The Foreign Investment in
Real Property Tax Act (FIRPTA) Made Simple
Andrea Comeau-Shirley and Charles
Harrison
This article describes the general principles
of FIRPTA and is intended for use by foreign persons, corporations,
and individuals who are considering investing in US real
estate. The title implies that the subject matter can be
simplified. However, in doing so, general statements will
be made without disclosure of all the related traps. The
US tax law is extremely complex and most of the general
principles have numerous exceptions that are, in turn, interpreted
by a jungle of regulations, judicial discussions, and rulings
by the tax authorities. This article should not be relied
upon as tax advice. Analysis for a specific investment should
be done in concert with a tax advisor If, however, the article
broadens your tax vocabulary so that the conversation with
your advisor is less painful, then the title is justified.
Foreign investment in the United States
is on the rise after a decline in the early 1990s. As part
of analyzing projected returns on investment in US real
estate, owners/investors need to examine how the United
States will tax that investment. Generally, the United States
taxes its citizens, residents and domestic entities on all
income regardless of where it is earned. Foreign entities
(including corporations, trusts, estates and partnerships)
and international investors are subject to US tax on only
their US-source income and on their income that is effectively
connected with a US trade or business. Rental income and
gain from the sale of real estate located in the United
States is US-source income. On the other hand, income from
the sale of stock is generally sourced to the country of
residence of the seller.
As such, if foreign investors structure
their US real estate investment through corporations, the
investors could avoid US income taxes and improve the return
on their investment simply by choosing to sell stock rather
than assets. Congress felt this created an unfair advantage.
The Foreign Investment in Real Property Tax Act of 1980
(FIRPTA) denies this exclusion for gains from dispositions
of US real property interests (USRPI) in an attempt to create
equity of tax treatment between international and US investors.
The law broadly defines USRPIs to include all direct and
indirect rights to appreciation in real estate.
The US taxation of international investors
is governed by either the Internal Revenue Code (the Code)
or income tax treaties that the United States has signed
with other nations. FIRPTA changed the Code and expressly
overrides the treaty negotiated right to tax gains from
the sale of stock solely in the country of residence of
the stockholder. The law, in essence, makes the gains effectively
connected to a US trade or business and, therefore, taxes
the gain netted with effectively connected expenses or losses
at the regular US tax rates (28 percent to 39.6 percent
for individuals and 35 percent for corporations).
When determining whether FIRPTA will impose
US taxation on your investment, you should be familiar with
several key terms: US Real Property Interest, US Real Property
Holding Corporation, base period and determination date.
US Real Property
Interests
A USRPI includes any interest in real property located in
the United States or the US Virgin Islands. Real property
includes the obvious items: land, buildings, timber and
mineral interests (such as mines and wells). It also includes
movable walls, furnishings, mining equipment, drilling rigs
and certain other property associated with the use of real
property. For example, farm tractors connected with the
farming operation in the United States are considered USRPIs.
In addition to these direct interests,
the term USRPI includes the stock of a domestic (US) corporation
that is or has been a US real property holding corporation
(USRPHC) during the period that the foreign investor held
the stock or the period five years preceding the sale, whichever
is shorter (the base period). A USRPHC is a corporation
whose assets consist primarily of USRPIs. Thus, it is no
longer possible to avoid US tax on the sale of US real property
by holding the property indirectly through a US corporation
and disposing of the corporation's stock.
If a foreign person disposes of stock
of a domestic company, such stock is presumed to be a USRPI
unless it is established that on specific dates during the
base period that the fair market value of its USRPIs is
less than 50 percent of the fair market value of all its
USRPIs, foreign real property and any other assets used
or held for use in the business (the 50 percent test). Conversely,
a corporation is presumed not to be a USRPI if the book
value of USRPIs held on specific determination dates during
the base period is 25 percent or less of the total book
value of the company's assets on those dates.
In performing these tests, if the company
owns an interest in a partnership or trust, it is treated
as owning its pro-rata share of the assets of such entity.
In addition, if the company owns more than 50 percent of
the stock of a second company, it is treated as owning its
pro-rata share of the assets of the second company. If the
company owns less than 50 percent of the second company,
those shares are treated as a USRPI if that company is itself
a USRPHC on any determination date during the base period.
Determination Dates
An investor will be subject to FIRPTA tax on the stock sale
only if the 50 percent test is met on certain determination
dates. These dates are the last day of its taxable year,
the date on which it acquires a USRPI, the date it disposes
of foreign real property or other trade or business assets,
and on the dates such acquisitions and dispositions are
made by entities whose assets the corporation is treated
as holding. These determination dates are waived for the
first 120 days after incorporation/acquisition and the last
12 months of a formal liquidation period (to avoid inadvertently
becoming a USRPHC). If the company is a USRPHC on any of
the determination dates in the base period, the stock is
a USRPI.
FIRPTA Exceptions
A foreign entity or international investor is not subject
to US tax on the disposition of stock that is not a USRPI.
A USRPT does not include a 5 percent or less interest in
a publicly traded corporation, an interest in a domestically
controlled real estate investment trust (REIT), or an interest
in a US company that has disposed of all its USRPIs in a
taxable sale. To meet this last exception, the US company
cannot, on the date of the disposition, own any USRPIs and
must have recognized all gains on USRPIs held during the
base period.
An interest in real property that is solely
a creditor's interest is also not subject to FIRPTA. Thus,
a mortgage interest or other security interest in US real
property, even if the interest rate is indexed, is not a
USRPI (and therefore not subject to FIRPTA). If the interest
extends beyond that of a creditor, however, FIRPTA may come
into play. Thus, an ownership, co-ownership or leasehold
interest in or option to buy real property is an interest
other than solely as a creditor and is, therefore, considered
an interest in real property. In addition, any right to
share in the appreciation in value of the real property
or in the gross or net proceeds or profits generated by
real property is also a USRPI. Thus, a loan with an equity
kicker is treated as a USRPI, and an international investor
disposing of this interest is subject to US tax. The collection
of principal and interest is not considered a disposition.
Therefore, the normal collection of interest and principal,
including the final equity kicker payment, is not subject
to the FIRPTA tax.
Significance of
USRPHC Status
It is important for international investors owning shares
in a US company to know whether the corporation is or was
a USRPHC on the applicable determination dates. If the US
company meets this test, the international investor is subject
to tax when the shares are sold or transferred and must
file a US tax return reporting the gain. In addition, any
person acquiring stock of a domestic company from a foreign
person is responsible for collecting a withholding tax,
unless the buyer determines that the stock is not a USRPI.
Since it is presumed that all shares of
a domestic company held by a foreign person are USRPIs,
the rules taxing dispositions of USRPIs by foreign investors
must be considered every time a foreign investor transfers
shares of a US company in a taxable sale or non-taxable
transfer. These rules can override the normal non-recognition
rules and cause an otherwise nontaxable transfer of shares
of a domestic corporation to be taxable. As previously mentioned,
FIRPTA expressly overrides the provisions of most tax treaties
that would otherwise have exempted the gain from US tax.
US tax treaties with Canada and the Netherlands provide
some relief to certain qualified residents of those countries.
For example, a Canadian resident selling a USRPI may be
eligible to take advantage of a provision that exempts gain
attributable to appreciation occurring prior to December
31, 1984. The Dutch treaty provides similar benefits that
are limited to sales of corporate stock held continuously
since June 18, 1980.
The definition of USRPHC includes only
domestic corporations. The shares of foreign corporations
are not subject to US tax under FIRPTA even if the foreign
corporation owns primarily USRPls. Thus, a foreign person
desiring to avoid US tax on the gain from the sale of US
real estate can have the property held by a foreign corporation
and then sell the stock of a foreign corporation. Sounds
incredibly simple. However, FIRPTA impacts the foreign corporation's
actions - even if it can't reach its owners - and this imbedded
tax will, in turn, have an impact on the market value of
the foreign corporation's shares.
Any person who purchases the shares of
the foreign corporation and plans to liquidate that corporation
will generally trigger tax on the appreciation in the USRPIs.
If the foreign corporation sells the USRPIs, that corporation
is subject to US tax on the sale. Alternatively, if the
foreign corporation transfers the USRPI to another entity
in a transaction that would generally be nontaxable under
the Code, the foreign corporation is taxable under FIRPTA
unless the asset the corporation receives in the transfer
is also a USRPI. These built-in taxes will be reflected
in the price an informed purchaser would be willing to pay
for the stock of the foreign holding company.
Other Indirect Ownership
US tax laws have made other forms of ownership - partnerships,
trusts & REITs - advantageous to investors. While interests
in partnerships, trusts and estates that hold US real property
is not defined to be a USRPI, FIRPTA taxes an international
investor that sells or exchanges such an interest at a gain.
The amount that is taxable is only that portion of the gain
that is related to the USRPI. If the partnership, trust
or estate sells the USRPI, each foreign partner or beneficiary
is deemed to have sold his/her pro-rata share of the USRPI.
REIT income earned by foreign investors is subject to FIRPTA
to the extent attributable to gains from sales or exchanges
of USRPIs. As previously mentioned, gains on the sale of
REIT shares are not subject to tax under FIRPTA, unless
the majority of the shares are held by foreign persons.
In light of these rules, foreign persons can avoid FIRPTA
by selling qualifying shares prior to receiving the distribution
from the REIT. Obviously, this tactic should only be used
when the investor believes the REIT investment is at maximum
value.
FIRPTA Withholding
You may be impacted by FIRPTA whether you are the buyer
or seller of US real estate. FIRPTA requires any person
acquiring stock of a domestic company from a foreign person
to collect a withholding tax, unless the buyer determines
that the stock is not a USRPI. This tax is 10 percent of
the gross sales price (or 10 percent of the fair market
value of the property exchanged) unless certain exemptions
apply. Additionally, if the seller determines that the actual
US tax owed is less than this amount, the parties can submit
a request to the IRS that only this lesser amount be withheld.
Without IRS permission, the 10 percent must be withheld
regardless of the actual US tax due or the amount of cash
received.
FIRPTA withholding also applies to property
and cash received in redemption of USRPHC stock (10 percent
withholding on the gross value), distributions of USRPIs
from foreign corporations (35 percent withholding on the
net gain), and gains realized by partnerships, trusts, estates
and REITs on the sale of USRPI (35 percent withholding on
the net gain).
These amounts must be paid over to the
IRS within 20 days of the transfer unless a withholding
certificate application to reduce or eliminate the withholding
has been submitted to the IRS. The application suspends
the obligation to pay over the amount withheld until 20
days after the IRS completes its determination.
Unlike other withholding taxes, FIRPTA
withholding does not eliminate the seller's obligation to
file a US tax return reporting its gain. The withholding
agent must report the details of the transaction on Forms
8288 and 8288A. The seller includes the Form 8288, which
has been stamped by the IRS, in its return in order to claim
credit for the withheld taxes.
Planning With FIRPTA
Although FIRPTA was drafted broadly to capture most real
estate investments, savvy investors still look for ways
to avoid characterization as a USRPI. Rather than direct
investment, foreign investors can structure their participation
in the property to meet the "solely as a creditor" exception.
If the investor wants additional upside potential, indexed
interest rates as well as equity kickers may avoid a FIRPTA
tax. Additionally, royalties and other fees can be imposed
which can allow a portion of the income to be returned to
the foreign investor without FIRPTA tax. Each investor should
review the alternatives to ensure that non-traditional notes
and other instruments are considered to take advantage of
all allowable FIRPTA exceptions or carve outs.
These options may also be available to
long term investors on their existing portfolios if appropriate
restructuring is done.As you begin or expand investment
in US real estate, remember that FIRPTA is only one of the
US tax costs which must be considered. Your after-tax return
on such investment can also be impaired by other US tax
laws such as Branch Profits Tax, Earnings Stripping, Partnership
Withholding and Estate Taxation.
