As U.S. real property prices continue to stagnate or even depress, and as the U.S. dollar continues to weaken against other currencies, U.S. real property becomes a more attractive investment for foreign persons. In fact, foreign investment in U.S. real property increased from less than $6 billion in 2009 to approximately $13.37 billion in 2010. Arleen Jacobius, Foreign Real Estate Investors Coming Ashore in U.S., Pensions & Investments (Apr. 4, 2011).
With increasing foreign investment, foreign persons are more likely to engage U.S. lawyers. Therefore, U.S. lawyers should be aware of the U.S. tax and reporting issues that await their foreign clients who own, or intend to own, U.S. real property. This article will provide 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 U.S. 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 (BEA), however, requires that certain surveys be completed by foreign persons who own substantial holdings of U.S. real property. These surveys are issued and collected by the BEA for purposes of gathering statistical data on foreign investment in the United States and can be summarized generally as follows:
- quarterly reporting of certain positions and transactions concerning the U.S. real property and its foreign owner(s), and foreign affiliates of its foreign owner(s), on the Quarterly Survey of Foreign Direct Investment in the United States (Form BE-605);
- annual reporting of financial and operating data concerning the U.S. real property on the Annual Survey of Foreign Direct Investment in the United States (Forms BE-15A, BE-15B, BE-15(EZ), and BE-15 Claim for Exemption); and
- benchmark reporting every five years of financial and operating data, positions, and transactions concerning the U.S. real property and its foreign owner(s), and foreign affiliates of its foreign owner(s), on the Benchmark Survey of Foreign Direct Investment in the United States (Forms BE-12(LF), BE-12(SF), BE-12 Bank, BE-12 Mini, and BE-12 Claim for Not Filing).
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 (or the total sales, operating revenues, or net income from such property). The filing thresholds for the BEA forms are quite high, with a threshold of $40 million for the annual and benchmark surveys and $60 million for the quarterly survey. The nuances of these surveys are also rather convoluted, so it is advisable to visit the BEA web site for guidance (current reporting requirements can be found at www.bea.gov/surveys/pdf/2010current_Reporting_ Requirements.pdf).
In addition, foreign ownership of U.S. real property could become reportable under the Internal Revenue Code in the future. The Foreign Investment in Real Property Tax Act of 1980 (FIRPTA), discussed in more detail below, added several sections to the IRC, including IRC § 6039C, which imposes certain information-reporting requirements to disclose foreign investment in U.S. real property. These reporting requirements, however, are not yet operative because the required Treasury Regulations have not been issued. Treasury has stated that it will implement such regulations only if it finds abuse of the IRC § 1445 withholding tax (also discussed below). T.D. 8000, 1985-1 C.B. 296, 301.
Income from U.S. Real Property
In general, 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. IRC § 861(a)(4). The taxation of that income depends on whether it is characterized as income “effectively connected with the conduct of a U.S. trade or business” or as passive investment income.
The question of whether income is effectively connected with the conduct of a U.S. trade or business is a highly factual, case-by-case determination. Rev. Rul. 88-3, 1988-1 C.B. 268. Numerous factors relating to the U.S. activities of the foreign person and its agents are taken into account. Rev. Rul. 70-424, 1970-2 C.B. 150; Rev. Rul. 80-225, 1980-2 C.B. 318. In addition, there generally is thought to be a spectrum of U.S. real property ownership as it relates to the conduct of a U.S. trade or business. On one end (when ownership is found not to constitute a U.S. trade or business) is the ownership of one piece of U.S. real property leased to a tenant on a triple-net basis. Neill v. Commissioner, 46 B.T.A. 197 (1942). On the other end (when ownership is found to constitute a U.S. trade or business) is the ownership of several properties with substantial, regular, and continuous management activities. Pinchot v. Commissioner, 113 F.2d 718 (2d Cir. 1940).
Passive Investment Income. 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% tax on all fixed, determinable, annual, or periodical (FDAP) income generated by U.S. real property (which includes rental income on U.S. real property). IRC §§ 871(a)(1)(A) and 881(a)(1). A foreign person is taxed on a gross basis of all FDAP income, and the 30% tax is collected by withholding at the source of the income (for example, the tenant paying rent). IRC §§ 1441 and 1442.
Trade or Business Income. 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, such as depreciation, mortgage interest, property taxes, and so on). IRC §§ 871(b)(1) and 882(a)(1).
Branch-Profits Tax. If the owner of U.S. real property is a foreign corporation, then the foreign corporation will be subject to the “branch-profits tax” on rental income generated by the U.S. real property that is effectively connected with the conduct of a U.S. trade or business. IRC § 884. In addition, a foreign corporation that owns U.S. real property may elect under IRC § 882(d) to treat all income related to the property as if it were income from a U.S. trade or business.
The branch-profits tax is essentially a double tax on the corporation’s effectively connected income and is aimed at mimicking the double taxation of dividends from U.S. corporations. Thus, the branch-profits tax is an additional tax of 30% (on top of the regular income tax) imposed on the “effectively connected earnings and profits” of a foreign corporation that are not reinvested in the corporation’s business. IRC § 884(a), (b).
Gains from Sales
Generally, a foreign person is not subject to U.S. capital gains tax on the sale of U.S.-sitused capital assets. 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 (and, in certain circumstances, the gain from the sale of an interest in U.S. corporations that own U.S. real property) is treated as income effectively connected with a U.S. trade or business. IRC § 897(a)(1). 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 (discussed above).
When a foreign person disposes of U.S. real property, 10% of the amount realized must be withheld by the transferee, regardless of the amount of the foreign person’s gain. IRC § 1445(a). 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 (as discussed below) to calculate the amount of tax due. Treas. Reg. § 1.1445-1(f)(1). 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. Treas. Reg. §§ 1.6012-1(b)(2)(i) and 1.6012-2(g)(2)(i)(a).
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. A foreign individual must file a Form 1040-NR (U.S. Nonresident Alien Income Tax Return), and a foreign corporation must file a Form 1120-F (U.S. Income Tax Return of a Foreign Corporation). 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. Treas. Reg. §§ 1.6012-1(b)(1)(i), 1.6012-2(g)(1)(i).
As a final matter, it should be noted that most states and local governments impose some combination of income tax and property tax (and related reporting obligations) on U.S. real property located within their jurisdictions, but such taxes are outside the scope of this article.
Gift of U.S. Real Property
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. Treas. Reg. § 1.1445-1(b)(1). 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. Treas. Reg. § 1.1445-1(g)(5)(iii).
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. IRC §§ 2501 and 2511. The donee then receives the property with the donor’s carryover basis. IRC § 1015.
A foreign individual must file Form 709 (United States Gift (and Generation-Skipping Transfer) Tax Return) to report all taxable gifts of U.S. real property. A gift of an interest in U.S. real property will be treated as taxable if such gift was of (1) a future interest, (2) a present interest or interests to one donee (other than a spouse or a charity) with a fair market value in excess of the annual exclusion amount (currently $13,000), or (3) a present interest or interests to a non-U.S. citizen spouse with a fair market value in excess of the foreign spouse annual exclusion amount (currently $139,000). IRC § 2503; Treas. Reg. §§ 25.2503-1, 25.2503-2, and 25.2503-3. In addition, all gifts to a U.S. citizen spouse are eligible for the unlimited marital deduction under IRC § 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. IRC § 2103. (Several states also impose forms of death, estate, or inheritance taxes on property located within their jurisdictions, but these taxes are outside the scope of this article.) 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 (that is, the lender can hold the foreign person personally liable for the debt) or nonrecourse (that is, the lender’s only recourse is through a foreclosure sale of the property). If the property is subject to recourse debt, then the full value of the property is included in the foreign person’s taxable estate, and the estate receives only a deduction for the portion of the debt that bears the same ratio as the value of the foreign person’s U.S.-situs property bears to his or her worldwide property. Treas. Reg. § 20.2106-2(a)(2). If the property is subject to nonrecourse debt, then only the net value of the property is included in the foreign person’s taxable estate. Treas. Reg. § 20.2053-7.
Currently, only a minimal estate-tax exemption of $60,000 is available to foreign individuals. IRC § 2102(b)(1). The executor of a foreign individual’s estate with gross assets in excess of $60,000 is required to file Form 706-NA (United States Estate (and Generation-Skipping Transfer) Tax Return).
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. IRC § 2104(a).
If a beneficiary receives U.S. real property outright from a foreign individual, then the beneficiary’s basis in such property is equal to the fair market value at the foreign individual’s date of death, thereby potentially reducing the gain on a subsequent sale. IRC § 1014; Rev. Rul. 84-139, 1984-2 C.B. 168. If the U.S. real property is held in a corporation, however, the basis of the property (which is presumably lower than its fair market value) remains the same.
U.S. Beneficiaries of Foreign Gifts and Estates
Generally, a U.S. person is not taxed on the receipt of gifts or bequests. But if a U.S. person (other than a spouse or a charity) receives a gift or bequest from a covered expatriate (as defined in IRC § 877A), then such gift or bequest will be subject to possible tax and reporting obligations. IRC § 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 § 2503(b) (currently $13,000). The tax is paid by the U.S. recipient of the covered gift or bequest. IRC § 2801(b).
A covered gift or bequest is any property received by gift or by reason of death from a covered expatriate other than the following gifts or bequests:
- any property that is taxable as a gift under IRC Chapter 12 and is included on a timely filed Form 709; or
- any property that is part of the covered expatriate’s U.S. gross estate under IRC Chapter 11 and is included on a timely filed Form 706.
IRC § 2801(e).
Thus, a gift or bequest of an interest in a foreign corporation (which owns U.S. real property) from a covered expatriate to a U.S. person (other than a spouse or charity) would be taxable to such U.S. beneficiary, while a gift or bequest of an interest in U.S. real property from a covered expatriate to a U.S. person would not be taxable to such U.S. beneficiary. IRC § 2801.
In any event, a U.S. person must file a Form 3520 (Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts) to report gifts or bequests from a foreign person if such gifts or bequests exceed $100,000 in the aggregate during the tax year. IRC § 6039F.
With depressed U.S. real property values and the appreciation of foreign currencies against the U.S. dollar, foreign investors have begun to dip back into the U.S. real property market. Add in the high likelihood of inflation in the long term, and U.S. real property may appear an attractive place to bet on the U.S. recovery.
As potential advisors to foreign investors, U.S. lawyers should be aware of the tax and reporting obligations that their clients will incur when holding U.S. real property. An understanding of these obligations and the associated U.S. laws and regulations can provide the basis for addressing foreign investors’ common questions (such as form of ownership), while ensuring that the client complies with his or her U.S. obligations.