With Foreign Investment, It's Both “Buyer Beware” and “Seller Beware”
The Association of Foreign Investors in Real Estate’s (AFIRE) annual foreign investment survey reported that 64 percent of respondents intend to increase U.S. investment in real estate in 2016. Data collected by Real Capital Analytics Inc. indicates that foreign purchases of U.S. real estate leapt from less than $5 billion in completed deals in 2009 to $87.3 billion of completed deals in 2015.
All of this investment has played a significant role in the overall rise of the U.S. real estate market since the Great Recession. However, for the uninformed or unwitting on both sides of the negotiation table, the tax compliance burden when foreign investors are involved can be characterized both as caveat emptor (buyer beware) and caveat venditor (seller beware).
Implications for Foreign Investors in U.S. Real Estate
A host of unique U.S. income tax implications must be considered when foreign persons engage in transactions involving U.S. real estate. Not only must the foreign person consider their obligations with respect to U.S. income taxes, but there are also withholding obligations imposed on U.S. buyers of real estate from foreign persons, U.S. partnerships that have foreign partners, and certain U.S. corporations that have foreign shareholders.
Persons who are not citizens, green card holders, or resident aliens of the United States (i.e. foreign persons) are subject to U.S. income taxation on:
- Income that is effectively connected with a U.S. trade or business activity; and
- U.S. sourced fixed or determinable annual or periodical (FDAP) income*.
FDAP income includes interest, dividends, rents, salaries, wages, and other similar items of income. However, most capital gain income is not considered effectively connected income or FDAP income. Thus, foreign persons are typically not subject to U.S. taxation on their capital gain income from investments.
Under the general capital gain rule stated above, foreign persons were not subject to U.S. taxation on capital gain income realized from their U.S. real estate investments. However, this changed with the passage of the Foreign Investment in Real Property Tax Act (FIRPTA) of 1980 on Dec. 5, 1980. The FIRPTA legislation provides the basis for the current rule that a foreign person’s capital gain income from U.S. real estate investments is treated as income that is effectively connected with a U.S. trade or business activity.
As a result, foreign persons are now subject to U.S. taxation on such capital gain income. In addition to being subject to U.S. taxation on the capital gain income from a direct disposition of U.S. real estate, a foreign person could also be subject to U.S. taxation on the capital gain income from a disposition of an interest in a business entity (e.g., stock in a corporation or units in an LLC or partnership) if such business entity predominately holds U.S. real estate.
Foreign persons must file U.S. income tax returns to report the disposition of U.S. real estate. Additionally, the buyer of a U.S. real estate interest from a foreign person will be required to comply with the FIRPTA withholding obligations. Generally, the buyer will end up withholding 15% of the gross sales price and remitting this withholding to the U.S. Internal Revenue Service.
Thus, it is important for buyers of U.S. real estate to identify the seller as either a U.S. person or a foreign person. The foreign person will then claim a credit for this withholding on their U.S. income tax return. If the foreign person’s actual U.S. income tax obligation is less than the amount withheld by the buyer, the foreign person will receive a refund of the excess withholding.
In addition to capital gain income, foreign persons will be subject to U.S. taxation on any rental real estate income they receive (directly or indirectly) from their U.S. real estate investments. The general rule is that foreign persons will be subject to a flat 30 percent U.S. income tax on their share of the gross rents they receive from U.S. rental real estate. An election is available to foreign persons that will allow them to be subject to net-basis taxation on their U.S. rental real estate income.
The difference between gross-basis taxation (i.e., no deductions against the rental income) and net-basis taxation (i.e., entitled to all deductions, including depreciation, against the rental income) is likely to be significant. Thus, it is important that foreign persons with U.S. rental real estate income are aware that a U.S. tax election must be made in order to obtain the benefits of net-basis taxation with respect to this income.
Implications for U.S. Businesses with Foreign Investors
Withholding obligations can also be imposed on U.S. business entities that have foreign investors. A U.S. partnership will be required to comply with withholding obligations imposed on allocations to foreign persons of rental income and capital gain income attributable to U.S. real estate. Similarly, U.S. corporations that predominately hold U.S. real estate may have withholding obligations on nondividend distributions to foreign shareholders.
Compliance with these withholding obligations can be complex. It is important for U.S. entities to properly identify the status of each partner or shareholder as a U.S. person or foreign person. All allocations of income to foreign partners or distributions to foreign shareholders must be analyzed to determine proper compliance with potential withholding obligations.
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