United States: U.S. Taxation of Foreign Investment in U.S. Real Estate

Investments in U.S. real estate by non-U.S. residents have increased in recent years due to lower interest rates and reduced tax rates on capital gains. The tax treatment of non-residents buying and selling U.S. real property is different in significant ways from the usual tax treatment of non-residents investing in or conducting business in the United States. This article discusses: (i) the general U.S. tax rules that apply to non-residents investing in the United States, (ii) how the Foreign Investments in Real Property Tax Act affects the tax treatment of investments in real estate, and (iii) the available structures for non-U.S. investors buying and selling U.S. real estate.

The U.S. tax treatment of a foreign citizen depends on whether the non-U.S. investor is a resident or a non-resident of the United States. A foreign citizen who is resident in the United States is taxed on worldwide income similar to a U.S. citizen. When computing taxable income, a resident is generally entitled to claim the same deductions and personal exemptions available to a U.S. citizen. By contrast, a non-resident generally is taxed only on his or her income from U.S. sources and is entitled only to limited deductions.

A U.S. "resident" is defined as a foreign citizen who meets either of two tests: (i) the lawful permanent resident test, or (ii) the substantial presence test. A foreign citizen who is a lawful permanent resident under U.S. immigration laws is considered a resident for U.S. income tax purposes. Under the substantial presence test, a foreign citizen will be considered a resident for tax purposes if:

(a) The foreign citizen is physically present in the United States for at least 31 days during the current calendar year, and

(b) The sum of the number of days of presence during the current calendar year, plus one-third of the days in the United States during the first preceding calendar year, plus one-sixth of the days in the United States during the second preceding calendar year, equals or exceeds 183 days.

Effectively Connected Income. If a non-resident is engaged in a U.S. business, all items of income which are effectively connected with such business ("effectively connected income" or "ECI"), less deductions attributable to such income, are subject to federal income taxation at ordinary tax rates.

1. Effectively Connected Fixed Determinable, Annual or Periodical Income. ECI that is "fixed determinable, annual or periodical" ("FDAP") income, such as interest, dividends, rents, or royalties, earned by a non-U.S. investor or foreign corporation is subject to tax, with appropriate deductions, at ordinary rates. To avoid withholding on such income, a person conducting a U.S. trade or business will be required to file certain forms with withholding agents each year.

2. Non-Effectively Connected FDAP Income. Unless reduced by treaty, non-U.S. investors and foreign corporations are subject to a 30% withholding tax on most items of U.S. source FDAP income that is not ECI.

Capital Gains from Assets other than U.S. Real Estate.

A non-U.S. investor generally is not taxed on the sale of capital assets, i.e., assets acquired and held for investment or use in a business, unless the capital assets are U.S. business assets or real property interests.

Gains from the sale of capital assets are exempt from U.S. tax if the gains are foreign source. Any gains from the sale of real estate located outside the United States are considered to be foreign source. Sales of stock and other personal property generally are sourced by the residence of the seller. Thus, when a non-resident sells personal property, the resulting capital gain will be treated as foreign source income which is not subject to U.S. tax.

Unless the full tax was withheld at source, a non-resident individual or foreign corporation will be required to file a U.S. income tax return if the non-resident individual or foreign corporation had U.S.-source income or was engaged in a U.S. business.

The withholding tax rules enacted under the Foreign Investment in Real Property Tax Act ("FIRPTA") require the buyer of a U.S. real property interest ("USRPI") sold by a non-U.S. investor to withhold 10% from the gross selling price of the property.  The withholding tax is the mechanism for the IRS to collect taxes, but does not represent the final determination of the tax liability (discussed below).

There is a presumption that every seller is a foreign person subject to withholding tax unless proof to the contrary is provided to the buyer. Usually, the proof is furnished in the form of a "non-foreign certification" signed by the U.S. seller certifying that the seller is not a foreign person.

In certain situations, such as when the tax due on the transferor’s gain from the sale is less than the withholding, the non-U.S. seller may submit a Form 8288-B, "Application for Withholding Certificate for Disposition by Foreign Persons of U.S. Real Property Interests", to request a reduction or elimination of withholding on a transfer of the property. Publications from the Internal Revenue Service ("IRS") state that the IRS generally will act on a completed withholding certificate application within 90 days of the request. The regulations permit the seller to request an early refund of the amounts withheld if the request for an early refund is combined with an application for a withholding certificate.

USRPI. A U.S. real property interest ("USRPI") is:

The term USRPI does not include an interest in a domestically controlled real estate investment trust ("REIT"). A domestically controlled REIT means a REIT in which, at all times during the relevant testing period, less than 50% of the value of the REIT stock was held directly or indirectly by non-U.S. persons.

USRPHC. A domestic corporation will be considered a USRPHC if the fair market value of its USRPIs equals or exceeds 50% of the sum of its worldwide real property assets and any other assets used in its business. Shares of a corporation that are traded on an established securities market will not be a USRPI except with respect to a person who holds more than five percent of such class of stock.

Exceptions to FIRPTA Withholding Requirements. No withholding is required if:

Election to be Treated as Domestic Corporation. Generally when a non-U.S. investor disposes of a USRPI, the buyer must deduct and withhold tax equal to 10% of the gross amount realized on the disposition. In some circumstances, a foreign corporation that disposes of a USRPI may make an election to be treated as a domestic corporation for withholding tax purposes.

Upon making this election, the foreign corporation could avoid the 10% withholding on disposition of the USRPI. The foreign corporation would still be liable for corporate income tax on the disposition of the USRPI, but the corporate income tax may be less than the withholding 10% of the gross proceeds. The payment of the corporate tax would be deferred until the due date of a regular estimated corporate income tax payment.

Determining the Tax owed; Capital Gain Rates. As stated above, the withholding tax is the mechanism for the IRS to collect taxes, but does not represent the final determination of the amount of tax owed on a sale of the property by a non-U.S. investor. For property held for more than 12 months, a non-U.S. person, whether an individual or business entity, is taxed on its net gain from the sale of U.S. real property at long-term capital gain rates.

Assets held by an individual for more than 12 months are taxed at a maximum rate of 15% upon disposition. Assets held by a corporation are taxed at rates between 15-35% upon disposition. Currently, there is no rate differential for corporations between ordinary income and capital gains. The amount of tax withheld offsets the amount of tax that the non-U.S. investor actually owes on the sale of the property. If an individual owns and disposes of the property within 12 months of acquiring the property, the individual will be subject to tax at the higher ordinary tax rates.

Holding Period. The holding period for determining whether capital gain qualifies as long-term does not begin until title passes to the property, rather than merely making an earnest money contract payment. Such considerations should be taken into account if a non-U.S. investor is considering reselling the real estate shortly after acquiring it.

The choice for non-U.S. investors structuring investments in U.S. real estate is typically between direct ownership by an individual and ownership by a domestic or foreign corporation.  

Direct Ownership by Non-U.S. Investor. Upon the sale of long-term capital assets, a non-resident individual would pay U.S. income tax at a maximum rate of 15%. Direct ownership by an individual will not result in dividend withholding tax or BPT, because those taxes only apply to corporations.

The two disadvantages of direct ownership by an individual are: (i) the requirement that the non-U.S. investor file a U.S. income tax return, and (ii) the exposure to U.S. estate tax. The filing of a U.S. income tax return is something that some non-U.S. investors may be reluctant to do, even if the alternative structures result in a higher tax bill.

Ownership by Domestic Corporation. If the property were held by a domestic corporation the corporation's income, both rental income and gain from the sale of the property, would be subject to tax at a maximum rate of 35%. If the domestic corporation makes dividend distributions to its non-U.S. shareholders, a withholding tax at a rate of 30% would be imposed, unless reduced by treaty.

Ownership by Foreign Corporation. Non-U.S. investors may be attracted to foreign corporate structures to own U.S. real estate which allows them to avoid filing U.S. income tax returns individually, protects against the U.S. estate tax, and gives them anonymity. This structure may, however, come with a higher tax cost compared to owning U.S. real property directly as an individual.

If income producing property were held by a foreign corporation, its taxable income would be subject to a tax at ordinary corporate rates. Instead of a withholding tax on distribution, a branch profits tax ("BPT") at the rate of 30% would apply. The BPT is designed to equalize the U.S. tax treatment between a non-resident operating in the United States through a domestic corporation and a non-resident operating in the United States through a branch of a foreign corporation. Unlike the dividend withholding tax, the BPT applies regardless of whether earnings are distributed. Thus, the BPT could be imposed earlier than the withholding tax on dividends.

An interest in a foreign corporation is not a USRPI, regardless of how much U.S. real estate the corporation owns. The sale by a non-U.S. investor of shares in a foreign corporation that owns a USRPI is completely exempt from U.S. income taxation. The disadvantage of holding U.S. property in a foreign corporation is that it may be difficult to convince a buyer to purchase shares of the foreign corporation in order to acquire the underlying property. The buyer likely would be buying stock of the foreign corporation with a built-in U.S. tax liability and would probably insist on a reduced purchase price for the shares.

Holding U.S. property through a foreign corporation is more common when the property is expected to be owned by a family for multiple generations. Because no sale is anticipated for many years, the difficulty in finding a willing buyer would be put off to a later date.

Real Estate Business Activities. The ownership of U.S. real property by a non-U.S. investor by itself will not constitute the conduct of a business in the United States. If the real estate investment is not treated as a business, the gross rents paid to the non-resident owner would be subject to 30% withholding tax as non-ECI. Foreign corporations or non-residents may make an election to treat their U.S. income as ECI, and pay a tax on their net income at ordinary rates. This election would enable the investor to deduct its real estate business related expenses.

For U.S. estate tax purposes, the gross estate of a non-resident consists of all U.S. property in which the decedent had an interest at death. Direct ownership of U.S. assets, such as U.S. real estate or shares of a corporation organized in the United States, would subject the non-U.S. investor to U.S. estate taxes if the investor still owns such assets at the time of his or her death.

This article has not addressed any state taxes on the disposition of real property interests or state or federal payroll taxes related to employees in the real estate business. These issues should be addressed with your tax counsel before finalizing any transaction or implementing any business plan.

The best choice for structuring investment in U.S. real estate will depend on a number of factors and depend on the unique circumstances of each individual investor, but the complex tax rules in this area should always be included among the factors considered before finalizing any investment structure.

IRS CIRCULAR 230 DISCLOSURE: This communication has not been prepared as a formal legal opinion within the procedures described in Treasury Department Circular 230. The information in this article was not intended or written to be used, and it cannot be used by the taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.