Buying America! Foreign investment in U.S. real property: recap and new developments.

• Author: Dorot, Datan

In the May 2011 issue of The Florida Bar Journal, I published an article titled "Foreign Investment in U.S. Real Property: Navigating Through the Income, Estate and Gift Tax Traps." Since 2011, much has changed in the U.S. tax law and economy, as well as in the manner in which foreign governments share tax and financial information worldwide. Consequently, this article revisits the issues previously discussed in the context of these developments.

When the 2011 article was published, the U.S. real estate market was flooded with inventory as a consequence of the real estate "bust" of 2008, which was combined with a weakening U.S. dollar and a strengthening of foreign currencies and economies. In the six years since, we have seen an upswing in the U.S. real estate market, fueled largely by foreign investors. Today, we are experiencing somewhat of a plateau, and some even predict a decline; however, what seems to be constant throughout is the appetite of foreigners to "Buy America!" Foreign investors should closely consider the issues raised in this article to avoid potentially disastrous consequences. This article sets forth the common pitfalls that foreign investors in U.S. real property interests (USRPI) face and the techniques every advisor should consider when engaged by such clients. Note that this article is merely a simplified introduction to a complex area of law; prior to engaging in any of the covered techniques, be sure to fully understand all of the implications associated with their implementation.

U.S. Taxation Regime

The Internal Revenue Code defines a "U.S. person" as a citizen or resident of the U.S., a domestic partnership, a domestic corporation, a U.S. estate, and certain trusts. (1) The determination of whether an individual is deemed a nonresident alien or a resident alien of the U.S. differs in the income taxation and the estate and gift taxation regimes. When used in this article, the term "NRA" refers to a nonresident alien of the U.S., both in the income tax and in the estate and gift tax contexts.

* Federal Income Taxation of Nonresident Aliens--For income tax purposes, an alien individual is treated as a U.S. taxpayer if such person 1) meets the substantial presence test; (2) 2) is a lawful permanent resident; (3) or 3) makes a first year election. (4) U.S. taxpayers are taxed on their worldwide income, (5) whereas NRAs are taxed only on their taxable U.S.-source income. (6) If an individual is deemed an income tax resident of the U.S. and another treaty country, the tax residence is determined by the tiebreaker rules of the governing treaty to overcome double taxation. (7)

For income tax purposes, NRAs are taxed under one of two tax regimes. The first is the "U.S. trade or business" regime, which applies to an NRA who is engaged in a U.S. trade or business, and the income is effectively connected with such U.S. trade or business ("effectively connected income" or ECI). ECI is taxed on a net basis at the regular graduated tax rates (in the same manner a U.S. person is taxed). (8) The determination of what activities give rise to ECI has developed through caselaw and IRS rulings and depends heavily on the facts and circumstances of each case. (9)

The second regime is the "passive income tax" regime. Income that is not ECI is deemed "passive" (also known as "fixed, determinable, annual, or periodic" or "FDAP" income) and is subject to a 30 percent tax on the gross amount of such income. (10)

* Rental Income of Nonresident Aliens--Rental income derived from USRPI activity by an NRA can be either ECI or FDAP. To the extent not deemed ECI, such income is deemed FDAP and is generally subject to a 30 percent withholding tax on the gross rent received. (11) In such case, no deductions for taxes, insurance, or depreciation would be available to offset the gross rental income. (12) Whereas if deemed ECI, such rental income would be subject to the ordinary graduated income tax rates of up to 39.6 percent on the net rent received. (13) Although a potentially higher maximum tax rate, under ECI treatment, the taxable amount would be net of applicable deductible expenses excluded under the FDAP rules.

* Income from Sale or Disposition of U.S. Real Property and FIRPTA--The Foreign Investment in U.S. Real Property Tax Act of 1980 (FIRPTA) was enacted to ensure that NRAs are taxed on the gain from disposition of their USRPI. (14) Under the FIRPTA regime, an NRA or foreign corporation that disposes of a USRPI must recognize gain or loss as if it is ECI and is subject to U.S. income tax at graduated rates for an individual and at the corporate tax rate for the foreign corporation. (15) Further, under the FIRPTA regime, the purchaser of the USRPI must withhold 15 percent of the amount realized on the disposition, (16) which was increased from 10 percent in December 2015 under new FIRPTA legislation. (17) It is important to note that this is a withholding and not the actual tax liability, the computation of which is discussed below. The FIRPTA regime applies not only to disposition of the actual USRPI, but also to a disposition of an interest in a U.S. real property holding corporation (USRPHC). A U.S. corporation is deemed to be a USRPHC if it holds USRPI having an aggregate fair market value that equals or exceeds 50 percent of the fair market value of the corporation's real property and business assets, including its USRPI, its interests in real property located outside of the U.S., and all other assets used in a trade or business, wherever located. (18)

The income tax rate applicable to the gain from the sale or disposition of a USRPI by an NRA depends on 1) the form of holding; and 2) the type of ownership. Once determined, the gain (or loss) will be subject to either the ordinary income tax rate (currently up to 39.6 percent) or the capital gains tax rate (currently at ordinary income rates for short-term and 20 percent for long-term capital gain). (19)

The first step, then, is to determine the form of ownership. In the case of direct ownership by an NRA, (20) trust or pass-through entity, gains from the sale or disposition of a USRPI are treated as capital gains (subject to the type of ownership, discussed below). (21) So long as the interest has been held for at least one year, the applicable rate will be the preferential long-term capital gains rate (currently 20 percent). (22) However, it is important to note that corporations are not eligible for the preferential long-term capital gains rate and, thus, gain from the sale of USRPI by a corporation will, therefore, be taxed at the corporate income tax rate (currently at 35 percent). (23) In addition, state corporate income tax may apply as well in certain states (the rate in Florida is currently 5.5 percent).

Once the form of ownership is deter mined, the second step is to determine the type of ownership. This depends on whether the USRPI produces ECI or FDAP. If the income earned from the USRPI is ECI, or if the USRPI is held as inventory, then gains from the sale thereof will be subject to the ordinary income tax rates. (24) If the income is deemed to be FDAP (and was held for at least one year), then the gain will be subject to the preferential long-term capital gains rate. (25) Accordingly, from a pure income tax perspective, ownership through a corporate structure is generally a less efficient approach.

* Federal Estate and Gift Taxation of Nonresident...