This article provides a broad overview of the U.S. tax and reporting issues related to the acquisition, ownership, and disposition of U.S. real property by foreign persons.
Acquisition and ownership. Currently, the United States does not tax or impose a filing obligation on the acquisition or mere ownership of U.S. real property by a foreign person. The U.S. Department of Commerce’s Bureau of Economic Analysis, however, requires that certain surveys be completed by foreign persons who own substantial holdings of U.S. real property.
A foreign person’s obligation to complete these surveys depends on the aggregate fair market value of all U.S. real property that he or she owns.
Income tax issues. Only certain U.S.-source income of a foreign person is subject to U.S. income taxation. For U.S. real property, all rental income is U.S.-source income, whether received by a foreign individual or by a foreign corporation. The taxation of that income depends on whether it is characterized as passive investment income or as income “effectively connected with the conduct of a U.S. trade or business.”
If a foreign person is not engaged in the conduct of a U.S. trade or business, then the foreign person is subject to a 30 percent tax on all fixed, determinable, annual, or periodical (FDAP) income generated by U.S. real property (which includes rental income). A foreign person is taxed on a gross basis of all FDAP income, and the 30 percent tax is collected by withholding at the source of the income (for example, the tenant paying rent).
If, instead, the foreign person’s rental income on U.S. real property is effectively connected with the conduct of a U.S. trade or business, then the foreign person is subject to regular U.S. income tax rates on a net basis (that is, after deductions attributable to the property).
If the owner is a foreign corporation, then the corporation will be subject to the “branch-profits tax” on rental income generated by the property that is effectively connected with the conduct of a U.S. trade or business. In addition, a foreign corporation that owns U.S. real property may elect under IRC Section 882(d) to treat all income related to the property as if it were income from a U.S. trade or business.
Generally, a foreign person is not subject to U.S. capital gains tax on the sale of U.S.-sitused capital assets. The Foreign Investment in Real Property Tax Act (FIRPTA), however, created an exception to that rule for U.S.-sitused real property. Under FIRPTA, a foreign person’s gain on the sale of U.S. real property is treated as income effectively connected with a U.S. trade or business. As effectively connected income, such gain is subject to regular U.S. income tax rates. As such, if the U.S. real property is held by a foreign individual, qualifies as a capital asset, and was held for at least one year, any gain will be subject to the lower capital gains tax rates. And, if the property is held by a foreign corporation, the corporation will be subject to regular income tax plus the branch-profits tax.
When a foreign person disposes of U.S. real property, 10 percent of the amount realized must be withheld by the transferee, regardless of the amount of the foreign person’s gain. The withheld amount is not the final tax obligation but is treated as an advance payment. A foreign person still must file the applicable U.S. income tax return to calculate the amount of tax due. The amount withheld is then credited against the total income tax liability.
If a foreign person is not engaged in a U.S. trade or business and all tax is fully withheld at the source, then no U.S. income tax return is required. If, however, any part of the tax is not withheld at the source, or if the foreign person receives income effectively connected with a U.S. trade or business, then a U.S. income tax return is required (Form 1040-NR for foreign individuals and Form 1120-F for foreign corporations). If engaged in the conduct of a U.S. trade or business, a foreign person is required to file the applicable income tax return even if (1) there was no net taxable income, (2) there was no U.S.-source income, or (3) a particular income tax treaty exemption applies.
Gift tax issues. If U.S. real property is disposed of by gift, then FIRPTA withholding does not apply, and the foreign donor does not recognize gain, unless the property is subject to liabilities in excess of the donor’s basis. If the U.S. real property is subject to liabilities in excess of the donor’s basis, then the amount realized would include the amount of any liability that the donee assumes, and the withholding obligation would apply to such amount realized.
On the disposition of an interest in U.S. real property by gift, the foreign donor is subject to U.S. gift tax at regular gift tax rates. The donee then receives the property with the donor’s carryover basis.
A foreign individual must file Form 709 to report all taxable gifts of U.S. real property. In addition, all gifts to a U.S. citizen spouse are eligible for the unlimited marital deduction under IRC Section 2523 and need not be reported on Form 709.
Estate tax issues. Generally, a foreign individual is subject to U.S. estate tax on all property situated in the United States. The treatment of a foreign individual’s ownership interests in U.S. real property at death depends on the form of ownership.
If U.S. real property is held outright by a foreign individual at his or her death, then that property is subject to U.S. estate tax. If the property is subject to a debt, the value of the property used for estate-tax purposes will depend on whether the debt is recourse or nonrecourse. A U.S. estate tax return must be filed if the value of the foreign individual’s gross U.S. assets exceeds $60,000.
If, however, the foreign individual owns U.S. real property in a foreign corporation, the individual will not be subject to estate tax on that property because the shares of a foreign corporation are considered non-U.S. sitused assets for U.S. estate tax purposes.
A beneficiary’s basis in U.S. real property received outright from a foreign individual is equal to the fair market value at the foreign individual’s date of death, thereby potentially reducing the gain on a subsequent sale. The basis of U.S. real property held in a corporation, however, remains the same.
U.S. beneficiaries of foreign gifts and estates. Generally, a U.S. person (other than a spouse or charity) is not taxed on the receipt of gifts or bequests. But if a U.S. person receives a gift or bequest from a covered expatriate, then such gift or bequest will be subject to possible tax and reporting obligations. IRC Section 2801 imposes an inheritance tax at the highest marginal estate tax rates on the fair market value of a “covered gift or bequest” that exceeds the annual exclusion amount under IRC Section 2503(b). The tax is paid by the U.S. recipient of the covered gift or bequest.
A U.S. person must file a Form 3520 to report gifts or bequests from a foreign person if such gifts or bequests exceed $100,000 in the aggregate during the tax year.
ABA Real Property, Trust and Estate Law Section
This article is an abridged and edited version of one that originally appeared on page 52 of Probate & Property, May/June 2012 (26:3).
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