Complying with FIRPTA and Using 1031 Exchanges
For many, the purchase of real property is the single largest investment of a lifetime. The excitement of buying real property is heightened when that property is located in a country other than one's own. For a variety of reasons, including the current weak dollar, U.S. real property looks very attractive to foreign investors. Non-US. citizens or residents may acquire real property in the United States with relative ease, with the caveat that financial institutions are often reluctant to provide mortgage financing for real property to foreign investors. There is a potential risk of tax not being collected when the foreign investor sells or disposes of U.S. real property and returns home. To avoid this, Congress enacted the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA).
The purpose of FIRPTA is to impose an income tax on the gains made by foreign persons upon disposition of real property situated in the United States. The FIRPTA tax is generally imposed on any U.S real property interest, which includes U.S. real estate owned directly by foreign persons, as well as shares owned by a foreign person in a U.S. corporation that owns substantial U.S. real estate (referred to as a U.S. real property holding corporation).
This article discusses basics that need to be considered when advising foreign clients who are planning to dispose of their U.S. real property and must comply with the provisions of FIRPTA.
Foreign Investment in Real Property Tax Act
The United States generally has no jurisdiction to tax foreign persons on capital gains that are sourced within the United States, unless those gains are "effectively connected with a US. trade or business." Under IRC section 897 (FIRPTA) rules, any gain realized by a foreign person upon the disposition of a U.S. real property interest (USRPI) is treated as being effectively connected with a US. trade or business. Such a gain is deemed to be a long-term capital gain, and it is subject to U.S. federal income tax at the graduated tax rates that apply to U.S. individuals. This contrasts sharply with the flat 30% tax rate (unless reduced by treaty) that the U.S. imposes, through the withholding procedure, on the U.S. source income of foreign persons that is not effectively connected with a U.S. trade or business. Income that is not effectively connected with a U.S. trade or business includes interest, dividends, rents, royalties, premiums, the income portion of annuities, prizes, awards, alimony, gambling income, and other "fixed or determinable, annual or periodical" income.
Before going further, it is important to determine what constitutes a USRPI. IRC section 897 (cXIXA) defines it as:
* A direct interest in real property (i.e., land, buildings, mines, wells, crops, or timber) located in the U.S.; and
* An interest (other than an interest solely as a creditor) in any domestic corporation that constitutes a U.S. real property holding corporation (USRPHC).
A USRPHC is a corporation whose USRPIs make up at least 50% of the total value of its real property interests and business assets. In certain circumstances, under IRC section 897(g) and Temporary Treasury Regulations section 1.897-7T, an interest in a partnership may also be considered to be a USRPI to the extent that the partnership owns USRPI.
According to Treasury Regulations section 1.897-1(d)(2)(i), "an interest other than an interest solely as a creditor" is expanded to include "any direct or indirect right to share in the appreciation in the value [of], or in the gross or net proceeds or profits generated by, the real property." The regulations further stipulate that a "loan to an individual or entity under the terms of which a holder of the indebtedness has any direct or indirect right to share in the appreciation in value of, or the gross or net proceeds or profits generated by, an interest in real property of the debtor or of a related person is, in its entirety, an interest in real property other than solely as a creditor. …