Tax Considerations For The Closely-Held Foreign Investor In U.S. Real Property – Part I
April 10, 2017
Over the last few years, we have received an ever-increasing number of inquiries from “foreigners” who are interested in acquiring U.S. real property (“USRP”).
Some of these foreigners – meaning closely-held business organizations formed outside the U.S., and individuals who are neither U.S. citizens nor U.S. permanent residents – were acquiring USRP to be used in their U.S. business operations (a “U.S. trade or business,” or “USTB”). Others were acquiring USRP for investment purposes, whether for the production of rental income or for appreciation.
Know the Client
Where the foreign client is acquiring USRP for business or investment use, we have to ascertain the client’s goals and, in the case of a client that is a business entity, the personal goals of its owners.
For example, are they looking to generate rental income, will they remit the net income out of the U.S., how important is limited liability protection, what about U.S. tax and other filing requirements?
In all cases, we need to understand whether the foreigner plans to dispose of the USRP in the relatively short-term, or whether the acquisition represents a longer-term investment.
Once we have determined these personal and business/investment goals, preferences, and concerns, we can turn to the related tax considerations.
U.S. Taxes – In General
There are a number of U.S. federal income tax consequences that may arise from a foreigner’s ownership, operation, and disposition of USRP. (There are state and local tax considerations, as well, of which the foreign person must be made aware, including, for example, the N.Y. Real Estate Transfer Tax and the N.Y.C. Real Property Transfer Tax.)
As in the case of any other business or investment transaction, taxes will have a significant impact upon the net economic benefit or cost realized by the foreigner. The more that a taxpayer pays in taxes in respect of the income or gain realized from a property, or the more slowly the taxpayer recovers the taxpayer’s investment in the property, the more expensive the investment becomes.
Where taxes are not considered early on, the acquisition and ownership of a USRP may not be properly structured to minimize taxes and expenses. Thus, it is critical to plan for taxes prior to the acquisition of the USRP. It may be very difficult, and very expensive, to “correct” the structure later, once the property has appreciated in value.
The Adviser’s Goal
The tax adviser’s job is to educate the foreign investor as to these basic U.S. tax considerations – before the USRP is acquired – and, then, to see how to accommodate the foreigner’s business, investment, and other goals within a tax-efficient structure.
I should note that, although we are focusing on a U.S.-tax-efficient structure, it is also imperative that the U.S. adviser confer with the foreigner’s non-U.S. tax advisers. The client’s U.S. and foreign plans must be coordinated, lest one undermine a purpose of the other. Thus, each of the transactions described below should be examined for the its consequences under the law of the foreign person’s home country.
For this reason, and for other reasons that will vary from taxpayer to taxpayer, I can say with some certainty that there is no single structure that satisfies all of a taxpayer’s goals.
U.S. Income Tax
We begin with a brief summary of the principles that govern the U.S. income taxation of foreign persons as it relates to USRP.
Income Taxes – Source
In general, the U.S. will tax foreigners only as to their U.S.-sourced real property income.
Rental income from a USRP, dividends paid by a U.S. corporation (“USC”) that owns USRP, an allocable share of income from a partnership that owns USRP, interest from loans made to U.S. persons to acquire or improve USRP, and gains from the sale of URSP are all treated as U.S.-sourced income that will generally be subject to U.S. income tax.
Income Tax – Nature of the Income
Next, we need to determine the nature of the US-sourced income. Specifically, is it “portfolio” investment income, or is it effectively connected to the foreigner’s conduct of a USTB?
Nature of the Income – FDAP
If it is “portfolio” income – i.e., not effectively connected to a USTB of the foreigner – the rental income, the dividend income, and the interest income will be characterized as so-called “fixed and determinable annual and periodic” (“FDAP”) income.
Notably, the gain from the sale of stock of a USC is not treated as FDAP. Indeed, it is generally not taxable by the U.S. at all, provided the stock is a capital asset in the hands of the foreign seller, it is not used in a USTB, and the corporation is not a U.S. real property holding corporation (“USRPHC”).
The U.S. taxes the gross amount of a foreigner’s FDAP income. Thus, in the case of “portfolio” rental income from USRP, no deduction is allowed for property taxes, maintenance, depreciation, etc.
In addition, the tax on such gross income is imposed at a default rate of 30%, though it may be reduced under a U.S. tax treaty if the foreigner is a bona fide resident of the other treaty country. This rate applies regardless of whether the foreigner is an individual or a corporation, and regardless of the assets held by the U.S. payor.
Thus, if a USC, the principal asset of which is USRP, pays a dividend to a foreign shareholder, the dividend will be treated as U.S.-sourced income and will be taxable at a 30% (or lower treaty) rate. If a U.S. borrower pays interest to a foreign lender, the interest will be taxable at a 30% (or lower treaty) rate.
By comparison, if the dividend is paid by a foreign corporation (“FC”), there generally is no U.S.-sourced income because the payor is not a USC; this is the case even if the FC’s only asset is USRP.
That being said, if a FC is treated as being engaged in a USRP trade or business, it may be subject to the so-called “branch profits tax” (“BPT”). This tax, which is basically a “deemed dividend tax,” is imposed at the rate of 30% on the FC’s accumulated net profits that were not reinvested in its USTB. It purports to be a tax on the FC’s undistributed U.S. income. Because it is applied after application of the U.S. corporate income tax, the BPT can result in a total federal corporate tax rate in excess of 54%.
FDAP Withholding
The tax on a foreigner’s FDAP is collected, or withheld, at the source, by the U.S. payor of the income, which then remits the tax to the IRS.
Assuming the withholding fully satisfies the foreigner’s U.S. income tax liability, the foreigner need not file a U.S. income tax return.
That being said, the foreigner may nevertheless choose to file a return so as to start the running of the limitations period for the assessment of any additional U.S. income tax; for example, just in case the IRS later determines that its USRP activities rise to the level of a USTB.
U.S. Trade or Business
Speaking of a USTB, what level of activity is required before the IRS will treat the foreigner’s USRP activity as a trade or business?
If a foreigner is developing property in the U.S., it is safe to say that the foreigner is engaged in a USTB, and that the net taxable income generated therefrom is effectively connected with such business and will be taxable as ordinary income at the graduated rates applicable to U.S. persons, up to a top marginal rate of 39.6% for individuals, and up to 35% for corporations.
It is equally safe to say, as one would imagine, that a triple net lease does not constitute a trade or business. The rental income therefrom is FDAP that is taxable on a gross basis.
In between, there can be a lot of uncertainty.
Thus, the management of a multi-unit building may rise to the level of a trade or business if the foreigner is involved (directly or through agents) in paying expenses, maintaining the property, making repairs, hiring contractors, interviewing tenants, handling tenant complaints, dealing with local government, etc., with some continuity and regularity, and the foreigner does not substantially rely upon a local management company. In the latter situation, the foreigner’s activities may be difficult to distinguish from those of a prudent investor.
Assuming the activity rises to the level of a trade or business, then the foreigner may deduct the expenses associated with the rental activity in determining taxable income. Thus, depreciation, property taxes, interest on a mortgage, contractor fees, insurance, etc., will be deducted from the gross income in determining the foreigner’s U.S. taxable income.
Partnership
Note that if a foreigner is a partner in a partnership that is itself engaged in a USRP trade or business, then the foreigner will be treated as being engaged in a USTB as to the foreigner’s distributive share of the partnership’s income, even if the foreigner is not itself actually so engaged.
USTB Election
Based on the foregoing, one would guess that being taxed on a net basis is usually better, economically speaking, than being taxed at a flat rate on a gross basis, and that is generally the case.
However, as we noted earlier, a foreigner whose USRP income is treated as FDAP is generally not required to file a U.S. income tax return, while a foreigner who is engaged in a USRP trade or business must file such a return. This is often an important consideration for some foreign investors.
Assuming that reporting is not an issue, the Code recognizes that it may be difficult to determine whether a USRP investment rises to the level of a USTB. Thus, a special election is provided.
If this election is filed timely – by the due date, with extensions, for the first year that the election is to apply – the foreigner who has rental income from USRP for the filing year may treat that income as being effectively connected with the conduct of a USTB. Thus, the foreigner will be able to claim the related expenses (including depreciation) as deductions for purposes of calculating its U.S. income tax liability. Once made, this election is irrevocable, and will apply for all subsequent years.
The IRS has taken this election a step further by allowing foreign taxpayers to make a protective election, such that if the IRS were to determine on audit that the rental income should have been taxed on a gross basis (as FDAP), the protective election would be triggered to preserve the tax treatment as a USTB reflected on the filed return.
Stay tuned for Part II, tomorrow.