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U.S. Real Property Interest Non-Recognition Transfers- Can the Internal Revenue Service Assess Interest When No Tax is Due?

U.S. Real Property Interest Non-Recognition Transfers- Can the Internal Revenue Service Assess Interest When No Tax is Due?

By Anthony Diosdi

When a U.S. income tax nonresident alien or a foreign corporation (hereinafter collectively referred to as a “Foreign Taxpayer”) disposes of a U.S. real property interest (“USRPI”), the Foreign Taxpayer is subject to the Foreign Investment in U.S. Real Property Tax Act of 1980 (“FIRPTA”). Pursuant to FIRPTA, a Foreign Taxpayer is subject to tax on the gain or loss from the disposition of a USRPI as if the Foreign Taxpayer was engaged in a U.S. trade or business during the taxable year, and as if such gain or loss was effectively connected with such trade or business. According to FIRPTA and presuming an exception to the general rule does not otherwise apply, if a Foreign Taxpayer disposes of a USRPI, the transferee of the USRPI is required to deduct and withhold a tax up to 15 percent of the amount realized by the Foreign Taxpayer on the disposition.

In certain circumstances, a Foreign Taxpayer may wish to exchange a USRPI for another USRPI, e.g., in a “like-kind exchange” of U.S. investment real property for similar U.S. investment real property, or where the Foreign Taxpayer transfers a U.S. investment real property to a domestic corporation for shares in such domestic corporation. This latter transfer is often done for potential U.S. tax avoidance where the Foreign Taxpayer is domiciled in a jurisdiction which has a tax treaty with the U.S. which which treaty precludes the U.S. from taxing such third country domiciliary on the shares of a U.S. company, or where the ultimate beneficial owner of the U.S. investment real property wishes to strengthen the protection against legal liability claims generally associated with the individual ownership of U.S. real estate. These types of transactions are generally considered “non-recognition” events for U.S. income tax purposes.

Regardless of the non-recognition for general U.S. tax purposes, it is imperative that the Foreign Taxpayer timely provide the transferee of the USRPI with a non-recognition statement, and by the 20th day after the date of the transfer, the transferee must file a statement with the Internal Revenue Service (“IRS”). The non-recognition statement puts the IRS on notice that a transaction has occurred in which there has been no recognition of gain or loss. If the non-recognition statement and the relevant procedures are not timely filed, and notwithstanding the general non-recognition treatment of the USRPI disposition under U.S. tax law, the IRS can impose interest on the 15 percent withholding that was due when the original transaction occurred.

A simple illustration should prove helpful: A nonresident alien has investment in land worth $1 million and the individual exchanges the investment for like-kind investment land having a similar value. Even if the individual would have recognized gain if he or she sold the investment land (assuming, for instance, the nonresident alien had a tax basis in the land of less than $1 million), the like-kind exchange will result in non-recognition treatment to the nonresident alien. The same result would follow if the nonresident alien transferred the investment land with a value of $1 million and a lesser tax basis to a U.S. company solely in exchange for the shares of such U.S. company. In the absence of properly following the non-recognition statement filing procedures, 15 percent of the investment land’s value, or $1 million x 15% = $150,000, would have to be forwarded to the IRS within 20 days of the transfer and the IRS has the authority to impose interest on such $150,000 regardless of whether or not the tax is or is not due as a result of the non-recognition provisions.

Some Foreign Taxpayers assume that because a non-recognition transaction is taking place, nothing additional must be done, this is incorrect. If you are a Foreign Taxpayer and own a USRPI, you should make certain that in the event you ever dispose of a USRPI in a non-recognition transaction, you meticulously follow the FIRPTA non-recognition statement procedures and filing requirements in order to preclude the assessment of unnecessary interest.

Anthony Diosdi concentrates his practice on tax controversies and tax planning. Diosdi Ching & Liu, LLP represents clients in federal tax disputes and provides tax advice throughout the United States. Anthony Diosdi may be reached at 415.318.3990 or by email: Anthony Diosdi – 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.