Business & Property Law

U.S. TAX IMPLICATIONS OF FOREIGN INVESTMENT IN U.S. REAL ESTATE

There are several different reasons why non-U.S. citizens might want to “own” real estate in the U.S.

First, an individual may want to own real property in the U.S. for personal and/or recreational purposes. Many non-U.S. citizens own homes in California and throughout the U.S. (either directly as individuals or indirectly through domestic or foreign entities).

Second, ownership in U.S. real estate may satisfy specific business objectives of a foreign company. For instance, a foreign company that exports goods to the U.S. may want to develop a distribution and/or warehousing network in the U.S. Also, a company may want to open a sales office (or offices) in the U.S. to help market its goods or services in the U.S. or other parts of North America.

If a non-U.S. citizen owns U.S. real estate, the method by which the real estate is owned is very important. For instance, a non-U.S. citizen (whether he or she resides in the U.S.) probably wants to avoid paying any U.S. estate tax upon his or her death to the extent possible. The U.S. has a tax known as the estate tax imposed upon the entire “taxable estate” 2 of an individual upon his or her death. This type of tax, which is a type of “death” tax like an inheritance tax, does not exist in many countries. The estate tax is discussed in more detail in another presentation, but it should be noted that a foreign citizen who owns real estate directly as an individual (as opposed to a foreign corporation owning the real estate) will be subject to the U.S. estate tax upon his or her death. The current estate tax rates range from 18 percent to *50 percent. These highest rates were modestly reduced from 55 percent beginning in 2002. The “taxable estate” of nonresidents who are not domiciled in the U.S. includes property situated within the United States. Property situated in the U.S. includes, among other things, U.S. real estate, most personal property physically located in the U.S., certain debt obligations, and stock in a U.S. Corporation.

A foreign investor should carefully plan for the tax consequences of U.S. real estate investments because of the complex legal framework of foreign real estate investments. Foreign investors should consider several important factors before investing, acquiring, or selling U.S. real estate. The following is a list of some of these considerations:

Although the definition of “real property” for purposes of a USRPI is expansive, a so-called “pure creditors’ interest” is not deemed a USRPI. A pure debt interest in U.S. real estate such as a mortgage (which is an example of a debt interest) does not create a USRPI. Instead, the foreign lender who takes a mortgage against the U.S. real estate would be subject to a withholding tax on the interest income received unless the loan is structured as portfolio interest. Therefore, debt “investments” in real estate might provide a more desirable means by which a foreign investor can invest in U.S. real estate to avoid any FIRPTA taxes. A pure creditor also has significantly fewer reporting obligations to the IRS. Also, the FIRPTA tax may be avoided by creatively structuring other types of debtor/creditor relationships.

The exact investment arrangement should be carefully planned. If a foreign investor were to take a disguised “equity” ownership interest (as opposed to a pure creditor’s interest or other non-USRPI), then the IRS might take the position that the gains derived by the foreign investor should be subject to the FIRPTA tax.

RATE OF TAX ON DISPOSITION OF USRPI

If a resident alien individual disposes of a USRPI, then he or she probably would be subject to a 15 percent tax rate (assuming the property was a capital asset in the hands of the foreign resident). This lower tax rate applies pursuant to the Jobs and Growth Tax Relief Reconciliation Act of 2003, by which the highest long term capital gains rate was reduced from 20 percent to 15 percent. If the real estate was not a “capital asset,” then the tax rate could be between 12 percent and **35 percent.15 A USRPHC that disposes of a USRPI will be subject to graduated tax rates upon the disposition, which may include tax rates at the highest marginal corporate rate of 35 percent.

There are other business forms which should be considered before acquiring real estate in the U.S. For instance, there are some benefits that can be obtained if a limited liability company owns the real estate, depending upon the type of real estate and the objectives of the investors. Also, a foreign investor may structure a U.S. investment interest by using certain grantor trusts, grantor option contracts, security interests, commission arrangements, administrative fees, and indexed rates to limit or avoid any FIRPTA tax.

Additionally, a foreign investor may avail himself or herself of certain tax-free transfers of USRPI to avoid or defer the payment of any FIRPTA taxes as follows:

WITHHOLDING REQUIREMENTS UNDER FIRPTA

Upon the sale or other disposition of a USRPI by a foreign person, the transferee (e.g., the buyer) generally must withhold 10 percent of the total amount realized from the sale and not just from the taxable gain. Also, if there is an installment sale over a period of time, the 10 percent withholding requirement is imposed upon the total amount realized at the time of the sale (and not over the term of the payments). A U.S. partnership, estate, or trust that disposes of a USRPI is generally subject to a **35 percent withholding tax to the extent such gain is allocable to a foreign partner or beneficial owner of the entity.

This **35 percent rate applies to non-corporate foreign partners. Foreign corporate partners are also subject to a 35 percent rate. The 2003 Tax Act reduces the current **35 percent withholding tax rates applicable to foreign persons (formerly 38.6 percent in the year 2002).

Foreign corporations must withhold 35 percent of the gain recognized with respect to any distributions of a USRPI to the corporations’ shareholders. A qualifying foreign corporation can make an election under Section 897(i) to be taxed as a USRPHC and not be subject to any withholding tax requirement, and instead, be taxed like a domestic corporation.

SPECIAL TAX TREATY PROVISIONS

Most tax treaties have special provisions relating to the ownership of “immovable property” in the U.S. by a resident of the other treaty country (and vice-a-versa). There is usually no maximum tax rate restriction imposed by a treaty with regard to FIRPTA taxes and tax treaty residents will normally continue to be subject to gains from the sale or disposition of any U.S. real property interests under FIRPTA in the same manner as persons that cannot utilize a U.S. tax treaty. Therefore tax treaties usually have little impact upon the application of FIRPTA, other than defining “immovable property.”

However, for foreign corporate owners, the tax treaties (as well as the nondiscriminatory treatment under the Section 897(i) election explained above) sometimes impact the U.S. branch profits tax.

STATE AND LOCAL TAXATION APPLICABLE TO FOREIGN INVESTORS WHO INVEST IN U.S. REAL ESTATE

This overview focuses upon U.S. federal income taxes applicable to foreign investors of U.S. real estate. In addition, States (e.g., California, Arizona, Texas and Florida) commonly impose income taxation along with local (e.g., County and City of San Diego) property taxes that should also be considered. For instance, California tax law requires buyers to withhold 3 1/3 of the total sales price of California real estate owned by non-California persons (including non-U.S. sellers of real estate). California escrow agents also have a duty to inform buyers of this California withholding tax obligation. The withholding tax, like FIRPTA (see below) is not a final tax, but merely a collection mechanism to be used against the final income tax. California individual and corporate tax rates, that may apply, range to as much as 9.4 percent. See the FIRPTA discussion below for a comparative analysis of federal income tax treatment and withholding taxes.

In addition to State income taxation (and the withholding tax mechanisms that may apply), there are typically local property taxes that will apply to a transfer or sale of real estate. In California, for instance, the California Constitution and tax code provides that all property in California that is not free from tax under federal or California law is subject to taxation “in proportion to its value.” The maximum ad valorem real property tax rate in California is one percent of the “full cash value.”24 Finally, California counties and cities may also apply a local documentary transfer tax on the transfer of real property.

In summary, all foreign investors that are contemplating investing in U.S. real estate should carefully consider and plan the legal structure utilized for this investment. If not carefully planned, a foreign investor can unwittingly expose himself, herself or itself to unnecessary U.S. income tax, gift tax and/or estate tax, especially in light of the complicated U.S. real estate taxation regime of FIRPTA.

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