Taxes on Foreign Investors in U.S. Real Estate Can Be Burdensome, But There Are Still Planning Opportunities
August 18, 2015
From a U.S. federal income tax perspective, the main cost facing non-U.S. persons who invest in U.S. real estate is the Foreign Investment in Real Property Tax Act (“FIRPTA”), which is embodied in the tax code primarily under IRC §897. Under this provision, any gain recognized by a foreign person on the disposition of a “United States real property interest” (“USRPI”) will be treated as if such gain were effectively connected with a U.S. trade or business and, therefore, subject to U.S. federal income tax at the graduated rates that apply to U.S. taxpayers. Additionally, when §897 may apply, the purchaser of a USRPI typically is required to withhold and pay over to the IRS 10% of the purchase price (including liabilities assumed) under §1445 (see IRS Form 8288). The requirement for purchasers of U.S. real property interests to document non-withholding positions, via advance certification by the sellers, in situations where the FIRPTA rules appear not to apply, is frequently overlooked by unadvised taxpayers.
Extensive Applicability of FIRPTA
USRPIs include both direct and indirect interests in U.S. real property. For example, a domestic corporation that holds substantial U.S. real property interests is a “United States real property holding corporation” (“USRPHC”). Applicable regulations clarify that a USRPI means “any interest, other than an interest solely as a creditor,” either in real property located in the U.S. or Virgin Islands, or in a domestic corporation unless it affirmatively establishes that it is not and was not a USRPHC.
Applicable regulations elaborate on the meaning of “an interest in real property 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.” Such regulations provide extensive descriptions of the interests in real property (other than interests solely as a creditor) treated as USRPIs, such as varieties of options, time-sharing arrangements, shared-appreciation arrangements, reversionary interests, life estates, and the list goes on and on. These regulations go 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 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.”
As extensively applicable as the FIRPTA rules may appear, the requirement for a purchaser of a U.S. real property interest to document a non-withholding position under §1445, by way of an advance certification of the seller’s U.S. residency, is even more broadly applicable.
Non-Owner Investors May Find a Few Opportunities
Investors who are averse to FIRPTA compliance requirements are not necessarily completely excluded from participating in the real estate investment market, but finding FIRPTA workarounds can be problematic, and would not be for the unadvised.
For example, an investment in a domestically controlled real estate investment trust (“REIT”) may not have to be treated as a USRPI. However, establishing that the REIT is domestically controlled requires less than 50% ownership of the REIT by non-U.S. persons over the five preceding years, and, according to the regulations, requires evaluation of the actual owners of the REIT during that period.
As another example, again not for the unadvised, some non-U.S. owners have taken the position that regularly scheduled payments of interest and principal in respect of shared-appreciation mortgages (“SAM”) may not be treated as giving rise to FIRPTA gain under the regulations. A technical example in the regulations appears to allow for this result by describing regularly scheduled payments on a SAM as not giving rise to FIRPTA gain. In the regulation’s example, 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 regulation’s example concludes that §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. Thus, the example concludes the receipt of the final appreciation payment that is tied to the value of the U.S. real property is not treated as a disposition of a USRPI for purposes of §897(a) because the amounts are considered to be interest and principal (rather than gain) for U.S. tax purposes, pursuant to the regulation’s example. 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 §897.
By characterizing the contingent payment in a SAM as interest and principal (and not as a disposition of a USRPI) for U.S. tax purposes, the §897 Regulations potentially allow non-U.S. taxpayers to avoid U.S. federal income tax on economic gains arising from U.S. real estate, if structured correctly.
Non-U.S. taxpayers generally are subject to a 30% withholding tax (unless reduced by treaty) on certain passive types of U.S. source income, including interest. An exception to this rule exists for “portfolio interest,” which is exempt from withholding tax in the U.S. The portfolio interest exemption, however, does not include certain “contingent interest.” For this purpose, a payment on a SAM that is otherwise treated as interest for U.S. federal income tax purposes will not qualify for the portfolio interest exemption if the payment is contingent on the appreciation of the financed real property. Accordingly, unless a treaty applies to reduce the withholding tax, the contingent-interest feature of a SAM would be subject to a 30% withholding tax in the U.S.
Under the interest and dividends articles of many U.S. tax treaties, all interest, including contingent interest, may qualify for reduced (or eliminated) rates of U.S. withholding tax, so long as the interest is not re-characterized as a dividend under U.S. tax law. As noted above, the FIRPTA regulations clearly indicate that contingent interest on a SAM will be respected as interest and will not be characterized as a dividend simply because of the contingent nature of the final payment. As a result, so long as the other requirements of the applicable tax treaty (including the “residence” and “limitations on benefits” articles) are satisfied, a non-U.S. investor lending money to a U.S. real estate venture may be able to participate in the upside of the venture without being subject to the FIRPTA provisions.
Of course, non-U.S. investors would not want to rely on the highly technical analysis above without the assistance of their own tax advisors to help review their particular facts and circumstances. It should also be noted that such investors will need to be made aware of potential U.S. estate and/or gift tax issues, because a debt instrument with a contingent interest feature may be treated as a U.S.-situated asset, and therefore may be subject to U.S. transfer taxes unless further planning were done.
Light at the End of the Tunnel?
In February of this year, the Senate Finance Committee unanimously approved a bill that primarily would modify the application of FIRPTA to foreign shareholders of REITs. The proposals under the bill were described in a Congressional Joint Committee on Taxation report released in the same month. Although the proposals would primarily impact REITs, the bill would, among other things, increase the 10% withholding tax under §1445 to 15%, create increased disclosure and reporting requirements for USRPHCs, and add withholding requirements for brokers.
In April of this year, the House moved forward with a companion bill, similar to that approved by the Senate Finance Committee, and will include a provision (like that supported by the Senate Finance Committee and the President) to eliminate the FIRPTA tax on foreign pension plans investing in U.S. real estate. The bill would also increase from 5% to 10% the maximum percentage that non-U.S. holders of interests in publicly traded REITs may hold and still qualify for exemption of REIT distributions and gain on sale of REIT stock from U.S. FIRPTA taxation. The draft bill also tightens the definition of “domestic control” for REITs. While many of these reform proposals (and certain revenue offsets) have been advanced in prior years, this year’s legislative action provides a sense of momentum.
In 2010, proposed legislation would have provided that certain interests in USRPHCs would not be considered USRPIs and would not be subject to FIRPTA. While the proposals demonstrate continuing bipartisan legislative commitment to reforming FIRPTA and attracting additional foreign capital to the US real estate market, significant time has passed without legislation being enacted in this area. As a result, it may be too early to count on final passage of some of the more significant relieving measures described above. Unless and until such relieving legislation is enacted, it will behoove non-U.S. persons and their advisors to remain mindful of FIRPTA, since the compliance requirements continue to be onerous and detailed advice continues to be required.
Whenever the FIRPTA rules may apply, the purchaser of a USRPI typically is required to withhold and pay over to the IRS 10% of the purchase price (including liabilities assumed) under §1445. The discussion above highlights the extensive applicability of FIRPTA, and the requirement for documenting a non-withholding position under §1445, by way of an advance certification of the seller’s U.S. residency, is even more broadly applicable.