If you are a foreign investor and considering purchasing real estate in the United States, this article is a must-read. The U.S. has a set of complex tax laws which develop rapidly with new proposals and interpretations changing practically every year. In order to mitigate any run-ins with the IRS, taxpayers must be proactive in making sure they are compliant with their U.S. filing requirements. This includes foreign persons who have ties with the U.S., such as owning real estate here. It’s very easy for any taxpayer to become confused or even fail to comply with U.S. tax obligations. In this article, we’re going to talk about the tax consequences of investing in U.S. real property as a foreign national or entity.
Are you ready to purchase real estate in the United States?
It is very common for visitors to the U.S. to purchase real estate here, whether it’s a vacation home or investment property. Before you sign the contract, we strongly suggest speaking with a tax advisor in the U.S. who can recommend an appropriate holding structure that will meet your needs and avoid potential unintended consequences of holding U.S. real estate, such as being subject to withholding taxes, estate taxes, and so on.
Foreign investment of property – Rent and Sale
To give some background information, nonresident aliens (“NRAs”) and foreign corporations (“FCs”) are generally taxed on two categories of income: (1) fixed or determinable annual or periodical income from U.S. sources (“FDAP”), and (2) income that is effectively connected with a U.S. trade or business (“ECI”). FDAP is subject to U.S. gross withholding tax at a 30% rate (or a lesser rate if a treaty in effect so specifies), and ECI is subject to tax on a net basis at the graduated rate schedule in effect for U.S. residents. If income constitutes ECI, then it will not also be subject to the gross withholding tax as FDAP.
As discussed in the following sections, an NRA or FC can have tax implications from an investment in U.S. real estate when rents are received, or the property is sold.
Rental Income Treatment
The tax implications from the receipt of rental income depend on whether the rent payments constitute ECI or FDAP. The income will constitute ECI if the NRA or FC engages in activities with respect to the rental property that are considerable, as well as continuous and regular. However, even if the rental income does not constitute ECI under the normal rules, the NRA or FC may nonetheless elect to treat the rental income as ECI. If the income is not treated as ECI, it will default to treatment as FDAP.
In general, an NRA or FC will prefer the income to be treated as ECI because the tax will be assessed on a net basis. Rental properties generally have many tax-deductible expenses associated with them, such as mortgage interest, homeowners’ association fees, insurance, property taxes, and depreciation. If the income is taxed on a gross basis, these expenses are wasted. For example, assume that Mr. Alien owns a rental property in the U.S and he receives $50,000 of rent payments and incurs $20,000 of expenses with respect to the property. If the income constitutes ECI, then Mr. Alien will be subject to tax on the net rental income of $30,000. Conversely, if the income constitutes FDAP, Mr. Alien will be subject to tax on the gross rental income of $50,000. Accordingly, the election to treat rental income as ECI will be the right choice for many NRAs and FCs, especially those from jurisdictions that have not entered any treaty with the U.S.
Sale of Real Property Treatment – Required Withholding
Because capital gains are not ordinarily considered FDAP income, the Foreign Investment in Real Property Tax Act (“FIRPTA”) was enacted to ensure that gains resulting from the disposition of U.S. real estate would be subject to tax here, in the United States. FIRPTA provides that gain or loss from the disposition of a U.S. real property interest (“USRPI”) will be treated as ECI and subject to tax at the graduated rate structure applicable to U.S. residents.
As an enforcement mechanism, FIRPTA imposes a withholding obligation on the purchaser of a USRPI. Accordingly, when an NRA or FC disposes of a USRPI, the purchaser or his agent is required to withhold 15% of the amount realized on the disposition (10% if the sales price does not exceed $1,000,000 and the purchaser acquires the property as a residence). The amount realized is the sum of cash paid, the fair market value of other property transferred, and the amount of any liability assumed by the purchaser or to which the property is subject immediately before and after the transfer. The purchaser is exempt from the withholding requirement if he or she acquires the property for use as a residence and the amount realized does not exceed $300,000.
For example, suppose Mr. Alien sold a parcel of real estate located in the U.S. for $2,000,000, the purchaser is required to withhold $300,000 (15%) from the sales price and remit the tax to IRS on Mr. Alien’s behalf. On the other hand, if the purchase price was only $1,000,000 and the purchaser was acquiring the property as a residence, then the purchaser is only required to withhold $100,000 (10%) from the sales price. Furthermore, if the purchase price was only $300,000 and the purchaser was acquiring the property as a residence, withholding would not be required. When Mr. Alien files his U.S. tax return, any amounts withheld will be credited towards his tax liability.
To sum up, the tax implications with respect to the investment into U.S. real estate by an NRA or FC hinge on the facts and circumstances of the investment. A qualified tax professional can help you identify whether you are engaged in a trade or business and, if not, whether it would be prudent to elect to be treated as if you were. Additionally, a tax professional can help you plan for the various withholding obligations that will apply when you dispose of the U.S. real estate and obtain a refund of any excess amounts withheld. Our team is trained in addressing these types of issues; and if reading this article raised some questions, please reach out to an HBK Tax Adviser.