Some of the world’s most desirable real estate markets are in the United States.
But to take advantage of those real estate markets, you have to understand the complex tax rules that govern foreign investment in U.S. real estate. The key federal law governing realty transactions is the Foreign Investment in Real Property Tax Act (FIRPTA).
Here’s what you need to know about investing in real property, REITs, and how recent changes to the law may affect you.
The key federal law governing realty transactions is the Foreign Investment in Real Property Tax Act (FIRPTA). FIRPTA was first passed by Congress in 1980. It went under significant changes in 2015 and again in 2017, with the passage of the Tax Cuts and Jobs Act. Unfortunately, due in part to its complexity, many investors fail to review FIRPTA’s provisions and aren’t prepared for the tax consequences it mandates.
The following will clarify the rules and responsibilities for the transferee (or buyer) and transferor (or seller) when non-U.S. investors seek to buy and sell U.S. real estate.
- A foreign person (individual or entity) will be subject to FIRPTA upon the disposition of a U.S. real property interest (USRPI).
FIRPTA is a process put in place to ensure the collection of tax from a foreign person upon the disposition of a USRPI. The disposition of an interest in U.S. real property by a foreign person is subject to tax. The transferee (buyer or agent) must usually withhold tax and submit the appropriate tax returns. The withholding tax is 15 percent of the net proceeds — typically the sales price less any sales commissions.
However, treaty exceptions may apply, and that the withholding obligation is on the buyer or their agent, and not on the foreign seller. Why? Because it is easier for the IRS to collect from someone with a U.S. connection.
- Tip: When discussing FIRPTA, remember that definitions are particularly important.
For the purposes of FIRPTA specifically, a foreign person can be defined as a:
- non-resident alien (NRAs);
- foreign corporation that has not made an election to be treated as a U.S. (domestic) corporation for FIRPTA purposes;
- foreign partnership;
- foreign trust;
- foreign estate.
- Tip: U.S. real property interest also has a specific meaning. It is defined in the tax code as:
- Any interest in real property and associated property located in the U.S. or the Virgin Islands.
- Interest in a domestic or foreign corporation defined as a U.S. real property holding company.
- A U.S. real property holding company (USPHC) is defined as a domestic or foreign corporation that has U.S. real property interests that equal or exceed 50 percent of the total fair market value of its U.S. and foreign real property and any other assets used in trade or business.
- There is an exception for stock regularly traded on an established securities market. Assets held by a partnership, trust, or estate are treated as being held proportionately by its partners or beneficiaries.
Recent FIRPTA Changes Affecting REITs
In 2017, the Tax Cuts and Jobs Act made significant changes to all aspects of U.S. income tax law. One of the areas most affected were real estate investment trusts (REITs). Transactions that had been subject
to a 35 percent FIRPTA tax rate are now indexed to the highest corporate tax rate in effect for the taxable year—which shifted to 21 percent under the 2017 tax reform law.
This means REITs have been treated particularly well under tax reform.
Some of the most important changes to note include: REITs are now subject to new corporate tax rates. Meaning, most REITs will be taxed at the lower 21 percent rate on undistributed income. This includes capital gain dividends and liquidating distributions. And, it should be noted that these reduced tax rates won’t sunset until Dec. 31, 2025.
FIRPTA’s 15 percent withholding rule generally applies regardless of the amount of gain (or loss) of the foreign seller. The amount realized is the net proceeds and includes cash, fair market value of other property, and liabilities assumed by the buyer or to which the U.S. real property interest is subject. Of course, there are exceptions to the rule—for example, if the property is acquired by the buyer for use as a residence and the purchase price is less than $300,000.
The transferee has 20 days after the transfer date to submit the tax withheld. The transferee will receive credit for the amount of tax withheld by attaching evidence of the withholding on their return. In this case, the 15 percent withholding is not the amount of tax, but merely a mechanism for the U.S. to ensure the collection of tax.
Foreign Person’s Tax Filing Requirements
NRAs who have a direct investment (own the property in their individual name) in U.S. real property must generally file income tax returns, except where they are engaged in a U.S. trade or business and the fair market value of the U.S. real property does not exceed $50,000. In addition, all persons subject to tax on their U.S. real estate investments must pay the required tax and file a return.
Taxable dispositions are broadly defined and include the following:
- Tax-free exchanges
- Certain gifts
- Sales of interests in partnerships with USRPIs
- Trusts with USRPIs
- Estates that have USRPIs
The 15 percent FIRPTA withholding is credited toward the ultimate tax liability, and the difference is refunded to the foreign person, unless the withholding was not sufficient to satisfy the tax. In that case, the taxpayer will owe the difference to the U.S. government.
- NRAs who have never filed a U.S. tax return or are unable to obtain a Social Security number must get an individual taxpayer identification number (ITIN) by filing Form W-7 with the IRS. An ITIN is needed to obtain a reduced withholding certification on FIRPTA Form 8288-B in order to file the required return if they are to receive a credit for overpayment of taxes.
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