Steven Weiser is a tax lawyer with a practice focusing on international tax matters. His contact information and information on his practice can be found on his web site at http://www.lw-law.com/.

In the first article of this series we began our review of the U.S. income tax laws with an analysis of the various tests used to determine whether an individual is considered a resident alien or nonresident alien of the U.S. The distinction, we learned is important, as the latter are subject to U.S. income tax on their worldwide income, and the former are generally only subject to U.S. income taxes on income earned from U.S. sources.

Last month we examined the U.S. income taxation of non-resident aliens, a group that often includes temporary residents of the U.S. We learned that earnings from a U.S. trade or business are ordinarily subject to U.S. income taxes on a net basis, meaning that certain deductions are allowed in arriving at taxable income. We also reviewed the taxation of fixed or determinable, annual or periodical gains, profits, and income (otherwise known as “FDAP”). Certain types of income are included in the definition of FDAP, including dividends, interest (subject to several exceptions), rents, salaries and wages. Specifically excluded from the definition of FDAP are capital gains. Income taxes are ordinarily imposed upon gross FDAP at a flat 30 percent rate, and are ordinarily withheld from the payment of such income by the payor, who remits these funds to the Internal Revenue Service.

This month we continue with our focus on the taxation of nonresident aliens, and specifically the taxation of investments in real estate.

Special rules apply to the taxation of real estate owned by nonresident aliens. To best understand these rules it is useful to briefly review how real estate investments would be taxed under the rules we learned last month. For example, if an investment in real estate constitutes a U.S. trade or business, rental income will be taxed on a net basis (deductions allowed) subject to ordinary graduated tax rates. If an investment in real estate does not constitute a U.S. trade or business any rental income generated by such property would be U.S. source FDAP, subject to the 30 percent withholding tax without any allowance for deductions. [1] Most significantly, if the investment is not a U.S. trade or business, any capital gains from the disposition of the investment would be exempt from U.S. taxes (since capital gains are not included in FDAP). Similarly, the nonresident alien could form a U.S. corporation through which the investment could be held. The corporation would be subject to income taxes on a net basis and pay capital gains taxes much like any other U.S. corporation, the only differences coming when profits are distributed from the corporation to its nonresident alien shareholder. These examples illustrate exactly how, until 1980, real estate owned by nonresident aliens was taxed.

Congress was concerned that foreign investors, whether individuals or corporations, were often able to escape all U.S. taxes upon the disposition of U.S. real estate held for investment or personal use. Congress realized that foreign owners of foreign corporations holding U.S. real estate were also able to avoid U.S. taxes when they sold their stock (since such sales were foreign source income, not subject to U.S. income taxes). Congress viewed the disparity between the taxation of U.S. citizens and residents investing in U.S. real estate and nonresidents investing in real estate as violating tax policy principles. As a result, Congress passed the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA).

FIRPTA essentially forces nonresident alien taxpayers to pay U.S. income tax at ordinary graduated rates on net income (certain deductions allowed) derived from U.S. real estate, generally a benefit to nonresidents. However, FIRPTA also insures that gains from the disposition of U.S. real property are also subject to U.S. income taxes. Owning real property through corporations provides no escape from FIRPTA.

FIRPTA imposes U.S. tax on income and gains from the operation and disposition of “U.S. real property interests” (USRPIs) by nonresident aliens and foreign corporations. A USRPI generally refers to any interest in U.S. real property (including interests in mines, wells and other unsevered natural resources, improvements and some personal property associated with the use of real property) and any interest in certain U.S. corporations (U.S. real property holding companies). It should be noted that a USRPI also exists with respect to real property located in the Virgin Islands (but not other U.S. possessions).

The determination of whether a domestic corporation is a U.S. real property holding company (USRPHC) is made based on the percentage of assets owned by the corporation that constitute USRPIs during a defined time period. The defined period is the shorter of (i) the period during which the taxpayer held the interest in the corporation, or (ii) the five year period ending on the date of disposition of the corporation. In general, a domestic corporation is a USRPHC if the fair market value of its USRPIs is equal to or greater than 50 percent of the fair market value of the corporation’s worldwide real property interests and all other assets used in a trade or business. The rules concerning USRPHCs are quite complex and several exceptions apply, including one exception applicable to corporations that previously sold all of their USRPIs, and another applicable to 5 percent-or-less owners of publicly traded USRPHCs.  

It should also be noted that special rules apply concerning other types of business entities (e.g., partnerships). Generally, an interest in a partnership is not a USRPI. Instead, a “look-through” treatment is applied when the partner receives a payment from the partnership. If the partner sells his interest in the partnership the amount of money or other property received by the partner to the extent attributable to USRPIs, is treated as an amount exchanged for a USRPI. 

Like other aspects of the U.S. tax laws applicable to nonresidents, FIRPTA is enforced through a withholding tax. If a nonresident alien disposes of a USRPI, the buyer must withhold 10 percent to the total purchase price of the USRPI and remit that amount to the IRS within 20 days of the transaction. This creates a problem where the sales price exceeds the amount of cash in the transaction (for instance, where the nonresident seller carries back a note on the property). No withholding is required if the buyer can establish that the seller is not a foreign person, that the interest transferred is not a USRPI, that the seller is not subject to taxation on the transaction (for a variety or reasons), or that the seller qualifies for reduced withholding (e.g. under certain tax treaties) or has qualified for a withholding certificate.

To obtain a withholding certificate and an exemption from withholding taxes, the nonresident seller should complete IRS Form 8288-B. That form requires a description of the USRPI being sold, the sales price, a calculation of the maximum tax owed, and evidence that the seller has no unsatisfied FIRPTA withholding obligations with respect to the purchase of the USRPI. If the withholding certificate is obtained, the nonresident alien must file a U.S. tax return for the year of sale and pay the appropriate amount of tax due at that time.

An investment in U.S. real estate may also create significant complexities in the estate and inheritance tax context. The U.S. has entered into estate tax treaties with several countries that serve to eliminate double estate and inheritance taxation by different countries. These treaties generally operate by subjecting a deceased person’s estate to taxation only in the country in which the person was domiciled (intended to permanently reside) immediately prior to death. However, exceptions exist, particularly with regard to real estate. For example, the estate of an individual domiciled in the Federal Republic of Germany owning real estate in the U.S., is primarily subject to German inheritance taxes. However, U.S. estate taxes will apply with respect to the U.S. real estate. As a result of the investment, the deceased person’s estate must deal with the complexities of estate tax treaties, transfer taxes payable in two countries, estate or inheritance tax returns in multiple jurisdictions, U.S. probate, and a host of other issues. Often, these rather expensive complexities can be avoided with proper estate planning.

For example, the German domiciliary in the above example could have held his interest in the U.S. real property through a German corporation. Under the tax treaty between the two countries the stock in the German corporation would not have been subject to U.S. estate taxes, thus providing complete protection from U.S. estate taxes. Note that transfers of U.S. property to foreign corporations always involve complex tax issues and you should always seek assistance from a qualified tax professional when dealing with such transactions.

In summary, FIRPTA causes foreign (including some temporary residents) investment in U.S. real estate to be taxed in much the same way as U.S. citizen or resident alien investment in U.S. real estate. Generally, taxes are imposed on net incomes from foreign owned real estate at graduated tax rates. Taxes are also imposed upon the disposition of such real estate, with a portion of such taxes withheld from the buyer’s purchase price and remitted to the IRS. When considering an initial investment in real estate, extreme care should be given to the estate tax consequences, particularly if the investor intends to permanently reside outside the U.S.

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[1] It should be noted that taxpayers may elect to treat U.S. real property income (e.g. rents) as income effectively connected with a trade or business, even if the ownership of such real estate ordinarily does not constitute a trade or business. This election is often beneficial as the 30 percent withholding tax with no allowance for deductions often creates an unduly harsh tax result. This election has been largely superceded by FIRPTA (see below).