Using shared application mortgages to avoid FIRPTA.

• Author: Rubinger, Jeffrey L.
• Position: Foreign Investment in Real Property Tax Act of 1980

The combination of a weak U.S. dollar and low interest rates has resulted in an enormous increase in foreign investment in U.S. real estate. (1) While investment is not expected to continue at the same pace, the U.S. is expected to remain the number one overall real estate market for non-U.S, investors. (2)

From a U.S. federal income tax perspective, the primary obstacle facing foreign persons who invest in U.S. real estate is the Foreign Investment in Real Property Tax Act (FIRPTA), more specifically [section] 897. Under this provision, any gain recognized by a foreign person on the disposition of a "United States real property interest" (USRPI) will be treated as if such gain were effectively connected to a U.S. trade or business and, therefore, subject to U.S. federal income tax at the graduated rates that apply to U.S. persons. Additionally, when [section] 97 applies, the purchaser of a USRPI typically is required to withhold and remit to the IRS 10 percent of the purchase price in accordance with [section] 1445.

One possible strategy to avoid FIRPTA involves the use of a shared appreciation mortgage (SAM). In a typical SAM arrangement, a lender provides a developer with a loan bearing a below-market fixed rate of interest, plus a share of the profit on a subsequent disposition of the property. SAMs were popular in the 1970s and 1980s when interest rates were in the double digits, but became less attractive as interest rates declined. Fueled by rising housing prices and mortgage rates, however, SAMs are staging a comeback, particularly with real estate projects that are perceived to be risky investments. As this article will illustrate, if the transaction is structured correctly, the taxpayers investing in U.S. real estate who may have the most to gain from the use of SAMs are non-U.S. taxpayers.

Section 897

Foreign persons typically are not subject to U.S. federal income tax on U.S. sourced capital gains unless those gains are effectively connected to a U.S. trade or business. (3) As stated above, [section] 897 treats any gain recognized by a foreign person on the disposition of a USRPI as if it were effectively connected to a U.S. trade or business.

A USRPI is broadly defined under [section] 897(c)(1)(A) as 1) a direct interest in real property located in the U.S., and 2) an interest (other than an interest solely as a creditor) in any domestic corporation that constitutes a U.S. real property holding corporation (i.e., a corporation whose USRPIs make up at least 50 percent of the total value of the corporation's real property interests and business assets). An interest in a partnership may also be considered a USRPI in certain situations. (4)

Regulation 1.897-1(d)(2)(i) elaborates on the phrase "an interest other than an interest solely as a creditor" by stating it includes "any direct or indirect right to share in the appreciation in the value, or in the gross or net proceeds or profits generated by, the real property." The regulation goes on to state that a "loan to an individual or entity under the terms of which a holder of the indebtedness has any direct or indirect right to share in the appreciation in value of, or the gross or net proceeds or profits generated by, an interest in real property of the debtor or of a related person is, in its entirety, an interest in real property other than solely as a creditor." Accordingly, a SAM that is tied to U.S. real estate is a USRPI for purposes of [section] 897.

Simply owning a USRPI, however, does not necessarily trigger any adverse tax consequences under [section] 897. Rather, a non-U.S, taxpayer will be subject to tax under that provision only when the USRPI is "disposed of." Reg. 1.897-1(g) provides that disposition "means any transfer that would constitute a disposition by the transferor for any purpose of the Internal Revenue Code and regulations thereunder." Furthermore, the Internal Revenue Manual provides that a disposition may include sales, gifts where liabilities exceed adjusted basis, like-kind exchanges, changes in interests in a partnership, trust, or estate, and corporate reorganizations, mergers, or liquidations, even foreclosures or inventory conversions. (5)

With respect to SAMs, Reg. [section] 1.897-1(h), Example 2, illustrates a significant planning opportunity for non-U.S, taxpayers investing in U.S. real estate. In the example, a foreign corporation lends $1 million to a domestic individual, secured by a mortgage on residential real property purchased with the loan proceeds. Under the loan agreement, the foreign corporate lender will receive fixed monthly payments from the domestic borrower, constituting repayment of principal plus interest at a fixed rate, and a percentage of the appreciation in the value of the real property at the time the loan is retired.

The example states that, because of the foreign lender's right to share in the appreciation in the value of the real property, the debt obligation gives the foreign lender an interest in the real property "other than solely as a creditor." Nevertheless, the example concludes that [section]...