Consider the Basics of U.S. Federal Income Tax Reporting and Compliance for Foreign Investors in U.S. Real Property

  |  January 29, 2019

The IRS has noted its awareness of the significant increase in inbound U.S. real property investment by foreign investors.  More recently, lower interest rates combined with a weaker U.S. dollar have continuously motivated inbound foreign investors to acquire U.S. real property.  The momentum of foreign investors is driven by the opportunity for appreciation in value and a profitable return on investment. Some foreign investors in U.S. real property may not be completely aware of the additional cost in terms of the U.S. tax reporting and compliance obligations.

What U.S. tax filings do foreign investors in U.S. real property need to comply with in the United States?  The answer depends on the structure of the investment in the U.S. real property interest.

Investment in U.S. Real Property with a U.S. Blocker Corporation Structure

A typical common U.S. real property investment structure is a U.S. blocker corporation that is classified as a Subchapter C corporation for U.S. federal tax purposes. The U.S. blocker corporation may own U.S. real property directly or it may own an interest in a U.S. or foreign partnership that invests in U.S. real property.  The foreign investor may acquire stock in the U.S. blocker corporation or stock in a foreign corporation that invests in the U.S. blocker corporation. It is generally preferable for a foreign individual to invest in a foreign corporation that invests in a U.S. blocker corporation.

The U.S. blocker corporation is required to file U.S. federal Form 1120 and state corporate income tax returns.  The U.S. corporate tax returns are due by the 15th day of the fourth month following the U.S. corporation’s tax year end.  It is possible to file extensions to extend the U.S. tax filing due date by six months.  However, the extension to file is not an extension of the time in which the tax must be paid.  The total tax liability must be paid for the tax year when the extensions are filed by the original U.S. federal and state tax return due dates.  In some states, the state tax return filing due date is different than the U.S. federal tax return filing due date.  If the tax is not fully paid with quarterly estimated tax payments throughout the year then the remaining balance of tax is due with the extension. If the tax is not paid on time with the estimates and extensions then interest and penalties are assessed.  The applicable penalties may include underpayment of estimated tax and late payment penalties.  If the tax returns or extensions are not filed on time then a late filing penalty also applies.

If the U.S. blocker corporation owns the U.S. real property directly then it will report any rental income from the U.S. real property, interest expense (subject to limitation) from liabilities, depreciation expense, and other operating expenses on the annual U.S. tax returns.  If properly deductible expenses exceed gross income then the U.S. blocker corporation reports a net operating loss (NOL) for U.S. tax purposes that can be saved for use to offset taxable income in the future subject to applicable limitations.

If the U.S. blocker corporation is invested in a partnership or a multi-member LLC that holds U.S. real property, then its Schedule K-1 distributive share of income, gain, loss, expense, deduction, and credit from the partnership is reflected on the U.S. blocker’s annual U.S. corporate tax returns.  When the U.S. blocker corporation sells the U.S. real property, if held directly, the net gain will be subject to U.S. federal and state corporate income tax on the U.S. annual tax returns.  The highest U.S. federal corporate income tax rate is a flat 21% which applies to the net taxable income including any net rental income and/or gain from a sale. The combined state and local corporate income tax rate may be 0% to 15% depending on where the property is located.

If the U.S. blocker corporation makes a dividend distribution out of its after-tax earnings and profits that accumulate as taxable income is earned over the years then there will be a 30% U.S. nonresident withholding tax on the distribution to the foreign investor.  This U.S. federal nonresident withholding tax is reportable on the U.S. federal Forms 1042 and 1042-S which are due by March 15th following the calendar year end.  It is possible to file for extensions.  The U.S. tax withheld is not refundable or creditable toward a U.S. federal tax liability of the foreign payee.  A U.S. income tax treaty may reduce the 30% U.S. nonresident withholding tax rate on the dividend. The 30% U.S. nonresident withholding tax applies to a distribution that is made to the extent of the U.S. blocker corporation’s current and accumulated earnings and profits.  Current earnings and profits (CEP) are undistributed after-tax earnings from taxable income earned in the current tax year.  Accumulated earnings and profits (AEP) are undistributed E&P from prior years before the current year.  Earnings and profits (E&P) are a concept for U.S. federal tax purposes.  E&P are not the same as financial accounting or “book” retained earnings for U.S. GAAP purposes.  Some adjustments are made to calculate earnings and profits based on U.S. tax principles.

The 30% U.S. nonresident withholding tax applicable to a dividend does not apply to the extent that the corporate distribution to the offshore investors exceeds E&P.  If the corporate distribution exceeds E&P then a U.S. federal Form 5452 is required to be filed with the U.S. federal Form 1120 corporation income tax return.  When a U.S. blocker corporation’s distribution exceeds E&P, the amount of the excess is first treated as a nontaxable return of capital to the extent of the shareholder’s capital contributions to the corporation.  If the distribution exceeds both E&P and the shareholder’s capital then the remaining amount of the distribution is treated as a capital gain to the foreign shareholder.  Depending on the structure and the type of foreign shareholder, a capital gain distribution may or may not be subject to U.S. tax. The 30% U.S. nonresident withholding tax applicable to a dividend does not apply if the U.S. blocker corporation disposes of all of its assets including U.S. real property interests that it owns and then makes a liquidating distribution of any remaining cash to its offshore investors.

The 30% U.S. nonresident withholding tax applies to payments of U.S. source interest income from the U.S. blocker corporation to foreign holders of the blocker’s debt obligations.  In a leveraged blocker structure, the foreign investors provide loans to the U.S. blocker.  The U.S. blocker’s repayment of principal is not subject to the 30% U.S. nonresident withholding tax.  The interest payments are subject to the U.S. nonresident withholding tax.  However, the portfolio interest exemption may apply if the debt obligation is in registered form and the foreign investor that provides the loan financing does not own 10% or more of the U.S. blocker corporation’s voting stock.  The foreign investor may own 10% or more of the economic interest in the U.S. blocker and still qualify for the exemption.  The U.S. blocker must file the U.S. federal Forms 1042 and 1042-S to report the payment of the interest income to the foreign investor and to claim the portfolio interest exemption.

The U.S. blocker corporation also may need to file the U.S. federal Form 5472 with its U.S. federal Form 1120 corporation income tax return.  The Form 5472 is required to be filed when the U.S. blocker corporation is owned at least 25% directly or indirectly by a foreign shareholder and there is a reportable transaction with a 25% foreign shareholder or a related party.  An example of a reportable transaction is a loan from a 25% direct or indirect foreign shareholder or a related party to the U.S. blocker corporation.  The penalty is $25,000 USD for not filing the Form 5472 on time with the U.S. federal Form 1120 corporation tax return by the original or extended due date.  The penalty applies for each required Form 5472 that is not filed on time.  A separate Form 5472 is required for each different 25% foreign shareholder or related party that engaged in a reportable transaction with the U.S. blocker corporation.  If the U.S. blocker corporation has four different 25% direct foreign shareholders and each shareholder provided a loan to the U.S. blocker then the Form 5472 failure to file penalty would be a total of $100,000 USD ($25,000 x 4).

Direct Investment in U.S. Real Property by a Foreign Corporation 

Alternatively, if a foreign corporation invests directly in U.S. real property, it will be required to file a U.S. federal Form 1120-F foreign corporation income tax return and state corporate tax return in the United States.  The U.S. federal Form 1120-F is generally due by the 15th day of the fourth month following the foreign corporation’s tax year end.  Similar to the U.S. blocker corporation, the foreign corporation reports its taxable income and deductible expenses annually on the U.S. tax returns.  Also the same as a U.S. blocker corporation, the foreign corporation pays U.S. federal and state corporate tax annually on the net taxable income earned each year.  The highest 21% U.S. federal corporate income tax rate also applies to the foreign corporation.  The foreign corporation is also subject to applicable state and local corporate income tax rates.

In addition to the regular U.S. federal income tax, a foreign corporation is generally required to pay a U.S. branch profits tax if its after-tax earnings are not reinvested in the U.S. business when it owns a direct interest in a U.S. real property.  The foreign corporation is not subject to the U.S. nonresident withholding tax on dividend distributions to foreign shareholders.  However, the U.S. branch profits tax effectively levels the playing field so that the U.S. income tax consequences to the foreign corporation are essentially comparable to the U.S. blocker corporation. If the foreign corporation disposes of all of its U.S. real property interests and liquidates then an exemption from the 30% branch profits tax may apply.

U.S. Real Property Investment through a U.S. or Foreign Partnership

While U.S. and foreign corporations may be preferable U.S. real property investment structures for certain reasons, U.S. and foreign partnerships also may provide certain advantages in terms of U.S. tax savings.  A potential downside to foreign investment in U.S. real property through partnerships is that the foreign investor is pulled into the U.S. tax system and must file U.S. tax returns.

A U.S. or foreign partnership that owns U.S. real property directly must file annual U.S. federal Form 1065 and state partnership tax returns.  Similar to the U.S. and foreign corporation structures, the partnerships must report the taxable income and expenses deductible for tax purposes on the annual U.S. tax returns.  The U.S. partnership tax returns are due by the 15th day of the third month following the partnership’s tax year end. The due date for the U.S. partnership tax returns may be extended by six months.  Late filing penalties apply if the U.S. partnership returns are not filed on time by the original or extended due dates.

However, the partnership generally is not required to pay U.S. tax at the partnership level.  The partnership issues a Schedule K-1 to the partners with their respective share of income, gain, loss, expense, deduction, and, credit from the partnership.  The partners are then required to file a U.S. tax return to report their share of the income from the partnership as effectively connected income from a U.S. trade or business.

With the U.S. federal partnership tax return filing, the U.S. or foreign partnership with foreign partners must report and pay foreign partner withholding tax.  This is an exception to the rule noted above that partnerships do not pay U.S. tax at the partnership level.  The partnership files the U.S. federal Forms 8804 and 8805 to report the foreign partner withholding tax.  The effectively connected taxable income (ECTI) from the partnership is subject to the highest U.S. federal tax rate depending on whether the foreign direct or indirect partner is a foreign corporation or a foreign individual.  This ECTI subject to the foreign partner withholding tax at the partnership level includes taxable income from net rental income if a proper election is made by the partner and any gain from the sale of U.S. real property.

The foreign partner files a U.S. tax return to report its respective Schedule K-1 share of income from the partnership.  The foreign partner then also claims a credit toward its U.S. tax liability on the partner’s U.S. tax return for its share of the foreign partner withholding tax that the partnership paid on behalf of the partner.  If the partner in the partnership is a foreign corporation then it files a U.S. federal Form 1120-F foreign corporation income tax return and state corporate tax return.  If the foreign partner in the partnership is a foreign individual then he or she files the U.S. federal Form 1040NR nonresident and state individual income tax returns.  The foreign partner is required to file a U.S. federal income tax return when they are invested in a U.S. or foreign partnership that owns U.S. real property.

In addition to a U.S. or foreign partnership’s obligation to comply with foreign partner withholding tax requirements, the partnership also may be required to file the U.S. federal Forms 1042 and 1042-S to report a foreign partner’s share of certain types of U.S. source passive income.  This other type of U.S. nonresident withholding tax applies at a rate of 30% to the foreign partner’s share of the U.S. source gross rental, dividend, or interest income from the partnership.  When a partnership has U.S. source rental income, the general rule is that the foreign partner’s share of the gross rental income is subject to a 30% U.S. nonresident withholding tax.  If the foreign partner makes an election, it is possible to avoid the 30% U.S. nonresident withholding tax on the gross rental income.  With the election, the foreign partner is subject to U.S. tax on the net rental income taking into account rental expenses instead of the 30% U.S. withholding tax on the gross rental income.

The partnership also reports the foreign partner’s share of interest income subject to the 30% U.S. federal nonresident withholding tax on the U.S. federal Forms 1042 and 1042-S.  If the foreign investor in the partnership has provided a loan to the partnership then this may give rise to the U.S. source interest income subject to the U.S. nonresident withholding tax.  If the debt obligation is structured in registered form then the foreign partner’s share of the interest income may qualify for the portfolio interest exemption.  To qualify for the exemption, the foreign partner cannot own 10% or more of the partnership. With this exemption, the foreign partner is effectively exempt from the 30% U.S. federal nonresident withholding tax.  However, the partnership must still file the U.S. federal Forms 1042 and 1042-S to report the foreign partner’s share of the U.S. interest income and to claim the portfolio interest exemption.

Foreign Direct Investment in U.S. Real Property      

As indicated above for the partnership structure, a foreign corporation will file a U.S. federal Form 1120-F foreign corporation and state corporate income tax return to report taxable income from a direct investment in U.S. real property.  Similarly, a foreign individual will file the U.S. federal Form 1040NR nonresident and state individual income tax returns to report taxable income from a direct investment in U.S. real property.  The due dates of the U.S. federal Forms 1120-F and 1040NR and state returns may be extended.

The foreign filers report taxable income such as rental income, gain from sale, and tax deductible expenses on the U.S. federal and state tax returns.  The U.S. federal and state tax liabilities are reflected on the U.S. tax returns.  The highest U.S. federal corporate income tax rate applicable to the foreign corporation on the U.S. federal Form 1120-F is the same flat 21% that applies to a U.S. corporation.  The highest U.S. federal individual income tax rate applicable to the foreign individual on the U.S. federal Form 1040NR is the same 37% that applies to a U.S. individual.  Foreign individuals that have U.S. source capital gain income may be exempt from U.S. federal tax.  Otherwise, capital gain tax rates up to 20% may apply.  In some circumstances, a foreign individual investor may qualify for a complete or partial exemption from U.S. federal tax on the capital gain from the sale of the U.S. real property.  This exemption may be based on the number of days present in the United States during the year of sale or certain applicable treaty provisions.    State and local taxes also may apply.

The pre-payment of U.S. federal and state estimated corporate and individual income tax is required to avoid an underpayment of estimated tax penalty.  If the foreign investor has not made the election to be subject to U.S. tax on the net rental income, then the 30% U.S. nonresident withholding tax applies to the gross rental income as noted above.  Without the election, the person responsible for making the payment of the U.S. rental income to the foreign person has the responsibility to deposit the tax withheld and file the U.S. federal Forms 1042 and 1042-S.

U.S. federal, state, and local income tax reporting and compliance requirements are quite technical for foreign investors in U.S. real property.  It is always advisable to consult with a qualified U.S. tax professional who has experience with these investment structures and who has the capability to address the specialized U.S. international tax and multi-state tax requirements.

For more information, please contact Alison Dougherty at ADougherty@wagnerduys.com

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