The combination of a weak U.S. dollar and low interest rates has resulted in more foreign investment in U.S., and South Florida, commercial real estate. But one of the primary obstacles facing foreign persons who invest in U.S. real estate is the Foreign Investment in Real Property Tax Act (FIRPTA), more specifically Section 897.
Under this provision, any gain recognized by a foreign person on the disposition of a U.S. real property interest will be treated as if such gain were effectively connected to a U.S. trade or business. Therefore it would be subject to U.S. federal income tax at the graduated rates that apply to U.S. persons.
Furthermore, when Section 897 applies, the purchaser of a U.S. real property interest typically is required to withhold and remit to the IRS ten percent of the purchase price in accordance with Section 1445.
One possible strategy to avoid FIRPTA is to use a shared appreciation mortgage.
In a typical shared appreciation mortgage arrangement, a lender provides a developer with a loan bearing a below-market fixed rate of interest, plus a share of the profit on a subsequent disposition of the property. If the transaction is structured correctly the investors who may have the most to gain are non-U.S. taxpayers.
Foreign persons are usually not subject to U.S. federal income tax on U.S. source capital gains unless those gains are connected to a U.S. trade or business. As stated above, Section 897 treats any gain recognized by a foreign person on the disposition of a U.S. real property interest as if it were effectively connected to a U.S. trade or business.
A U.S. real property interest is broadly defined as a direct interest in real property located in the United States, and an interest, other than an interest solely as a creditor, in any domestic corporation that constitutes a U.S. real property holding corporation.
Regulation 1.897-1(d)(2)(i) elaborates on the phrase “an interest other than an interest solely as a creditor” by stating it includes “any direct or indirect right to share in the appreciation in the value, or in the gross or net proceeds or profits generated by the real property.”
The regulation goes on to state that a “loan to an individual or entity under the terms of which a holder of the indebtedness has any direct or indirect right to share in appreciation in value of, or in the gross or net proceeds or profits generated by, an interest in real property of the debtor is, in its entirety, an interest in real property other than solely as a creditor.”
This principle is illustrated by example in the regulation: A non-U.S. taxpayer lends money to a U.S. resident to use in purchasing a condominium. The nonresident lender is entitled to receive 13 percent annual interest for the first ten years of the loan and 35 percent of any appreciation in the fair market value of the condominium at the end of the ten-year period. The example concludes that, because the lender has a right to share in the appreciation of the value of the condominium, he has an interest other than solely as a creditor in the condominium — i.e., a U.S. real property interest.
Accordingly, a shared appreciation mortgage that is tied to U.S. real estate is a U.S. real property interest for purposes of Section 897.
But simply owning a U.S. real property interest does not necessarily trigger any adverse tax consequences.
Rather, a non-U.S. taxpayer will be subject to tax under Section 897 only when the U.S. real property interest is disposed of. While Section 897 does not define “disposition,” Regulation 1.897-1(g) provides that disposition “means any transfer that would constitute a disposition by the transferor for any purpose of the Internal Revenue Code and regulations.”
Reguglation 1.897-1(h), Example 2 , illustrates a significant planning opportunity for non-U.S. taxpayers investing in U.S. real estate.
In the example, a foreign corporation lends $1 million to a domestic individual, secured by a mortgage on residential real property purchased with the loan proceeds. Under the loan agreement, the foreign corporate lender will receive fixed monthly payments from the domestic borrower, constituting repayment of principal plus interest at a fixed rate, and a percentage of the appreciation in the value of the real property at the time the loan is retired.
Because of the foreign lender’s right to share in the appreciation in the value of the real property, the debt obligation gives the foreign lender an interest in the real property “other than solely as a creditor.” Nevertheless, Section 897 will not apply to the foreign lender on the receipt of either the monthly or the final payments because these payments are considered to consist solely of principal and interest for U.S. federal income tax purposes.
Thus, the example concludes the receipt of the final appreciation payment that is tied to the gain from the sale of the U.S. real property does not result in a disposition of a U.S. real property interest for purposes of Section 897 because the amount is considered to be interest rather than a gain.
By characterizing the contingent payment in a shared appreciation mortgage as interest, the regulations allow non-U.S. taxpayers to avoid U.S. federal income tax on gain arising from the sale of U.S. real estate — if structured correctly.
The next issue is the withholding requirement on U.S.-source interest.
Non-U.S. taxpayers generally are subject to a 30 percent withholding tax on certain passive types of U.S. source income, including interest. An important exception to this rule exists for portfolio interest, which is exempt from withholding tax in the United States. Portfolio interest is any interest paid on a note that is in registered form and certain other conditions are satisfied.
But portfolio interest does not include certain contingent interest.
Therefore, a payment on a shared appreciation mortgage that is otherwise treated for U.S. federal income tax purposes as interest will not qualify for the portfolio interest exemption if the payment is contingent on the appreciation of the financed real property.
Unless a treaty applies to reduce the withholding tax, the contingent interest feature of a shared appreciation mortgage would be subject to a 30 percent withholding tax in the United States.
Currently, there are at least seven jurisdictions with income tax treaties with the United States. They entirely eliminate U.S. withholding tax on contingent interest paid from the U.S. to the respective treaty jurisdiction: The Czech Republic, Norway, Poland, the Russian Federation, Greece, Ukraine and Hungary — although a new treaty with Hungary, which is not yet in effect, will change this result.
A payment of U.S. source interest made to a resident of one of these treaty jurisdictions generally would not be subject to U.S. withholding tax, assuming such person otherwise is eligible for treaty benefits.
For a non-U.S. taxpayer to be eligible for treaty benefits, the taxpayer must be considered a resident of the particular treaty jurisdiction and must satisfy any limitation-on-benefits provision in the treaty. Under most modern income tax treaties, the resident must be an individual or a corporation that is at least 50 percent owned by citizens or residents of the United States or by residents of the jurisdiction where the corporation is formed. No more than 50 percent of the gross income of the foreign corporation can be paid or accrued, in the form of deductible payments, to persons who are neither citizens nor residents of the United States or residents of the jurisdiction where the corporation is formed.
In order for a non-U.S. taxpayer who is not resident in one of the treaty jurisdictions listed above to obtain a complete exemption from U.S. withholding tax on the contingent interest payment, that taxpayer must rely on a treaty that has been concluded with the U.S. which has no limitation-on-benefits provision. Currently there are four: Hungary (as noted above, the new Hungary treaty, once in effect, will change this result), Norway, Poland and Greece.
Therefore, a non-U.S. taxpayer who is not a resident in a favorable treaty jurisdiction can obtain a complete exemption from withholding on contingent interest — and therefore avoid FIRPTA — by investing through a corporation formed in one of these three jurisdictions. Once the income is received in the respective foreign jurisdiction, there are strategies available to minimize or eliminate any foreign corporate tax on such income.