狼协博客

U.S. TAX IMPLICATIONS OF
FOREIGN INVESTMENT IN U.S. REAL ESTATE
By Patrick W. Martin, Esq.
Procopio, Cory, Hargreaves & Savitch LLP
There are several different reasons why non-U.S. citizens (e.g., Mexican citizens or Mexican companies) might want to
乬own乭 real estate in the U.S.
First, an individual may want to own real property in the U.S. for personal and/or recreational purposes. Many non-U.S.
citizens own homes in California and throughout the U.S. (either directly as individuals or indirectly through domestic or
foreign entities).
Second, ownership1 in U.S. real estate may satisfy specific business objectives of a foreign company. For instance, a
Mexican company that exports goods to the U.S. may want to develop a distribution and/or warehousing network in the
U.S. Also, a company may want to open a sales office (or offices) in the U.S. to help market its goods or services in the U.S.
or other parts of North America.
If a non-U.S. citizen owns U.S. real estate, the method by which the real estate is owned is very important. For instance, a
non-U.S. citizen (whether he or she resides in the U.S.) probably wants to avoid paying any U.S. estate tax upon his or her
death to the extent possible. The U.S. has a tax known as the estate tax imposed upon the entire 乬taxable estate乭2 of an
individual upon his or her death. This type of tax, which is a type of 乬death乭 tax like an inheritance tax, does not exist in
many countries such as Mexico. The estate tax is discussed in more detail in another presentation, but it should be noted
that a Mexican citizen who owns real estate directly as an individual (as opposed to a foreign corporation owning the real
estate) will be subject to the U.S. estate tax upon his or her death. The current estate tax rates range from 18 percent to
*50 percent.3 These highest rates were modestly reduced from 55 percent beginning in 2002. The 乬taxable estate乭 of
nonresidents who are not domiciled in the U.S. includes property situated within the United States. Property situated in
the U.S. includes, among other things, U.S. real estate, most personal property physically located in the U.S., certain debt
obligations, and stock in a U.S. corporation.4
*In 2001, a new federal tax law (the 乬Act乭) modified estate and gift tax rates as follows:
Death in
Year
Estate Tax Life Time
Exemption Equivalent
for Non-U.S. Citizens
with Foreign Domicile
Estate Tax Exemption Equivalent
For U.S. Citizens or U.S. Domicile
Highest estate and
gift tax Rate
2002 US$ 60,000 US$ 1 million 50%
2003 US$ 60,000 US$ 1 million 49%
2004 US$ 60,000 US$ 1.5 million 48%
2005 US$ 60,000 US$ 1.5 million 47%
2006 US$ 60,000 US$ 2 million 46%
2007 US$ 60,000 US$ 2 million 45%
2008 US$ 60,000 US$ 2 million 45%
2009 US$ 60,000 US$ 3.5 million 45%
2010 Estate Tax . Repealed
Gift Tax Rate
Estate Tax . Repealed
Gift Tax Rate . Maximum Rate
N/A
35%
2011 US$ 60,000 US$ 1 million 55% + 5% (surtax
in higher estates)
OCTOBER 9, 2003
Copyright @2003 Procopio, Cory, Hargreaves & Savitch LLP. All rights reserved. www.procopio.com 劆 2
A foreign investor should carefully plan for the tax consequences of U.S. real estate investments because of the complex
legal framework of foreign real estate investments. Foreign investors should consider several important factors before
investing, acquiring, or selling U.S. real estate. The following is a list of some of these considerations:
. Will the real estate generate income?
. Does the investor want only a debt interest in the real estate, an equity interest, or some combination of both?
. Should a corporation, partnership, trust, or an individual acquire the real estate?
. Should the entity be domestic, foreign, or some combination of both?
. Should the real estate be leveraged significantly, through medium-term or long-term financing to obtain the
tax benefits of interest expense paid? If so, should the financing come from the U.S. or outside the U.S.?
. If a foreign corporation owns U.S. real estate, should it make an election to be taxed like a domestic U.S.
corporation in relation to its U.S. real estate investment?
. What U.S. tax returns must be filed, and what information must be disclosed to the IRS regarding the foreign
investors? Can the investment be restructured to avoid some of these reporting requirements?
These questions cannot be adequately answered until the economic and business objectives of a particular foreign
investor are carefully examined. Why invest in U.S. real estate? Does the foreign investor want to lease real estate or
purchase real estate? Does the foreign investor want capital appreciation or annual income from the real estate
investment? Does the foreign investor need initial 乬income tax losses乭 to offset against other sources of U.S. income? How
long does the foreign investor want to own an interest in real estate?
This presentation cannot answer all these questions. However, it is designed to provide a framework of some of the more
significant tax issues that should be considered before a foreign individual or company invests in U.S. real estate.
SPECIAL TAX RULES APPLICABLE TO FOREIGN INVESTORS WHO INVEST IN U.S. REAL ESTATE
There are several unique rules applicable to non-U.S. citizens, non-U.S. residents5 and foreign companies that own real
estate situated in the U.S. Congress passed most of this legislation nearly 20 years ago known as the Foreign Investment
in Real Property Tax Act of 1980 (乬FIRPTA乭).
Generally, a non-U.S. citizen (e.g., a Mexican citizen who resides in Mexico or outside the U.S.) who does not have (1) U.S.
source income or U.S. source income 乬effectively connected乭 with a trade or business,6 and (2) does not stay in the U.S. for
the 乬183乭 days test per year, does not have to pay taxes to the U.S. government. Consequently, prior to the enactment of
FIRPTA, a foreign investor could purchase real estate in the U.S. (e.g., a bare tract of land that had development potential)
for USD$ 100,000 and sell it for USD$ 300,000. The U.S. would generally not tax the Mexican citizen on the USD$ 200,000
gain. If a U.S. citizen were to have that same USD$ 200,000 gain, it would have to pay income tax on the gain. Congress
passed FIRPTA because it thought foreign investors were receiving more favorable tax treatment on some of their U.S.
real estate investments than U.S. residents.
FIRPTA created a completely different tax method by which non-U.S. residents are taxed upon their gains derived from
ownership in U.S. real estate. FIRPTA also imposes a mandatory withholding mechanism by which part of the tax must be
withheld by the buyer (or third party withholding agent) immediately upon the sale or disposition of the U.S. real
property interest.
IMPOSITION OF TAXES UNDER FIRPTA
A tax cannot be imposed unless there is a sale or other disposition of a U.S. Real Property Interest (乬USRPI乭) under FIRPTA.
Any direct ownership interest in real property located in the U.S. or the U.S. Virgin Islands (as well as certain ownership
interests in corporations,7 partnerships,8 and estates which own real property that is located in the U.S. or the U.S. Virgin
Islands)9 is a USRPI. 乬Real property乭 is defined by IRS Regulations (and not by local laws such as California or New York
law), and includes the following items:10
. Undeveloped land;11
. Crops and minerals that are not severed or extracted from the ground;
. Permanent structures such as improvements and buildings that are inherently permanent;12 and
. Personal property that is particularly associated with real property (e.g., mining equipment, timbering
equipment, construction equipment used predominantly for developing real property, hotels, motels,
apartments, and equipment predominantly used in the rental of furnished office and other work space).13
Copyright @2003 Procopio, Cory, Hargreaves & Savitch LLP. All rights reserved. www.procopio.com 劆 3
Although the definition of 乬real property乭 for purposes of a USRPI is expansive, a so-called 乬pure creditors乫 interest乭 is not
deemed a USRPI. A pure debt interest in U.S. real estate such as a mortgage (which is an example of a debt interest) does
not create a USRPI. Instead, the foreign lender who takes a mortgage against the U.S. real estate would be subject to a
withholding tax on the interest income received unless the loan is structured as portfolio interest.14 Therefore, debt
乬investments乭 in real estate might provide a more desirable means by which a foreign investor can invest in U.S. real
estate to avoid any FIRPTA taxes. A pure creditor also has significantly fewer reporting obligations to the IRS. Also, the
FIRPTA tax may be avoided by creatively structuring other types of debtor/creditor relationships.
The exact investment arrangement should be carefully planned. If a foreign investor were to take a disguised 乬equity乭
ownership interest (as opposed to a pure creditor乫s interest or other non-USRPI), then the IRS might take the position
that the gains derived by the foreign investor should be subject to the FIRPTA tax.
For example, assume MEXICOMPANY, S.A., lends Mr. Martinez USD$ 500,000 pursuant to a promissory note to purchase
undeveloped real estate in San Diego, and MEXICOMPANY, S.A. takes back a security interest in the real estate (i.e., a
mortgage). Assume, further, that the terms of the promissory note require Mr. Martinez to pay MEXICOMPANY, S.A. 50
percent of the appreciation of the real estate based upon annual appraisals of the undeveloped property. This type of loan
arrangement would likely be deemed an 乬equity kicker乭 and thus would likely require MEXICOMPANY, S.A. to pay FIRPTA
tax upon the sale or exchange of the promissory note.
RATE OF TAX ON DISPOSITION OF USRPI
If a Mexican resident individual disposes of a USRPI, then he or she probably would be subject to a 15 percent tax rate
(assuming the property was a capital asset in the hands of the Mexican resident). This lower tax rate applies pursuant to
the Jobs and Growth Tax Relief Reconciliation Act of 2003, by which the highest long term capital gains rate was reduced
from 20 percent to 15 percent. If the real estate was not a 乬capital asset,乭 then the tax rate could be between 12 percent
and **35 percent.15 A USRPHC that disposes of a USRPI will be subject to graduated tax rates upon the disposition, which
may include tax rates at the highest marginal corporate rate of 35 percent.
**The Act as well as the 2003 tax reforms modified income tax rates from the year 2000 forward as follows:
Year Marginal Tax
Rates
Marginal
Tax Rates
Marginal
Tax Rates
Marginal
Tax Rates
Marginal
Tax Rates
Marginal Tax
Rates
2000 N/A 15% 28% 31% 36% 39.6%
2001 Rebate Unchanged 27.5% 30.5% 35.5% 39.1%
2002 10% Unchanged 27% 30% 35% 38.6%
2003-
2010
10% Unchanged 25% 28% 33% 35%
There are other business forms which should be considered before acquiring real estate in the U.S. For instance, there are
some benefits that can be obtained if a limited liability company owns the real estate, depending upon the type of real
estate and the objectives of the investors. Also, a foreign investor may structure a U.S. investment interest by using
certain grantor trusts, grantor option contracts, security interests, commission arrangements, administrative fees, and
indexed rates to limit or avoid any FIRPTA tax.
Additionally, a foreign investor may avail himself or herself of certain tax-free transfers of USRPI to avoid or defer the
payment of any FIRPTA taxes as follows:
. Like-kind exchanges;
. Exchanges of stock for stock in the same corporation;
. Liquidations of a subsidiary into a parent corporation;
. Transfers to a controlled corporation;
. Exchanges of stock in certain reorganizations, corporate spin-offs, split-offs, and split-ups; and
. Certain distributions of property by a partnership.
. Election by Foreign Corporation to be Taxed as Domestic Corporation
A qualifying foreign corporation can elect to be treated like a domestic corporation regarding any disposition or sale of a
Copyright @2003 Procopio, Cory, Hargreaves & Savitch LLP. All rights reserved. www.procopio.com 劆 4
USRPI. Only certain foreign corporations (e.g., a Sociedad Anonima de Capital Variable) are eligible to make this election.16
The foreign corporation must also obtain consents from all of its shareholders to make such an election.
WITHHOLDING REQUIREMENTS UNDER FIRPTA
Upon the sale or other disposition of a USRPI by a foreign person, the transferee (e.g., the buyer) generally must withhold
10 percent of the total amount realized17 from the sale and not just from the taxable gain. Also, if there is an installment
sale over a period of time, the 10 percent withholding requirement is imposed upon the total amount realized at the time
of the sale (and not over the term of the payments).18 A U.S. partnership, estate, or trust that disposes of a USRPI is
generally subject to a **35 percent withholding tax to the extent such gain is allocable to a foreign partner or beneficial
owner of the entity.19
This **35 percent rate applies to non-corporate foreign partners. Foreign corporate partners are also subject to a 35
percent rate. The 2003 Tax Act reduces the current **35 percent withholding tax rates applicable to foreign persons
(formerly 38.6 percent in the year 2002).
Foreign corporations must withhold 35 percent of the gain recognized with respect to any distributions of a USRPI to the
corporations乫 shareholders.20 A qualifying foreign corporation can make an election under Section 897(i) to be taxed as a
USRPHC and not be subject to any withholding tax requirement, and instead, be taxed like a domestic corporation.
SPECIAL TAX TREATY PROVISIONS (E.G., U.S./MEXICO TAX TREATY)
Most tax treaties have special provisions relating to the ownership of 乬immovable property乭21 in the U.S. by a resident of
the other treaty country (and vice-a-versa). For instance, the U.S./Mexico Tax Treaty allows the U.S. to tax Mexican
residents on their income, profits and gains from U.S. real estate (and vice-a-versa). There is usually no maximum tax rate
restriction imposed by a treaty with regard to FIRPTA taxes and tax treaty residents will normally continue to be subject
to gains from the sale or disposition of any U.S. real property interests under FIRPTA in the same manner as persons that
cannot utilize a U.S. tax treaty. Therefore tax treaties usually have little impact upon the application of FIRPTA, other than
defining 乬immovable property.乭
However, for foreign corporate owners, the tax treaties (as well as the nondiscriminatory treatment under the Section
897(i) election explained above) sometimes impact the U.S. branch profits tax. For example, the U.S./Mexico Tax Treaty
limits the amount of the branch profits tax that can be imposed by the U.S. government on the U.S. profits of a Mexican
corporation (e.g., from its U.S. real estate investment enterprises) to a 10 percent (and sometimes as low as 5 percent) tax
on the 乬dividend equivalent amount.乭 This U.S./Mexico Tax Treaty rate is significantly less than the non-treaty branch
profits tax rate equal to 30 percent of the dividend equivalent amount of the foreign corporation for the taxable year.
STATE AND LOCAL TAXATION APPLICABLE TO FOREIGN INVESTORS WHO INVEST IN U.S. REAL ESTATE
This overview focuses upon U.S. federal income taxes applicable to foreign investors of U.S. real estate. In addition, States
(e.g., California, Arizona, Texas and Florida) commonly impose income taxation along with local (e.g., County and City of
San Diego) property taxes that should also be considered. For instance, California tax law requires buyers to withhold 3
1/3 of the total sales price of California real estate owned by non-California persons (including non-U.S. sellers of real
estate).22 California escrow agents also have a duty to inform buyers of this California withholding tax obligation.23 The
withholding tax, like FIRPTA (see below) is not a final tax, but merely a collection mechanism to be used against the final
income tax. California individual and corporate tax rates, that may apply, range to as much as 9.4 percent. See the
FIRPTA discussion below for a comparative analysis of federal income tax treatment and withholding taxes.
In addition to State income taxation (and the withholding tax mechanisms that may apply), there are typically local
property taxes that will apply to a transfer or sale of real estate. In California, for instance, the California Constitution and
tax code provides that all property in California that is not free from tax under federal or California law is subject to
taxation 乬in proportion to its value.乭 The maximum ad valorem real property tax rate in California is one percent of the
乬full cash value.乭24 Finally, California counties and cities may also apply a local documentary transfer tax on the transfer
of real property.25
In summary, all foreign investors that are contemplating investing in U.S. real estate should carefully consider and plan
the legal structure utilized for this investment. If not carefully planned, a foreign investor can unwittingly expose himself,
herself or itself to unnecessary U.S. income tax, gift tax and/or estate tax, especially in light of the complicated U.S. real
estate taxation regime of FIRPTA.
Patrick W. Martin is a U.S. lawyer licensed in California and Washington, D.C. and specializes in international tax and related
international law-matters. Mr. Martin is the partner in charge of the international practice group of the Tax Team with the
Copyright @2003 Procopio, Cory, Hargreaves & Savitch LLP. All rights reserved. www.procopio.com 劆 5
San Diego based law firm of Procopio, Cory, Hargreaves & Savitch LLP. He is the Immediate Past Chair of the International
Tax Committee of the State Bar of California Taxation Section. He received his J.D. from the University of San Diego School of
Law, has passed the Certified Public Accountant乫s exam, previously worked for the Internal Revenue Service, and studied
postgraduate law studies in international business transactions at the Escuela Libre de Derecho, in Mexico City. Reach him at
619.515.3230 or [email protected].
ENDNOTES
1 For purposes of this discussion, 乬ownership乭 will usually refer to most types of real estate interests (e.g., leasehold interests in real estate,
direct ownership, corporate ownership, etc.).
2 Internal Revenue Code (乬I.R.C.乭) 仒仒 2103 and 2106.
3 I.R.C. 仒 2001(c).
4 I.R.C. 仒 2104.
5 There are special 乬residency乭 rules for individuals that apply for income tax purposes. A U.S. resident for tax purposes might not be a U.S.
resident for immigration or other legal purposes. Whenever the word U.S. 乬resident乭 or 乬non-resident乭 or 乬foreign investor乭 is used in this
presentation, it is only referring to the applicability of the U.S. tax laws - and not immigration laws, or any other legal purposes. The U.S. tax
laws define a U.S. tax resident based upon the number of days spent in the U.S., the lawful permanent residency of the individual in the U.S.
(i.e., whether they have a 乬green card乭), or based upon an election made by the taxpayer.
6 The tax rules relating to U.S. source and effectively connected income from a U.S. trade or business are impacted significantly by tax treaties
between the U.S. and other countries. For example, the U.S./Mexico Tax Treaty requires that a Mexican resident usually have a 乬permanent
establishment乭 in the U.S. before being taxed in the U.S. on its business activities. The U.S./Mexico Tax Treaty, however, does not
significantly alter the way Mexican citizens are taxed on their gains from the sale of U.S. real estate (other than the application of the
branch profits tax). Not all U.S. Tax Treaties are the same, and therefore each foreign investor should exercise whether there exists an
applicable tax treaty within the U.S.
7 USRPI also includes any interests in a 乬U.S. real property holding corporation乭 (乬USRPHC乭). A USRPHC is any domestic U.S. corporation that,
if at any time during the past five years during which a foreign person held shares of the corporation, its USRPI乫s fair market value equaled
or exceeded 50 percent of the aggregate value of the corporations乫 (1) USRPIs, (2) its real property located outside the U.S., and (3) its other
trade or business assets.
8 If 50 percent of a partnership乫s assets are U.S. real property, or 90 percent or more of its assets are made up of USRPIs, cash, and cash
equivalents, then an interest in the partnership attributable to the partnership乫s USRPIs will be subject to FIRPTA with certain limitations.
9 I.R.C. 仒 897(c).
10 Treas. Reg. 仒 1.897-1(b).
11 Treas. Reg. 仒 1.897-(b)(2).
12 Treas. Reg. 仒 1.897-(b)(3).
13 Treas. Reg. 仒 1.897-(b)(4).
14 Qualifying portfolio interest is not subject to U.S. withholding tax.
15 Plus, a foreign individual may be subject to the so-called alternative minimum tax (AMT) upon the disposition of the USRPI.
16 The foreign corporation must (1) be a USRPHC, (2) hold a USRPI, and (3) must be entitled to nondiscriminatory treatment under a treaty
with the U.S. The Mexico/U.S. Tax Treaty will qualify a Mexican corporation (e.g., a Sociedad Anonima de Capital Variable or a Sociedad
Anonima) as a qualifying entity for purposes of the election.
17 乬Realized乭 is a technical tax term, and generally refers to all consideration paid or received in a transaction. Assume a Mexican resident
owns undeveloped real estate in California with a fair market value of $2 million. Assume further, that the real estate has an outstanding
mortgage of $1.75 million. If a buyer is willing to pay the Mexican real estate owner $100,000 in cash, promise to pay $150,000 pursuant to
a promissory note, and assume the outstanding mortgage of $1.75 million, the total amount 乬realized乭 equals $2 million (and not $100,000,
the amount of cash received). The Mexican resident who sold the real estate became $2 million richer, because he received (1) $100,000 of
cash, (2) a promise purportedly worth $150,000, and (3) was relieved of an outstanding debt of $1.75 million. Assuming the Mexican
resident乫s tax basis in the property was $1.8 million, there would have been a taxable gain under FIRPTA of $200,000 (the amount realized
of $2 million less the tax basis of $1.8 million).
18 A buyer of a USRPI should be aware of an installment sale where the total 10 percent withholding requirement exceeds the amount of the
initial payment upon closing of escrow. The buyer could actually be in a position of paying a greater amount to the government than is
actually received by the foreign seller at the time of the sale.
19 Treas. Reg. 仒 1.1445-5(c)(1).
20 I.R.C. 仒 1445(e)(2).
21 Article 6 of the U.S./Mexico Tax Treaty defines real property broadly and in reference to the laws of the country in which the real property is
located. Therefore, the laws of the U.S. need to be examined to determine exactly what constitutes real property as set forth in Treas. Reg.
1.897-1(b). As was explained above, the federal tax regulations define 乬real property乭 for purposes of FIRPTA and not local laws, such as
California State law. Notwithstanding the local laws of each country, 乬immovable property乭 is defined by the Tax Treaty as including
unharvested agriculture and forestry situated in the U.S. or Mexico, and property which is an accessory to immovable property, including
equipment used in agriculture and forestry, and rights to mineral deposits and other such natural resources.
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