Tax Aspects of Foreign Investment In U.S. Real Estate

December 16, 2011Articles The Legal Intelligencer

Foreign investment in U.S. real property has increased in recent years, driven, in part, by the weakness of the U.S. dollar, low interest rates and the deflation of previously high property valuations. Before making a substantial investment in U.S. real property, however, foreign persons should fully consider the U.S. tax consequences of their investment, including those that arise when property is sold and the proceeds are repatriated overseas.

For many individual foreign investors, the desired ownership structure is to employ the use of a foreign corporation, generally one that is organized in a low-tax or tax-haven jurisdiction, to hold title to the U.S. real property. While this strategy may provide estate tax benefits for nondomiciliary individuals who would otherwise be subject to U.S. estate tax if they directly owned U.S. real property at death, a closer evaluation should be made weighing the income tax benefits of various ownership structures versus potential adverse estate tax consequences. Of course, an applicable income or estate tax treaty may have substantial influence on the ultimate form of ownership selected.

In contrast to individual nonresident aliens investing in U.S. real property, foreign business organizations frequently evaluate whether to make an investment through the formation of a wholly owned U.S. corporate subsidiary or through a U.S. partnership, the interests of which are held through a wholly owned U.S. subsidiary of the foreign entity. The use of a U.S. corporate subsidiary, even if the subsidiary is owned through a U.S. partnership, prevents a foreign investor from being deemed as engaged in a U.S. trade or business. This mitigates exposing the foreign business venture to additional U.S. income tax on business operations conducted from within the United States. The use of a U.S. corporation also avoids the imposition of the branch profits tax under Section 884 of the Internal Revenue Code on U.S. sourced income (subject to treaty override).

The reach of U.S. income taxation extends to both U.S. citizens and residents on a worldwide basis, and to nonresident, noncitizens to the extent of their U.S. source income. Because foreign persons are subject to a different taxing regime than U.S. persons, it must first be determined whether a person is a U.S. person under U.S. domestic tax law principles. U.S. persons include citizens and residents, as specifically defined, of the United States, as well as domestic corporations and partnerships (domestic corporations and partnerships, including entities taxed as partnerships, are those that are organized under U.S. laws). Thus, foreign persons would be nondomestic corporations and partnerships as well as individuals who are not U.S. citizens or residents.

Unless foreign persons are engaged in a "U.S. trade or business" (which is not specifically defined in the code or the regulations), the tax rate applicable to the foregoing income types, other than income associated with the disposition of a U.S. real property interest, is 30 percent. Where a foreign person is treated as engaged in a U.S. trade or business, income attributable to that activity is subject to the graduated income tax rates for U.S. residents and corporations, as the case may be.

Whether a foreign person's investment in U.S. real property constitutes a U.S. trade or business is a factual determination based on the extent, continuity and substantial nature of the activity. To be a trade or business, an activity must be engaged in for profit and with some regularity and continuity, even if not by the taxpayer personally. In contrast, merely managing or preserving investment assets is not a trade or business activity even if engaged in for profit on a full-time basis. As the nature and scope of the activities grow, however, what may initially begin as merely a passive investment in the United States may later rise to the conduct of a U.S. trade or business.

Also, if a domestic or foreign partnership is engaged in a U.S. trade or business, each partner, including a foreign partner, is treated as engaging in the U.S. trade or business conducted by the partnership. A foreign person, in order to take advantage of cost recovery allowances and other deductions attributable to an investment in real property, including improvements, may file an election to treat the income as effectively connected with a U.S. trade or business.

The enactment of Code Section 897 in 1980 brought about a major shift in the treatment of foreign investors with U.S. real estate holdings. Before the enactment of the Foreign Investment in Real Property Tax Act of 1980, foreign investors in U.S. real property were able to avoid paying U.S. tax on gains realized on the disposition of property. The realized gains could escape taxation on the basis that the gain was neither "fixed or determinable annual or periodic income" nor effectively connected with a U.S. trade or business. Thus, prior to FIRPTA, a nonresident alien would be subject to U.S. income tax on capital gains from the disposition of U.S. real property interests, only if, for that year, the individual was present in the United States for at least 183 days or the gain was effectively connected with a U.S. trade or business. Moreover, capital gain from the sale of stock by a nonresident individual was not subject to U.S. income tax.

FIRPTA was designed to eliminate the disparity between the taxation of U.S. and foreign real estate investors with respect to U.S. real property interests. In an effort to remove what was perceived to be an unfair economic subsidy to many foreign investors by failing to tax gains realized on their disposition of U.S. real property interests, Congress leveled the playing field by enacting Code Section 897, which characterizes a nonresident's U.S. real property gains as being effectively connected. Even though a person, by application of the code or relevant tax treaty, is not a resident for U.S. income tax purposes, his or her gains, losses and income from interests in U.S. real property are nevertheless subject to U.S. taxation. More specifically, a foreign person's gain or loss from the disposition of a U.S. real property interest, as defined in Section 897(c) and the accompanying regulations, is treated as income that is effectively connected with a U.S. trade or business in which the foreign person is deemed to be engaged in during the year of disposition.

Section 897(a) provides that a nonresident alien's or foreign corporation's gain or loss on the disposition of a USRPI is deemed to be effectively connected with a trade or business carried on in the United States even if the property was a wholly passive investment of the taxpayer. The gain or loss is combined with income, gain or loss for the tax year from any business actually carried on by the taxpayer in this country and taxed are regular marginal rates applicable to an individual or a corporation.

Section 897's reach also extends to gain from the taxable dispositions of a domestic corporation's stock if a majority in value of the corporation's asset base over the recent period is composed of U.S. real property interests. In addition, Section 897 applies to gain on the sale of a foreign corporation's stock, but only if the corporation elects under Section 897(i) to be treated as a domestic corporation and the corporation owns U.S. real property.

In general, a USRPI is one of four classes of interests: (1) Any interest in real property (including an interest in a mine, well or other natural deposit) located in the United States or in the Virgin Islands; (2) an interest in a domestic corporation that is, or was, a U.S. real property holding corporation; (3) an interest in a foreign corporation that elects under Section 897(i) to be treated as a domestic corporation and that is or was a USRPHC; (4) a publicly traded interest in a partnership or trust held by a 5 percent owner. The term "real property" includes three types of property, including land, improvements, natural products unsevered from the land, etc.

An interest in a partnership, trust or estate is not a USRPI, but Section 897(g) applies a look-through rule for such pass-through entities. More particularly, Section 897(g) provides that under the regulations, any money and the value of any property received by a nonresident alien individual or foreign corporation in exchange for all or part of its interest in a partnership, trust or estate to the extent attributable to USRPIs, are taxable gain or loss under Section 897(a). Therefore, gain or loss is recognized upon partnership formation and only subsequent appreciation is taxed upon a disposition.

The current regulations apply only to partnerships that satisfy two requirements: (1) At least 50 percent of the value of the partnership's gross assets must, directly or indirectly, be composed of USRPIs; and (2) at least 90 percent of the value of the partnership's gross assets, again, directly or indirectly, must be composed of USRPIs plus cash or cash equivalents. In such a case, the interest in the partnership is treated as a USRPI but only to the extent that the gain on the disposition is attributable to U.S. real property interests (and not cash or cash equivalents, or other property).

Careful thought and consideration of various tax issues, both income and transfer tax, must be taken into account in advising nonresident clients on one or more preferred methods for owning real property in the United States. Part of the planning environment must include consideration of the nonresident's tax residence and whether such jurisdiction has a tax treaty with the United States. Consideration must go into the initial acquisition and funding, property operations and the anticipated sell-off stage. Also factored may be a nonresident's exposure to U.S. estate tax were he or she to die holding an ownership position in a USRPI.

Reprinted with permission from the December 16 issue of The Legal Intelligencer. (c) 2011 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.