Tax Considerations For The Closely-Held Foreign Investor In U.S. Real Property – Part II
April 11, 2017
Catching up? Start with Part I here.
Sale of USRP – FIRPTA
Aside from planning for the taxation of U.S.-sourced rental income, the foreigner must plan for the disposition of the USRP pursuant to a sale.
The taxation of gain realized by a foreigner on the sale of an interest in USRP is governed by FIRPTA (the “Foreign Investment in Real Property Tax Act of 1980”).
Because FIRPTA treats such gain as income that is effectively connected with the conduct of a USTB, the tax rate that is applied to the gain will depend upon whether the foreign seller is an individual or a corporation.
Assuming the property is a capital asset in the hands of a foreign individual (not inventory or otherwise used in a USTB – the sale of either of which would have been taxable as effectively connected income anyway), and has been held by the foreign individual for more than twelve months, the gain from the sale will be taxed as capital gain at a rate of 20%.
If the seller is a FC, the gain will be taxed at the applicable corporate rate, up to 35%.
FIRPTA – Withholding
Upon the foreigner’s sale of USRP, the buyer is required to withhold 15% of the gross purchase price, which amount must be remitted to the IRS. The purchase price includes the amount of any liability assumed or taken subject to. The remaining tax, if any, must be paid by the foreign seller when it files its U.S. income tax return. If the tax withheld exceeds the amount of tax owed as a result of the sale, the foreigner may use the filing of the tax return to claim a refund.
Because the 15% withholding does not necessarily bear any relationship to the amount of tax actually owed – indeed, the sale may have generated a loss – IRS regulations allow a foreign seller to request a certificate from the IRS that directs the buyer to withhold a lesser amount, based upon the information submitted by the foreigner to establish its actual tax liability.
For example, one may apply for a withholding certificate based on a claim that the transfer is entitled to nonrecognition treatment (as in the case of a like-kind exchange for other USRP), or based on a calculation of the foreigner’s maximum tax liability.
There are also other exceptions to FIRPTA withholding, where a USC, the stock of which is sold by a foreigner, certifies that it is not a USRPHC, and has not been one in the last five years.
Withholding as to Corporate Distributions
Note that special withholding rules apply to certain dispositions by corporations.
If a FC distributes USRP to its shareholders, it must withhold tax at a rate equal to 35% of the gain that is recognized by the FC on the distribution. (The distribution of appreciated property by a corporation to its shareholders in respect of their stock is treated as a sale of such property by the corporation.)
In the case of a USRPHC, it must withhold 15% of the amount distributed if the distribution is made in redemption of a foreigner’s shares or in liquidation of the corporation.
U.S. Real Property
The foregoing has assumed that the property being sold by the foreign person is a direct interest in USRP.
FIRPTA, however, covers not only direct interests in USRP, but also certain indirect interests.
Specifically, if the FMV of a USC’s USRP equals or exceeds 50% of the sum of (i) the FMV of all of its real property plus (ii) the FMV of its trade or business assets, then the corporation will be treated as a USRP Holding Corporation (“USRPHC”), and any gain realized on the disposition of any amount of stock in that USRPHC will be subject to tax under FIRPTA (so long as the disposition is treated as a sale or exchange for tax purposes).
What’s more, if a USC was a USRPHC at any time during the five-year period ending with the date of the sale of stock therein by a foreigner, the gain realized will remain subject to FIRPTA even if less than 50% of the value of the corporation is attributable to USRP at the time of the sale.
Fortunately, there is an exception to this five-year rule: under the so-called “cleansing” rule, if the USC disposes of all of its interests in USRP in taxable sales or exchanges, such that the entire gain thereon has been recognized, and the corporation owns no USRP at the time of the stock sale by the foreign person, then the stock sale shall not be taxable under FIRPTA (or at all for that matter).
Election to be treated as a USRPHC
As you may have gathered, a FC cannot be a USRPHC. Seems straightforward enough, except that there is a special election that allows a FC to elect to be treated as a USRPHC exclusively for purposes of FIRPTA.
Why would a FC make such an election? One reason is to avoid gain recognition upon the transfer of USRP to the FC. Among the requirements that must be satisfied in order for an election to be effective, the FC must satisfy the above “50% of value” test for USRPHCs.
Exceptions to FIRPTA
Not every disposition of USRP by a foreign person is taxable and subject to withholding under FIRPTA.
For example, a foreigner may sell USRP and roll over the net proceeds therefrom as part of a deferred like-kind exchange without incurring a tax liability (provided that the replacement property is also USRP, the subsequent disposition of which would be taxable to the foreign seller).
This principle underlies other exceptions to gain recognition; specifically, if a foreign person exchanges one interest in USRP for another interest in USRP, the gain realized on the exchange may not be taxable if certain regulatory requirements are satisfied.
For example, a foreigner may contribute USRP to a USC (or to a FC that has elected to be treated as a USC under FIRPTA) in exchange for shares of stock in that corporation without incurring a tax liability, provided the foreign person “controls” the USC immediately after the exchange, and provided the transferee USC is a USRPHC after the contribution. (A narrower exception applies for certain transfers by foreigners to a non-electing FC, which is somewhat inconsistent with the above principle.)
Varieties of Dispositions
A sale of USRP is the most common type of disposition that triggers FIRPTA. However, there are many other transactions of which a foreigner needs to be aware.
For example, if a USRPHC redeems some (but not all) of the shares of a foreign shareholder, the redemption may not be subject to FIRPTA, and may instead be treated as a dividend, if the foreigner’s stock ownership is not sufficiently reduced.
If a USRPHC makes a cash dividend distribution to its shareholders in an amount that exceeds its earnings and profits, the distribution may result in taxable gain that will be subject to FIRPTA.
The partnership rules may generate similar results as to both distributions by, and contributions to, partnerships. The disguised sale rules, for example, may convert what appears to be a tax-free contribution of USRP by a foreigner to a partnership in exchange for a partnership interest into a partially taxable sale that is subject to FIRPTA.
Our next post will review the U.S. gift and estate tax consequences of which a foreign investor in USRP must be aware and must consider in structuring the acquisition, operation, and disposition of such property.