Foreign investors often invest in commercial and residential real property located in the United States. The economic advantages of U.S. real property investment include the opportunity for appreciation in value and a profitable return on the investment. The Internal Revenue Service has noted a “phenomenal rise” in foreign investment in U.S. real property due to recent lower interest rates and a weakened U.S. dollar.
There is a requirement for the buyer to withhold U.S. federal tax when a foreign investor sells U.S. real property. The U.S. withholding tax is a percentage of the gross sale proceeds that the seller receives from the sale. In many cases, the U.S. withholding tax as a percentage of the gross sale proceeds will be a greater amount than the final U.S. tax liability on the seller’s gain from the sale.
The legal authority for the U.S. withholding tax is based on a law referred to by the acronym FIRPTA. FIRPTA is the Foreign Investment in Real Property Tax Act. It was enacted in the year 1980 as part of the U.S. federal tax law in the Internal Revenue Code.
A foreign seller of U.S. real property is subject to FIRPTA withholding tax on the total gross sale proceeds received which may include cash, debt relief, i.e., liabilities assumed by the buyer, and the fair market value of any other property received. However, the seller’s final U.S. tax liability is based on the gain from the sale which is the amount of the gross sale proceeds received less the seller’s adjusted basis in the property. The adjusted basis is generally the original cost to purchase the property plus the additional cost of any improvements less any depreciation on a rental property. The seller is also allowed to decrease the gain on sale by certain selling costs.
Foreign investors are often interested in what U.S. tax planning opportunities may be available to mitigate the impact of the FIRPTA withholding tax requirement. A highly effective way to minimize a foreign seller’s FIRPTA withholding tax liability is to file a U.S. federal Form 8288-B application for a FIRPTA withholding tax exemption certificate. If the seller’s final U.S. tax liability on the gain will be less than the FIRPTA withholding tax liability then the IRS may issue a certificate that allows a reduced amount of U.S. tax withholding. Due to the time required for the IRS to process the application, the Form 8288-B should be filed at least 90 days prior to the closing date of the sale. The buyer is typically required to collect and remit the FIRPTA withholding tax to the U.S. Government within 20 days of the closing date of the sale.
The following is a basic example. A foreign investor purchases U.S. real property for $7M USD in Year 1. The original $7M purchase price includes $2M of cash and a $5M mortgage liability. The property is held as a rental property. The foreign investor incurs an additional cost of $500K to improve the property. Depreciation on the property is allowed or allowable in the total amount of $300K for the first four years. The foreign investor sells the U.S. real property for $10M USD in Year 4. The foreign seller’s gross sale proceeds include $6M USD of cash and $4M of debt relief, i.e., the mortgage liability assumed by the buyer. The seller’s selling costs are $600K. The foreign seller’s FIRPTA withholding tax liability would be $1.5M USD which is 15% multiplied times the gross sale proceeds of $10M USD. The foreign seller’s gain on the sale is $2.2M USD which is the gross sale proceeds, i.e., the amount realized of $10M USD, less the seller’s adjusted basis of $7.8M USD ($7M original cost + $500K improvements + $600K selling costs – $300K depreciation). For this example, it is assumed that the gain is sourced to a state that does not impose tax on the gain.
If the foreign seller is a foreign corporation that owns the U.S. real property directly, the U.S. tax liability is approximately $983K USD which is the U.S. federal corporate tax at 21% on the $2.2M gain plus a 30% branch profits tax on the after-tax earnings that are not reinvested in other U.S. assets. This assumes that the foreign corporation continues to own other U.S. real property interests after the sale. 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.
If the foreign seller is a foreign individual that owns the U.S. real property directly, the U.S. federal tax liability is approximately $455K which is the U.S. federal individual tax at 20% on the $2.2M gain less $300K attributable to depreciation plus tax at 25% on the depreciation recapture from the rental property. In some circumstances, a foreign individual investor may qualify for a complete or partial exemption from U.S. federal tax on the 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.
Based on this example, it is evident that the U.S. federal tax liability on the gain is much less than the FIRPTA withholding tax liability on the gross sale proceeds. For illustrative purposes, the example above focuses on the U.S. federal tax liability and does not take into account the state income tax liability.
If the foreign investor files the Form 8288-B, the IRS may reduce the FIRPTA withholding tax liability to the amount of the actual U.S. federal income tax liability that is due on the gain. In the example above, this means that the total U.S. tax liability is approximately $983K USD if the foreign investor is invested in a foreign corporation that owns the U.S. real property. The total U.S. tax liability is $455K if the foreign individual investor is invested directly in the U.S. real property. As the example demonstrates, the foreign investor’s actual U.S. tax liability is much less than the $1.5M FIRPTA withholding tax liability. The FIRPTA withholding tax exemption certificate will authorize the buyer to withhold and remit the reduced amount of the FIRPTA withholding tax based on the seller’s actual U.S. federal tax liability on the gain.
It is important to note that even if the IRS allows the FIRPTA withholding tax exemption certificate, the foreign investor must file a U.S. federal income tax return for the year in which the U.S. real property is sold. The U.S. tax return will report the final amount of the U.S. tax liability for the year which could result in the amount of a tax refund or additional tax due.
Another possible planning opportunity to mitigate FIRPTA withholding tax is to structure the foreign investor’s investment in the U.S. real property through a U.S. blocker corporation. Assume the same facts as the example above. If the foreign seller is invested in a U.S. corporation, i.e., a U.S. blocker corporation, that owns the U.S. real property, the U.S. federal tax liability is approximately $983K USD which is U.S. corporate tax at 21% on the $2.2M gain plus a 30% U.S. nonresident withholding tax on the U.S. corporation’s distribution of its after-tax earnings from the gain as a dividend distribution to the foreign investor. A U.S. income tax treaty may reduce the 30% U.S. nonresident withholding tax rate on the dividend. This assumes that the U.S. blocker corporation continues to own other U.S. real property interests and it does not make a final liquidating distribution of the sale proceeds. If the U.S. blocker corporation disposes of all of its U.S. real property interests, then the liquidating distribution to the foreign investors is not subject to the 30% U.S. nonresident withholding tax. The U.S. blocker corporation structure avoids the FIRPTA withholding tax liability on the U.S. corporation’s sale of the U.S. real property interests.
It is advisable to work with a qualified FIRPTA specialist who has experience preparing and filing the U.S. federal Form 8288-B with the IRS. Certain information must be provided. The IRS will effectively grant the FIRPTA withholding tax exemption certificate when sufficient documentation is presented to support the application. Effective planning with the U.S. blocker corporation structure would include modeling the calculations of the U.S. tax consequences. It is important to consult with a qualified tax professional who has the capability to add value in the planning process.
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