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U.S. Tax and Transactional Issues Relevant to Foreign Owners of U.S. Real Estate and Parties to the Sale Thereof; PART II – What are the U.S. Tax Implications?

U.S. Tax and Transactional Issues Relevant to Foreign Owners of U.S. Real Estate and Parties to the Sale Thereof; PART II – What are the U.S. Tax Implications?

PART II — What are the U.S. Tax Implications?

Prospective foreign purchasers of real estate situated in the U.S. should pay careful attention to the U.S. tax ramifications of their acquisition. In particular, the manner in which rental income or sale proceeds are taxed, the impact of repatriation of those profits, and transfer tax consequences, e.g., taxes on the transfer of property to heirs, warrant special consideration.  In addition, there is a somewhat onerous tax withholding requirement imposed on buyers when U.S. real estate is acquired from sellers who are foreign persons, which withholding requirement is elaborated on in Part I of this article.

In many ways the tax consequences of the ownership of U.S. real estate hinge upon the manner in which the real estate is held, i.e., titled in the individual name of the foreign person or owned indirectly by the foreign person through some form of business entity or trust. In addition, the U.S. taxation of foreign persons may be modified by an applicable bi-lateral treaty between the applicable foreign jurisdiction and the U.S.

Depending on the manner in which the foreign person owns the real estate, tax planning in this area generally implicates a combination of some or all of the following goals:

  1. An attempt to minimize taxation of operating income;
  2. The avoidance of a double tax on corporate profits;
  3. To ensure sale proceeds qualify for long-term capital gains tax treatment;
  4. The avoidance of transfer taxes, e.g., estate and gift taxes;
  5. An attempt to minimize withholding;
  6. To avoid taxation of the same income by both the U.S. and foreign tax authority; and
  7. An attempt to minimize tax reporting in the U.S.

In most cases it is impossible to achieve all of these objectives, so the planning needs to be specifically tailored to the particular facts and circumstances of each case.

For example, if a foreign person owns U.S. real estate directly in his or her individual capacity, then the gross rental income attributable to such real estate is subject to a flat 30% tax via withholding unless the foreign person elects “net basis” taxation, in which latter case the graduated income tax rate brackets for individuals apply (up to 39.6%) to net rental income taking account of certain expense deductions allowable depending on the use of the property (personal or business).  If the U.S. real estate is held by the foreign person for more than one year, then the long-term capital gains tax rate (20%) is applicable to the gain on sale. In the case of personal use property, the foreign person and family members can enjoy the use of the property without imputation of rental income but if the “net basis” election is made then deductions are limited to real property taxes and qualified mortgage interest. The big disadvantages of direct ownership by a foreign person are (i) exposure to U.S. estate tax (applies at 40%) in the event of the death of the foreign owner; (ii) that a gift of U.S. real estate by a foreign person is subject to U.S. gift tax without the benefit of the lifetime gift tax exemption available to U.S. persons; and (iii) to ensure the collection of U.S. tax upon the sale of the U.S. real estate, the foreign owner will be exposed to the Foreign Investment in Real Property Tax Act (“FIRPTA”), which, subject to certain exceptions discussed in Part I of this article, requires the buyer to withhold an amount generally equal to 10% of the gross sale price at closing (“FIRPTA Withholding”).

By way of comparison, if a foreign person owns U.S. real property through a foreign corporation, then both U.S. estate tax and U.S. gift tax can be avoided.  This structure also provides the advantages of limited liability and anonymity for the foreign shareholder(s). If shareholders or officers of the corporation will enjoy ‘personal use’ of the U.S. real estate, then a major disadvantage of this structure is the imputation of rental income to such persons; that is, unless the foreign corporation charges fair market value rent to such persons, such rent is imputed to the corporation and will trigger income tax. Another major disadvantage is exposure to the “branch profits tax”, subject to potential reduction via bi-lateral treaty. In lieu of withholding on dividends paid by the foreign corporation that owns the U.S. real estate to its beneficial owners that are foreign persons, the “branch profits tax” imposes a 30% tax on the operating profits of the foreign corporation attributable to the operations of its U.S. real estate that are “deemed” for this purpose to be repatriated to the applicable foreign country. It is important to note that this 30% “branch profit tax” is in addition to the corporate tax on the foreign corporation’s earnings in the U.S. (15% to 35% on net rental income or 30% on gross rental income via withholding by lessee), potentially resulting in an effective tax rate up to 54.5%.  Gain on the sale of U.S. real estate by a foreign corporation is taxable at a 35% rate, and FIRPTA Withholding is required. Thus, if income from the U.S. real estate is expected to be significant and there is no relief available from a bi-lateral treaty then this structure may not be the most attractive option.

There are additional alternative ownership structures that can be utilized, including (i) ownership through a U.S. corporation owned by a foreign corporation; or (ii) ownership through a partnership (U.S. or foreign) or a limited liability company taxed as a partnership; or (iii) ownership though a trust (U.S. or foreign trust, grantor or non-grantor trust).  Again, all of these structures are designed to achieve as many of the above-enumerated planning goals as possible, and the optimal structure always depends on the facts and circumstances of the particular case; that is, there is no ‘one size fits all’ structure.

At the end of the day, foreign persons intent on acquiring U.S. real estate should consult with tax advisors with knowledge of the legion of complex tax rules that confront the foreign owner of U.S. real estate. The failure to do so could easily result in dramatically higher than anticipated tax rates, an inadvertent but costly failure to comply with U.S. tax reporting and compliance rules, and exposure to U.S. transfer taxes as a result of the untimely death of a foreign owner or a gift of the U.S. real estate without proper planning. If you would like to discuss any of these issues, please feel free to contact our firm and we will be happy to evaluate your options.

U.S. Tax and Transactional Issues Relevant to Foreign Owners of U.S. Real Estate and Parties to the Sale Thereof; PART I – Foreign Owner Transfer of a U.S. Real Property Interest

U.S. Tax and Transactional Issues Relevant to Foreign Owners of U.S. Real Estate and Parties to the Sale Thereof; PART I – Foreign Owner Transfer of a U.S. Real Property Interest

PART I – Heightened Interest in Tax Implications of Foreign Owner Transfer of a U.S. Real Property Interest

The number of foreign persons investing in U.S. real estate has continued to rise in recent years. The National Association of Realtors reports that foreign buyers purchased more than 104 billion dollars in U.S. real property from March 2014 to April 2015.  Florida was named the state most favored by foreign buyers, garnering twenty-one percent (21%) of the total purchases made by foreign buyers. This trend spotlights the importance of the Foreign Investment in Real Property Tax Act of 1980, I.R.C. § 1445, more commonly known as FIRPTA.  Also, recent changes to FIRPTA made in December, 2015, resulting from the Protecting Americans from Tax Hikes Act, mean the amount of taxes to be withheld on certain transfers of a U.S. real property interest by foreign nationals has increased.

FIRPTA was enacted, in part, to ensure that foreign sellers pay taxes on the sale of a U.S. real property interest.  Under FIRPTA, all sellers of a U.S. real property interest (considered to be transferors) are presumed to be foreign and the burden of proving otherwise is placed squarely on the shoulders of the property buyer. Buyers of a U.S. real property interest, considered to be transferees and withholding agents by the Internal Revenue Services (IRS) for purposes of FIRPTA, must withhold and remit taxes to the IRS in the amount equal to fifteen percent (15%) of the amount realized from the sale of real property (usually the contract price) in order to be protected from any tax liability which the seller fails to satisfy to the IRS.

As the withholding agent, the buyer/transferee is required to remit the tax withheld from the amount realized on the sale to the IRS within twenty (20) days of the property transfer utilizing the appropriate IRS forms which require that the seller/transferor has a U.S. tax identification number. The foreign transferor can have the amount to be withheld reduced if it applies, no later than the day of closing, for a withholding certificate and demonstrates the existence of certain conditions meriting a reduction in the amount of taxes due on the property transfer.

The buyer/transferee is relieved of the withholding requirement if the seller/transferor gives the buyer a certification, signed under penalties of perjury, that the seller/transferor is not a foreign person.  The certification is required to contain the seller/transferor’s name and address, and tax identification number. The buyer can only rely on this certification if the buyer has not been provided with a notice or does not otherwise have actual knowledge that the seller/transferor is a foreign person.

In a buy-sell transaction of a residence for $300,000.00 or less involving a foreign seller/transferor, a buyer is not required to withhold and remit taxes to the IRS if the buyer is an individual and is willing to sign an affidavit stating that the buyer or a member of the buyer’s family will be occupying the purchased residence for at least fifty percent (50%) of the time that the purchased residence is occupied during the first two (2) twelve (12) month periods following the transfer. When the amount realized on the transaction exceeds $300,000.00 but is less than $1,000,000.00, and the buyer, who is an individual, is willing to sign an affidavit stating that the buyer or a member of the buyer’s family will be occupying the purchased residence for at least fifty percent (50%) of the time that the purchased residence will be occupied during the first two (2) twelve (12) month periods following the transfer, then ten percent (10%) of the amount realized must be withheld.  These exceptions to the withholding requirement can benefit the foreign seller because funds will not be withheld from the sales proceeds in an amount up to fifteen percent (15%) of the amount realized; however, they can result in exposing the buyer to liability for taxes, penalties, and interest owed by the foreign seller to the IRS resulting from the sale of the residence.

The withholding rate remains at fifteen percent (15%) when the amount realized is greater than $1,000,000.00 regardless of the use of the property. Likewise, the fifteen percent (15%) withholding rate applies when the buyer is not an individual or when the property will not be utilized by an individual buyer as a residence.

FIRPTA does not apply only to transactions involving residential property; rather, it includes any real property located in the U.S. or the U.S. Virgin Islands, personal property associated with the use of real property, and interests in a mine, well, growing crops, timber or other natural deposits, as well as rents paid to a foreign person (note: withholding rules governing rental payments made to a foreign person are beyond the scope of this article). A foreign person includes non-resident alien individuals, as well as partnerships, trusts, estates, and (certain) corporations and limited liability companies domiciled outside of the United States.  And, whether involving individuals or entities, FIRPTA applies to real property transfers including, but not limited to gifts, sales, exchanges, redemptions and transfers.

Since seller/transferors are presumed foreign, and it is the buyer/transferee’s burden in a transaction involving the transfer of a U.S. real property interest to prove otherwise, or to be saddled with potential tax liabilities related to the disposition of U.S. real property by a foreign transferor, buyers or transferees (other than certain U.S. governmental entities) are advised to seek legal counsel if the seller/transferor is unable to produce the certification described above attesting that it is not a foreign person.