Pending Tax Legislation’s Effect on Timing the Sales of Real Estate by Foreign Investors in U.S Real Estate (FIRPTA)
Brad Wagner | December 13, 2017
Under the pending legislation in Congress, the House of Representatives has passed legislation to reduce the corporate income tax rate from 35% to 20% effective January 1, 2018. The Senate tax bill reduces the corporate income tax rate from 35% to 20% but the effective date is one full year later on January 1, 2019. For a large syndicated or unsyndicated foreign investor(s) in US real estate the question is whether to sell in 2017, 2018 or 2019.
If there are no pressing business reasons to sell in 2017, pushing the closing date into January 2018 makes sense. Since the current version of the House’s bill provides for a 20% corporate tax rate for sales in 2018, holding off one month has the potential to significantly increase your after tax returns. It is very possible that a bill passed later in 2018 will be effective to the first day of the year. Obviously various non-tax factors such as current contractual obligations, effect on internal rate of return for investors and possible price fluctuations. The latter two can come into play if the sale is to be deferred past 2018.
Let’s take a closer look at how that pending legislation affects foreign investors in US. real estate under the Foreign Investment in Real Property Tax Act (FIRPTA). In the typical FIRPTA structure, the foreign investors contribute capital to a foreign corporation in a non-tax jurisdiction such as the Cayman Islands. The foreign corporation then contributes the funds as capital or capital and debt to a wholly owned US C Corporation, known as a blocker corporation. The blocker corporation can purchase the real estate directly, but typically does so with a joint venture partner utilizing an LLC, with the LLC owning the real estate. The blocker corporation is a US taxpaying C Corporation. It blocks the foreign individual investor from paying US taxes, or any filing disclosures in the U.S. Utilizing the foreign corporation as the wholly owned parent of the US blocker corporation avoids the foreign investors from US estate taxes.
Let’s see how the current and pending legislation effects the Federal income tax on a FIRPTA investor using the structure discussed above. Under current law, the Federal corporate income tax rate is 35% for both ordinary income and capital gains. If the investor has property that it is ready to sell with a projected gain of $100 million, the following are the Federal tax projections in the four scenarios.
One. If the property is sold in December 2017, the $100 million gain is subject to a 35% Federal income tax rate and the Federal income tax is $35 million.
Two. If the property is sold in January of 2018 and the House legislation passes the full Congress, then the Federal income tax rate is 20% and the Federal income tax is $20 million. This is a $15 reduction in Federal income tax versus the current tax law.
Three. If the Senate bill passes and the property is sold in January 2018, the tax will be $35 million, the same as the current tax law.
Four. If the Senate bill passes and the property is sold in January 2019, the Federal income tax would be $20 million, a $15 Federal income tax reduction versus the current tax rate. To hold the property another year could have a significant effect on the price of the real estate either going up or down in value. This is a risk that the investors and their investment advisers will need to weigh.
It should be noted that state income tax due on the gain will continue to be deductible by the blocker corporation under both the House and Senate plans.
Other tax issues that need to be considered in the pending legislation include treatment of net operating loss (“NOL”) carryforwards to the blocker C Corporation. They may be limited to 80% or 90% of taxable income after 2017. However, existing NOLs may be grandfathered in. Carrybacks may not be allowed.
Earnings stripping rules under code section 163(j) may be repealed.
There will be a limitation on interest deductibility. The limitation on the deductibility of interest may be 30% of the taxable income before interest, taxes, depreciation, amortization and NOL deductions. Real estate trades or businesses are exempt from the interest deduction limitations. This is clear for the mortgage interest paid at the LLC level. It is ambiguous if this applies to the interest expense at the C corporation blocker level. Under the Tax proposals, businesses with average annual gross receipts of $25 million or less for the prior 3 tax years (or since inception if less than 3 years), are exempt from the interest limitations. Therefore, FIRPTA blockers may be exempt from the interest deduction limitations.
The pending tax legislation in Congress offers significant income tax planning opportunities to the FIRPTA investors and their investment advisors with sound advice from their tax advisor who is closely following the current tax legislation.