Foreign (non-US) taxpayers are generally exempt from US federal income tax on gains from the sale of capital assets that are located, or treated as located, in the United States. For example, stock in a US company such as Google is treated as a US situs asset, but gain on the sale of the stock by a foreigner who is not resident in the US, can completely escape US taxation. The major exception to this general rule of tax exemption, involves the sale of so-called "US real property interests" (USRPIs). USRPI's include assets such as an apartment in New York, or stock in a US corporation the assets of which are predominantly US real property (for example, a so-called "Real Estate Investment Trust" or REIT).
Under the so called "Foreign Investment in Real Property Tax Act" or "FIRPTA", gain from the foreigner's sale of a USRPI is subject to US federal income tax at the graduated income tax rates applicable to US persons. Furthermore, when FIRPTA applies, the purchaser of the US real property is generally required to withhold a percentage of the purchase price and pay it over to the US Internal Revenue Service (IRS). This withholding tax serves as a mechanism for ensuring the foreigner will not sell his US real property and never pay the US taxes that might otherwise be due. You can read more about FIRPTA here.
Let's look at how these various rules might work in a real world example: If you are a foreign investor and you invest in a US corporation that owns a lot of real estate (e.g., a REIT), your sale of the REIT stock will be treated as the sale of a USRPI and you will have to pay tax on the gain when you sell your shares. However, if instead, you own stock in Google, you could sell your Google shares and not pay any US tax on the gain. This disparate tax treatment on dispositions of US stock provided a disincentive for foreigners to invest in the US real property market and in order to counteract this effect an exception was put in place for small shareholders in publicly traded corporations (even if the corporation held significant real estate assets). Under this exception, foreign investors owning less than 5% of the corporation were not subject to tax under FIRPTA on the sale of their shares.
On Friday, December 18, 2015, President Obama signed into law the "Protecting Americans from Tax Hikes Act of 2015" (PATH Act). Among other things, the PATH Act included significant changes to the tax treatment of foreign investment in US real estate, particularly investments made through REITs. It is anticipated that these changes will make REITs an even more attractive investment vehicle for foreign investors in the US real estate market. Some of the new provisions are highlighted below:
Generally speaking a REIT is a corporation that owns and usually operates income-producing real estate. To qualify as a REIT under US tax rules, the company must have the bulk of its assets and income connected to real estate investments and must make annual dividend distributions to its shareholders of at least 90% of its taxable income. There are many other hurdles the company must meet in order to have REIT status, for example, it must have fully transferable shares, be managed by a board of directors or trustees, have a minimum of 100 shareholders after its first year qualifying as a REIT and meet certain percentage tests regarding the real estate related sources of its gross income and assets.
Prior to the PATH Act, foreign shareholders owning 5 percent or less of a publicly-traded corporation (whether or not the corporation qualified as a REIT) were not subject to the taxation provisions of FIRPTA when the investor sold the shares or received a capital gain distribution from the company. The PATH Act has now increased this ownership ceiling from 5 to 10% for publicly-traded REITS, allowing foreign investors to dramatically increase their investment stakes in publicly-traded REITs. Note however, that this increased ownership rule applies only to shares in REITs that are publicly traded on an established securities market and not to other US corporations holding significant US real estate assets or to privately held REITs. Ordinary dividend distributions from REITs made to foreign shareholders continue to be subject to the 30% US withholding tax, unless reduced pursuant to an applicable income tax treaty.
A huge benefit from the PATH Act was provided for so-called "qualified foreign pension funds" ("QFPs") investing in US real property. While further details of this aspect of the new law will be forthcoming in future Treasury Regulations, the likely result will mean a significant boon to the US real property market. Under the new law, QFPs, including entities that are wholly owned by the QFP, are granted a complete exemption from FIRPTA under new Section 897(l) of the Internal Revenue Code. The new law provides that FIRPTA shall not apply to any USRPI held directly (or indirectly through one or more partnerships) by a QFP; the exemption also applies to USRPI capital gain distributions from REITs.
In order to qualify as a QFP, various tests must be met. A "qualified foreign pension fund" is any trust, corporation, or other organization or arrangement which: is created or organized under foreign law; established to provide retirement or pension benefits to participants or beneficiaries that are current or former employees of one or more employers in consideration for services rendered; does not have a single participant or beneficiary with a right to more than five percent of its assets or income; is subject to government regulation and provides certain annual information reporting to the relevant foreign tax authority. In addition, under the laws of the relevant foreign country: contributions to the QFP which would otherwise be subject to tax must be deductible or excluded from the gross income of the entity or taxed at a reduced rate, or, taxation of the investment income of the QFP must be deferred or taxed at a reduced rate.
Under the PATH Act, the rate of withholding when a foreigner disposes of a USPRI will increase from 10% to 15% of the purchase price. However, the withholding rate would remain at 10% for residences sold for less than US$1 million. This increase in withholding rate will likely render it far more difficult for a foreign seller who has a significant mortgage to dispose of the US property. Remember, the withholding rate is imposed on the sales proceeds and not on the gain. Thus, if 15% of the sales price is skimmed immediately for the withholding tax, and additional amounts must be paid toward commissions and closing costs, a highly-leveraged property will be difficult to sell since a cash shortfall is likely to kill the deal.
In many cases, the seller can apply to the IRS for a withholding certificate in order to obtain a reduction or complete elimination of the withheld amount. Applying takes time and requires some advance planning. See Form 8288-B, Application for Withholding Certificate for Dispositions by Foreign Persons of U.S. Real Property Interests. The IRS will normally act on an application within 90 days of receipt of all information necessary to make a proper determination. The IRS will determine whether withholding should be reduced or eliminated or whether a withholding certificate should not be issued.Back to Articles Back to Virginia La Torre Jeker J.D.
The information provided in this article is for general information purposes only. The information is not intended to be comprehensive or to include advice on which you may rely. You should always consult a suitably qualified professional on any specific matter.
Virginia La Torre Jeker J.D.
Virginia La Torre Jeker J.D., is based in Dubai. Virginia has been a member of the New York Bar since 1984 and is also admitted to practice before the United States Tax Court. She has over 30 years of experience specializing in the international aspects of US tax, including FATCA. She has been quoted in the New York Times and Newsweek, and is regularly quoted in many local news articles and publications."
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