Foreign Investment in U.S. Real Property
Complying with FIRPTA and Using 1031 Exchanges

By Bert J. Zarb

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The purpose of FIRPTA is to impose an income tax on the gains made by foreign persons upon disposition of real property situated in the United States. The FIRPTA tax is generally imposed on any U.S real property interest, which includes U.S. real estate owned directly by foreign persons, as well as shares owned by a foreign person in a U.S. corporation that owns substantial U.S. real estate (referred to as a U.S. real property holding corporation).

This article discusses basics that need to be considered when advising foreign clients who are planning to dispose of their U.S. real property and must comply with the provisions of FIRPTA.

Foreign Investment in Real Property Tax Act

The United States generally has no jurisdiction to tax foreign persons on capital gains that are sourced within the United States, unless those gains are “effectively connected with a U.S. trade or business.” Under IRC section 897 (FIRPTA) rules, any gain realized by a foreign person upon the disposition of a U.S. real property interest (USRPI) is treated as being effectively connected with a U.S. trade or business. Such a gain is deemed to be a long-term capital gain, and it is subject to U.S. federal income tax at the graduated tax rates that apply to U.S. individuals. This contrasts sharply with the flat 30% tax rate (unless reduced by treaty) that the U.S. imposes, through the withholding procedure, on the U.S. source income of foreign persons that is not effectively connected with a U.S. trade or business. Income that is not effectively connected with a U.S. trade or business includes interest, dividends, rents, royalties, premiums, the income portion of annuities, prizes, awards, alimony, gambling income, and other “fixed or determinable, annual or periodical” income.

Before going further, it is important to determine what constitutes a USRPI. IRC section 897 (c)(1)(A) defines it as:

• A direct interest in real property (i.e., land, buildings, mines, wells, crops, or timber) located in the U.S.; and
• An interest (other than an interest solely as a creditor) in any domestic corporation that constitutes a U.S. real property holding corporation (USRPHC).

A USRPHC is a corporation whose USRPIs make up at least 50% of the total value of its real property interests and business assets. In certain circumstances, under IRC section 897(g) and Temporary Treasury Regulations section 1.897-7T, an interest in a partnership may also be considered to be a USRPI to the extent that the partnership owns USRPI.

According to Treasury Regulations section 1.897-1(d)(2)(i), “an interest other than an interest solely as a creditor” is expanded to include “any direct or indirect right to share in the appreciation in the value [of], or in the gross or net proceeds or profits generated by, the real property.” The regulations further stipulate 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 the 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.”

IRC section 897(h)(2) provides that if stock is held in a real estate investment trust (REIT), it is not considered to be a USRPI if the REIT is controlled by U.S. persons at all times during the year. Typically, REITs are trusts or corporations that invest primarily in real estate equity and debt instruments. Under the de minimis rules of IRC section 897(c)(3), in the case of publicly traded stock, a USRPI generally does not exist where a shareholder, directly or constructively, owns no more than 5% of a company’s regularly traded stock.

Therefore, the mere fact that a foreign person owns USRPI does not trigger any negative tax consequences under IRC section 897. Tax consequences occur only when that foreign person disposes of the USRPI. Conspicuous by its absence under IRC section 897 is a definition of “disposition.” The definition is afforded by the Treasury Regulations, where the term includes “any transfer that would constitute a disposition by the transferor for any purpose of the Internal Revenue Code and regulations thereunder”; that is, sales; gifts where liabilities exceed adjusted-basis; like-kind exchanges; changes in interest in a partnership, trust, or estate; corporate reorganizations, mergers, liquidations, foreclosures, and inventory conversions; and distributions of and contribution to capital.

If a non–U.S. individual or corporation holds real property for longer than 12 months, the net gain from the subsequent sale is taxed at the long-term capital gains rate, currently 15%. In the case of a corporation, any long-term capital gain is taxed at between 15% and 35%, because there is no distinction between corporate capital gains and ordinary income.

FIRPTA creates a withholding mechanism under which the buyer (transferee) of any U.S. property purchased from a foreign person must withhold 10% of the purchase price at closing and remit it to the IRS within 20 days, instead of paying the full amount to the foreign seller. Form 8288, U.S. Withholding Tax Return for Dispositions by Foreign Persons of U.S. Real Property Interests, is used. It also serves as the transmittal form for copies A and B of Form 8288-A, Statement of Withholding on Dispositions by Foreign Persons of U.S. Real Property Interests. Form 8288-A must be prepared for each person for whom tax has been withheld. Copy B of Form 8288-A is retained by the withholding agent. The IRS will send a stamped Copy B of Form 8288-A back to the person subject to withholding, who can attach it to the U.S. tax return to receive credit for any tax withheld.

The 10% withholding applies to the amount realized, irrespective of the seller’s gain on the sale of the U.S. real property. The amount realized is usually the sales price and includes the cash paid to the seller, the fair market value of any other property transferred by the buyer to the seller, and the outstanding amount of any liabilities assumed by the transferee. This withheld tax is treated as an advance payment against the actual individual or corporate capital-gains taxes discussed above.

Note that the 10% withholding is not the amount of tax actually due. It is simply an advance payment made at closing, and applied toward the foreign seller’s U.S income tax obligation arising from the sale of the U.S. property. In this case, the foreign seller must file a U.S. income tax return for the year in which the property was sold. This return will show the gain derived from the disposition of the sale of the property and the amount of U.S. income tax due on the gain. The amount of the foreign seller’s final U.S. tax obligation, or refund, is determined by crediting the withheld tax against the amount of income tax shown on the return. Additionally, some states, such as Hawaii, California, and Colorado, also have a withholding tax on sales of real estate located within their borders.

Exceptions to the Withholding Requirement

There are some notable exceptions to the FIRPTA withholding provisions of IRC section 1445. Upon proof that the seller is not a foreign person, the 10% withholding requirement does not apply. If the seller or the buyer obtains a withholding certificate from the IRS stating that the seller is entitled to a reduced or zero withholding amount, or has provided adequate security or made other arrangements for the payment of tax with the IRS, then section 1445 does not apply. In this case, the seller must submit Form 8288-B, Application for Withholding Certificate for Dispositions by Foreign Persons of U.S. Real Property Interests, to the IRS. If the USRPI sold consists of shares of a domestic corporation (USRPHC) that are regularly traded on a stock exchange, then the FIRPTA withholding provisions would not apply either.

Should the purchaser plan to use the real property as a residence (not necessarily as a principal residence) for at least 50% of the number of days that the property is to be used during each of the first two 12-month periods following the date of sale, and the purchase price is not more than $300,000, then the 10% FIRPTA withholding obligation does not apply either.

A foreign corporation that disposes of a USRPI can avoid the 10% FIRPTA withholding if it elects to be treated as a domestic corporation for withholding-tax purposes. This would be beneficial to the foreign corporation if its corporate income tax liability from the sale of the USRPI would be less than the 10% withholding. Any corporation tax due is thus deferred until the next regular payment of estimated corporate income tax.

When ascertaining whether the provisions of FIRPTA apply to a foreign person, it is crucial to determine who is a foreign person for income tax purposes. Under IRC section 7701(b), a nonresident alien, for federal tax purposes, is defined as an individual who is neither a U.S. citizen nor a U.S. resident. In order to be considered a U.S. resident, an alien individual must meet either of two tests under section 7701(b), commonly referred to as the “green card test” and the “substantial presence test.”

An individual satisfies the green card test if legally admitted into the United States as a permanent resident. Once an individual obtains a green card, she is treated in the same way as a U.S. citizen for federal income tax purposes and is taxed on her worldwide income. A foreign person generally meets the substantial presence test (and is thus treated as a resident alien) if physically present in the United States for at least 31 days during a calendar year, and if the sum of the number of days physically spent in the United States in the current year, plus one-third of the number of days physically spent in the United States during the preceding calendar year, plus one-sixth of the number of days physically spent in the United States during the second preceding calendar year, is equal to 183 days or more. A foreign person who meets the substantial presence test is taxed on worldwide income in the same way as a U.S. citizen.

Corporations are deemed to be “foreign” if they are not incorporated in the United States. There are complex rules for other types of entities, as there are different rules for eligible foreign entities that file the “check-the-box” election.

IRC Section 1031 Exchange

One strategy that may be used by a foreign investor when disposing of U.S. real property is an IRC section 1031 exchange.

An IRC section 1031 exchange defers the payment of capital gains tax that is otherwise due upon the sale of business or investment property. This type of exchange does not eliminate taxes entirely; it just defers them, giving the owner the opportunity to use this amount in the business. In a 1031 exchange, the owner of business or investment property typically sells the property and is required to use the proceeds to acquire replacement property within 180 days from the date of sale. If the replacement property is acquired before the expiration of this 180-day period, then any capital gains tax that would have been due on the sale is deferred, generally until the eventual sale of the replacement property. To fully defer all capital gains tax, the replacement property should be of equal or greater value than the property sold.

In order to benefit from the deferment of taxes, the IRS stipulates that the owner cannot have any direct or indirect control over the proceeds from the sale of the first property until the purchase of the replacement property. Anything received directly, or indirectly, by the seller, no matter how insignificant, disqualifies the entire transaction and results in the imposition of FIRPTA withholding and recognition of the entire gain. This problem is solved by appointing a “qualified intermediary,” such as a bank, to hold the sales proceeds. Most business or investment property—e.g., land, office buildings, apartments, and other real property—qualifies for a 1031 exchange.

Therefore, to successfully complete a 1031 exchange, the first step would be to enter into an agreement with a “qualified intermediary” (i.e., not a family member, personal accountant, or lawyer, but a truly independent third party). Once this agreement is in place, then the sale of the business or investment property is made and the proceeds are immediately deposited in full with the qualified intermediary. The IRS rules then stipulate a 45-day period, starting from the sale date, within which a list of potential replacement properties are to be drawn up. The replacement property must be acquired from the 45-day list within 180 days of the sale of the property, using the funds deposited with the qualified intermediary. These deadlines are strictly implemented and are not extended by holidays or weekends.

A foreign seller is entitled to defer recognizing a gain on the sale of real property by exchanging it for another real property, provided the provisions of IRC section 1031 are complied with. If the exchange qualifies under U.S. law, then the recognition of the gain is deferred and no FIRPTA income or withholding tax will be due on the transaction.

Therefore, the foreign seller must ensure that:

• The replacement property is located within the United States;
• The qualified intermediary is provided, within 45 calendar days from the date of disposition of the first property, with a list of properties that the foreign seller may wish to buy;
• A replacement property identified on the 45-day list is purchased within 180 days from the date of the close of the sale of the old property;
• Title to the new property is taken in exactly the same legal name in which the seller owned the old property;
• The price of the new property is equal to or greater than the sale price of the old property;
• All cash from the sale of the old property, less closing costs and liabilities, is deposited in full with the qualified intermediary and used for the purchase of the new property; and
• The title or closing company is furnished with either a withholding certificate issued by the IRS that permits the transferee to avoid withholding any tax, or a notice that certifies that the seller has applied for a withholding certificate.

Other Considerations

The sale of U.S. property by foreign persons triggers tax obligations for both the seller and the buyer. Strict withholding requirements exist on the part of the buyer of U.S. real property sold by a non–U.S. person, and the filing of a U.S. tax return by the non–U.S. seller. Foreign owners of U.S. real property could avail themselves of several planning techniques to mitigate the effects of the FIRPTA requirements. One such strategy involves a carefully planned IRC section 1031 exchange.

A foreign person who owns U.S. real property may be exposed to legal liability unless the U.S. property is owned through a limited liability company (LLC). A more insidious issue is the fact that a foreign person could be exposed to U.S. estate tax [IRC section 2103; Treasury Regulations section 20.2104-1(a)(1)] as well as U.S. gift taxes if the real property is gifted inter vivos [IRC section 2511 (a); Treasury Regulations section 25.2511-1(b)]. Moreover, ownership of U.S. real estate does not afford the anonymity that a foreign person might desire. Several business and legal transactions usually require the disclosure of personal information, such as names, addresses, and some form of identification. There is also the possibility that the disposal of a USRPI may expose the foreign person to the provisions of the alternative minimum tax (AMT).

©2009 The New York State Society of CPAs. Legal Notices