FIRPTA rules impact U.S. real estate transactions.

• Author: Hobbs, Jonathan
• Position: Foreign Investment in Real Property Tax Act of 1980

The Association of Foreign Investors in Real Estate released the group's 22nd annual survey in early 2014, indicating that the United States remained the most stable and secure country for foreign investment in real estate by more than 50 percentage points over the second most stable and secure country, Germany, the widest margin since 2006. The United States led the rankings for planned real estate acquisitions in 2014, with 48% of respondents projecting a modest increase in their U.S. portfolio size and 20% projecting a major increase. As these foreign holders of U.S. real estate dispose of their U.S. real estate holdings, prospective purchasers should be aware of potential withholding tax obligations and tax reporting requirements under the Foreign Investment in Real Property Tax Act (FIRPTA), P.L. 96-499, before entering into such transactions.

Taxation of Foreign Persons: Generally

The United States taxes U.S. citizens, resident aliens, and domestic corporations on worldwide income. However, for nonresident alien individuals and foreign corporations, the United States generally taxes only U.S.-source income of specified types and income effectively connected (or treated as effectively connected) with a trade or business conducted by the foreign person within the United States. Under Secs. 871(b) and 882, such nonresident alien individuals or foreign corporations generally pay U.S. income tax at the regular U.S. rates on income (including certain foreign-source income) that is effectively connected with a U.S. trade or business.

The FIRPTA Rules

Under Sec. 897(a)(1) (enacted in 1980), a foreign seller's gain or loss on a sale or disposition of a U.S. real property interest (FIRPTA gain or loss) is considered 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. Taxpayers must combine their FIRPTA gain or loss with income, gain, or loss for the tax year from any business actually carried on by the taxpayer in the United States and, if the taxpayer so elects, with other nonbusiness income from U.S. real property (e.g., rental income from U.S. real property).The sum of this income or loss constitutes effectively connected income (ECI), and non-U. S. taxpayers must pay tax at the rates provided by Sec. 1 or 11.

Congress passed FIRPTA to achieve parity in the tax treatment of foreign and domestic investors in U.S. real estate. Thus, under FIRPTA, foreign sellers and U.S. sellers pay U.S. tax on the disposition of U.S. real estate at the same rates.

U.S. Real Property Interests and U.S. Real Property Holding Corporations

Under Sec. 897, gain or loss on the disposition of a U.S. real property (USRP) interest is ECI. Defined in Sec. 897(c) and Regs. Sec. 1.897-1, USRP interests include direct interests in real property (land, buildings, and other improvements) located in the United States. USRP interests also may include direct or indirect rights to share in appreciation in value, gross or net proceeds, or profits from real property, as well as growing crops, standing timber, mines, wells, and other natural deposits.

In addition...