U.S. residential and commercial real estate has been a popular source of investment for foreign persons for decades and easily exceeds $100 billion dollars on an annual basis. Because of the unique way that the U.S. taxes nonresident individuals and entities on the sale of U.S. real estate, it is crucial to plan before acquiring or selling such investments. This article briefly discusses the U.S. tax rules related to nonresident investments in U.S. real estate assets.
Foreign Investment in Real Property Tax Act
Nonresident individuals and entities are generally exempt from U.S. tax on the sale of most types of U.S. capital assets, including investment securities. However, this tax exemption does not extend to nonresidents’ sale of U.S. real property interests.
Nonresidents’ disposition of U.S. real property interests is governed by the U.S. tax regime known as the Foreign Investment in Real Property Tax Act (“FIRPTA”). FIRPTA provides a comprehensive set of rules for taxing both the sale of real property interests and the direct or indirect transfer of U.S. real property interests within a family or group of related entities.
What is a U.S. real property interest?
Under FIRPTA, a “U.S. real property interest” includes direct ownership of U.S. real property by a nonresident individual or entity, other than as a creditor. Relevant U.S. real property interests includes directly owned land, residential property, and commercial property.
A U.S. real property interest also includes an interest (other than as a creditor), in a U.S. corporation whose U.S. real property interests equal or exceed 50 percent of the fair market value the company’s assets. This type of corporate U.S. real property interest is referred to as a U.S. Real Property Holding Corporation (“USRPHC”).
A nonresident’s sale or transfer of either type of U.S. real property interests is subject to the U.S. FIRPTA rules.
When Does FIRPTA come into play?
FIRPTA tax is triggered when a non-resident individual or a foreign entity sells or transfers their U.S. real property interest. Complex FIRPTA rules also apply to certain transfers of real property that are carried out via transactions that would otherwise qualify as tax-free reorganizations.
How is a Sale or Transfer of U.S. Real Property Taxed?
When a nonresident sells or disposes off a U.S. real property interest that is subject to FIRPTA tax, the acquiror (individual or entity) is required to withhold 15% on the gross amount realized by the seller. The gross “amount realized” includes the cash paid to the nonresident seller, the fair market value of any other property transferred, as well as any outstanding liabilities attached to the U.S. real property interests.
Subject to fulfillment of certain conditions, the transferor may apply to the U.S. Internal Revenue Service for non-applicability or reduced rate of withholding tax. Processing times for these certificates can take several weeks, so this should be considered well in advance when undertaking any transactions.
Nonresident Seller or Transferor Generally Required to File a U.S. Income Tax Return?
In addition to being subject to U.S. withholding tax, a seller must file a U.S. income tax return for the year of disposition to report the disposition. To the extent the withholding tax on the gross sales price exceeds the U.S. tax that would be applied on a net basis (i.e., after taking into account applicable deductions), the nonresident seller may request a refund of excess amounts withheld.
For nonresident companies, the applicable tax rate that would apply on net proceeds of real property sales or dispositions is 21 percent, while the tax rate for individuals would be the applicable graduated tax rate (between 10 and 37 percent).
Advanced Planning is Crucial Prior to Acquisition or Sale of U.S. Real Estate
To ensure that nonresidents’ investments in U.S. real property is undertaken as tax efficiently as possible, it is important that careful consideration be given to the following items:
- Tax efficient financing of the acquisition
- Tax efficient ownership structure
- Tax efficient operating structure where the U.S. real property will generate leasing income
- Potential exposure to multiple layers of U.S. tax on disposition
- Potential exposure to U.S. estate tax
Our international tax group has extensive experience is helping nonresidents with the acquisition and disposition of U.S. real property and our dedicated team of specialists would be happy to assist you to ensure that your investment is carried out as efficiently as possible.
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