping centers, and commercial buildings. Many foreign investors own recreational property in popular U.S. beach and ski destinations. Any foreign investor in U.S. real estate should consider the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”). 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. See Canadian Investing in U.S. Real Property, Jack Bernstein (2016).
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. If a U.S. corporation owns U.S. property, it may be advantageous to sell the property and pay U.S. property, it may be advantageous to sell the property and pay U.S. corporate tax on the gain. Once the corporation has no real estate and has recognized all real estate gains, it would no longer constitute a RPHC and it would be possible to liquidate the corporation with no FIRPTA tax consequences to the shareholders. This would potentially allow a foreign corporate shareholder to avoid U.S. tax on a distribution from the U.S. corporation.
A foreign investor who personally owns U.S. real property may wish to avoid U.S. estate and gift tax by transferring the property to a foreign corporation. However, U.S. FIRPTA will apply to tax any gain to the date of transfer. If the property is not appreciated over its tax basis, there would be no FIRPTA tax, although it will be necessary to apply for a FIRPTA withholding certificate to avoid FIRPTA withholding. It may be possible to overcome this obstacle, by having the foreign corporation elect to be treated as a U.S. corporation for FIRPTA purposes under Section 897(1) of the Internal Revenue Code.
The benefit of this election is that the deemed contribution of U.S. real property to the corporation would now be afforded nonrecognition treatment under FIRPTA regulations because the transferred corporation itself would be considered a U.S. real property interest. Because the tax effect of this election is limited to FIRPTA provisions, the foreign investor would be considered to have died holding stock in a foreign corporation out of the foreign investor’s U.S. estate.
In order to qualify for the Section 897(1) election, the corporation must be entitled to nondiscriminatory treatment under a U.S. treaty. However, the treaty does not have to be an income tax treaty. Even if the entity is formed in a country that does not have an income tax treaty with the United States, there may be a friendship, commerce or navigation treaty with the requisite nondiscrimination provision. See Daily Tax Report, 215 DTR J-1, 11/07/2016. Most such treaties do not include “limitation-on-benefit” or “LOB” provisions comparable to what one would find in a modern income tax treaty, making it easier to qualify for a Section 897(1) election.
Conclusion
The foregoing discussion is intended to provide a basic understanding utilizing multi-tiered structures to avoid FIRPTA. It should be evident from this article, however, that this is a very complex subject. As a result, it is crucial that a foreign investor in U.S. real estate review his or her circumstances with a qualified international tax attorney.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.