U.S. individual's investment in overseas rental property.

• Author: Wise, Dan

The regulations under Sec. 904, issued in July 2004, make clear that the subpart F provisions continue to apply to overseas investment in real property by individuals. Those regulations expand the definition of what are considered active rents for the purposes of determining the passive activity foreign tax credit limitation. However, in passing, the preamble to those regulations reaffirms the longstanding but often overlooked and misunderstood rules about what constitutes active rents for subpart F inclusion purposes (TD 9141).This item addresses the tax ramifications of a typical scenario in today's hot Costa Rican real estate market, which likely is applicable to many practitioners.

Example: X and Y,, a U.S. couple, in 2005 formed two Costa Rican SAs (sociedades anonimas, or corporations), A and B, which purchased two condominium units (each costing approximately $120,000), partly through cash contributions from X and Y and partly through mortgage financing obtained by A and B. X and Y intend to rent out the condo units and have little interest in visiting Costa Rica. The purchase is an investment, which will be managed by a local management company in Costa Pica. Costa Pica will impose tax on the income derived from the rental operation.

Individuals generally are taxable on the cash basis. Corporations that do not repatriate earnings to individuals generally do not trigger a second layer of tax at the individual level. However, these rules are potentially superseded in certain cases, such as foreign corporations that are predominantly U.S. owned (controlled foreign corporations, or CFCs).

In the example, X and Y are significant U.S. shareholders and hold 100% of both A and B. Thus, it is clear under Sec. 957 that A and B are CFCs. X and Yare therefore subject to the CFC rules for A and B.

The CFC rules create for the CFC's owners a deemed inclusion of income for certain types of income, all called subpart F income. The issue here is to determine whether the Costa Rican CFCs (A and B) have subpart F income. Under the CFC rules in the context of foreign rental operations, rents are generally subpart F income, with certain exceptions. Thus, unless an exception applies, X and Y would need to report A and B's rental activity on a current basis.

Exceptions

The only possibly relevant exceptions in a typical individual ownership scenario are either (1) rents in an active trade or (2) rents earned in a "high tax" foreign country. Rents are...