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

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

By Anthony Diosdi

When a U.S. income tax nonresident alien (“NRA”) or a foreign corporation (hereinafter 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 the 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 were engaged in a U.S. trade or business during the taxable year, and as if such gain or loss were 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 equal 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. estate tax avoidance where the foreign taxpayer is domiciled in a jurisdiction which has a tax treaty with the U.S. which 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. tax purposes.

Regardless of the non-recognition treatment 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 copy of the 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 15 percent withholding that was due when the original transaction occurred.

For example, suppose an NRA has investment land in the United States worth $1 million and the NRA exchanges the investment land for like-kind investment land having a similar value. Even if the NRA would have recognized gain if it had sold its investment land (assuming, if instance, the NRA had a tax basis in the land of less than $1 million), the like-kind exchange will result in non-recognition treatment to the NRA. The same result would follow if the NRA 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 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 tax is or is not due as a result of the non-recognition provisions.

The “unwary” Foreign Taxpayer sometimes assumes that because a non-recognition transaction results in no U.S. income tax, nothing additional must be done. These Foreign Taxpayers could be in for a very unpleasant surprise when they are assessed an interest charge on the failure to withhold 15 percent in the absence of properly following the non-recognition statement procedures. If you are a Foreign Taxpayer and own a USRPI and are considering selling or exchanging the USRPI, you should consult with a competent international tax attorney.

We provide international compliance assistance and international tax planning services to domestic corporations. We also assist other tax professionals who need guidance regarding international tax compliance matters.

Anthony Diosdi is a partner and attorney at Diosdi Ching & Liu, LLP, located in San Francisco, California. Diosdi Ching & Liu, LLP also has offices in Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in tax matters domestically and internationally throughout the United States, Asia, Europe, Australia, Canada, and South America. Anthony Diosdi may be reached at (415) 318-3990 or by email: 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.