How U.S. Tax Law Impacts Foreign Investors Considering a Sale

The U.S. commercial real estate market’s instability may lead to more distressed sales, deleveraging, or portfolio adjustments. For foreign investors considering any of these transactions within the United States, it’s important to understand the current impacts of the Foreign Investment in Real Property Tax Act of 1980. This decades-old law covers U.S. federal income tax implications that are still relevant today but might be overlooked by foreign investors. FIRPTA requires U.S. tax withholding and compliance from foreign investors, and dealing with these tax matters can be complicated and burdensome for companies and investors alike.

When exploring tax considerations, withholding exemptions, and the nuances of selling, it can be beneficial for real estate investors to work with a tax advisor to tailor strategies supported by an informed understanding of FIRPTA.

When foreign investors owe taxes on US real-estate gains

Foreign investors are generally not taxed on gains from the sale of capital assets—unless that gain is effectively connected to a U.S. trade or business. As a result, a foreign investor can sell shares of a U.S. corporation without being taxed on the gain. Regarding real estate assets, FIRPTA overrides this general rule to treat a gain or loss on the disposition of a U.S. Real Property Interest as effectively connected income—which is subject to U.S. tax. As such, foreign investors who hold USRPIs would be subject to U.S. federal income tax at the appropriate U.S. income tax rate. This would include foreign corporations, which would be subject to tax at 21 percent.

Further, FIRPTA imposes a 15 percent withholding tax on any foreign seller of U.S. real estate, and the withholding obligation falls on the buyer of the real estate. Generally, tax treaty benefits may apply to reduce the rate of withholding. The withholding is assessed on total proceeds (rather than on the sale’s net gain), which will reduce after-tax cash flows. If a foreign investor overpays the withholding tax, they can file a U.S. tax return to claim a refund from the Internal Revenue Service. It is important to note that a FIRPTA presumption applies to treat all U..S corporations as U.S. Real Property Holding Companies unless documented otherwise.

Real estate assets or stocks subject to FIRPTA

Under FIRPTA, U.S. Real Property Interest is a key consideration. USRPI is broadly defined as any direct interest in real property located in the United States or the Virgin Islands, including fee ownership, leaseholds, or options to acquire fee or leasehold ownership, as well as land improvements, and any associated personal property. The Internal Revenue Code further assigns the USRPI designation to include an interest, other than as a creditor, in any U.S. corporation which is determined to be a U.S. Real Property Holding Company. Note that a five-year lookback would apply to any USRPHC determination.

A USRPHC is any corporation where the fair market value of its USRPIs is at least equal to 50 percent of the sum of the fair market values of the corporation’s USRPIs, foreign interests in real property, and other assets used or held for use in a trade or business. Thus, the sale of stock in a domestic corporation heavily invested in U.S. real estate would be subject to FIRPTA.

Generally, any foreign investor holding stock in a publicly listed U.S. company is exempt from FIRPTA unless the investor holds more than 5 percent of the outstanding shares of the company or the company meets the definition of a Real Estate Investment Trust or Regulated Investment Company.

The FIRPTA rules also apply to corporate liquidations of any USRPHCs. Generally, corporate liquidations involve the exchange of stock for the liquidating corporation’s assets. As a result, liquidation can be considered a disposition of a USRPI. Taxable liquidations under Section 331 involve shareholders that are partnerships, individuals, or corporations that own less than 80 percent of the liquidating corporation. Section 331 liquidations trigger FIRPTA, while nontaxable liquidations under Section 332 would not. Care should be given to the gain recognition rules under Section 367(e)(2), which contain a toll charge that imposes a tax on the gain. To avoid corporate level gain recognition upon an outbound corporate liquidation, a USRPHC must meet the specific exception provided by the regulations that allow for a nontaxable liquidation to the USRPHC’s shareholder having 80 percent or more.

 Withholding tax exemption

 As mentioned, Section 1445 requires transferees of USRPIs, including USRPHCs, to withhold 15 percent of the amount realized on a disposition by a foreign person. As noted, tax treaty benefits may apply.

Exemptions to withholding require the foreign investor to provide documentation about its tax status to the transferee. Meeting these requirements is crucial to obtaining the exemption and, therefore, proper deal execution. For example, the foreign investor may provide:

• Written documentation by the investor that they hold a valid U.S. taxpayer identification number and they are not a foreign person;
• In the case of a disposition of any interest in a U.S. corporation, written documentation stating the corporation is not and has not been determined to be a USRPHC for the five-year period prior to the disposition of the real property or as of the date of disposition.
• A withholding certificate from the IRS providing for no withholding due to the transaction qualifying as nontaxable—or reduced withholding when the taxpayer’s maximum tax liability from the transaction is less than the 15 percent withholding amount.

 U.S. real estate deal considerations

A common example of a simple U.S. real estate partnership structure is as follows:

In the above structure, U.S. investors, such as private equity funds and other institutional investors, own an indirect interest in a Real Estate Partnership through a U.S. partnership intermediary. Foreign investors—which could be corporations, partnerships, or individuals—typically own an indirect interest in the Real Estate Partnership through a U.S. blocker corporation. The Real Estate Partnership invests and manages the real estate portfolio.

For instance, assume that the Foreign Investors own 100 percent of the U.S. Blocker Corporation, the U.S. Partnership owns 60 percent of the Real Estate Partnership, and the U.S. Blocker Corporation owns 40 percent. Also assume that the Real Estate Partnership is 100 percent invested in U.S. real property interests.

Under Section 897(c)(4)(B), the U.S. Blocker would be treated as owning its share of the Real Estate Partnership’s USRPI. Since the U.S. Blocker has no other activity, 100 percent of its assets are classified as USRPIs, and as such it is likely to be treated as a USRPHC.

As the U.S. Blocker is subject to U.S. federal income tax, FIRPTA would not apply to its allocation of gains or losses from the Real Estate Partnership.

If, on the other hand, the foreign investor sold its shares in the U.S. Blocker, this transaction would be subject to FIRPTA. The transferee or withholding agent would request documentation to exempt U.S. Blocker from withholding, or reduce withholding, if applicable, on the foreign investor.

How the structure impacts selling

 When planning to exit, it’s important to consider the legal structure. The outcome may vary based on the chosen exit approach:

• A direct disposition of the U.S. Blocker that could be considered a disposition of a USRPHC and subject to 15 percent withholding and related filing requirements with the IRS. 
• A sale of property by Real Estate Partnership, could create gain or loss allocated to the U.S. Blocker. A subsequent distribution of sale proceeds to the U.S. Blocker would reduce U..S Blocker’s outside basis in Real Estate Partnership; however, due to U.S. Blocker’s status as a U.S. corporation, FIRPTA withholding would not apply. 
• A sale or redemption of the U.S Blocker’s interest in the Real Estate Partnership would be recognized and taxed at the U..S Blocker. No FIRPTA consequences would result, as the U.S. Blocker has recognized the gain from the disposition of the USRPI.

Exiting investments in U.S. real estate can be complicated. All parties involved should seek guidance and assistance from experienced tax advisors who can help investors understand the necessary steps and provide recommendations for the transaction.