With the significant and increasing foreign investment in real property in South Florida, planning to anticipate and minimize any associated tax is of paramount concern.
Foreigners are generally exempt from U.S. federal income tax on gain from the sale of U.S. capital assets. The major exception is U.S. real estate.
Under the Foreign Investment in Real Property Tax Act, or FIRPTA, gain on the disposition of a U.S. real property interest is treated as effectively connected income. Therefore, U.S. income tax is imposed on this gain at regular graduated tax rates.
“Interest” in real property includes any direct equity interest in the property, such as a fee simple ownership or a leasehold, but it does not include interests solely as a creditor.
Importantly, provisions of the law that would prevent the application of FIRPTA, such as tax treaties and corporate reorganizations, generally do not apply unless the seller receives a U.S. real property interest in a qualifying nonrecognition exchange.
In addition, FIRPTA requires the buyer to withhold 10 percent of the proceeds of the sale—even if the property is being sold at a loss. Withholding may be reduced from the standard 10 percent to an amount that will cover the tax liability, upon application in advance of sale to the Internal Revenue Service on Form 8288-B. Penalties apply to a purchaser who fails to withhold, file Form 8288 or pay the required withholding within 20 days of the sale.
There are four exceptions to FIRPTA’s withholding requirement: where the buyer purchases the property for use as a residence for $300,000 or less; where the buyer receives a statement from the seller that the seller is not a foreign person; upon acquisition of an interest in a nonpublicly traded domestic corporation where the corporation provides the required affidavit; and upon acquisition of shares of a publicly traded corporation.
FIRPTA also includes a corporate component: if greater than 50 percent of a corporation’s assets consist of U.S. real estate, then sale of its stock is similarly taxed. FIRPTA is designed to prevent foreign owners from removing profit from the sale of U.S. real property from the United States, outside the jurisdiction of the IRS.
So what to do?
Enter the real estate investment trust. REITs have long been a tax-efficient vehicle for foreigners seeking to invest in U.S. real estate. A REIT is a company that owns income-producing real estate or real estate-related assets.
To qualify as a REIT, an organization makes an election by filing a Form 1120-REIT with the IRS. In addition, a company must have at least 75 percent of its total assets invested in real estate, and it must derive at least 75 percent of its gross income from rents or mortgage interest. Furthermore, it must distribute at least 90 percent of its taxable income each year via shareholder dividends. Finally, the REIT must be jointly owned by 100 people or more, but no more than 50 percent of the shares can be held by five or fewer individuals during the last half of each taxable year, known as the 5/50 rule.
Once a company qualifies as a REIT, its REIT status can help overcome some of the tax hurdles imposed by FIRPTA.
For example, a REIT is entitled to deduct dividends paid to its owners. Therefore, a REIT that distributes all of its taxable income is not subject to U.S. corporate tax.
Foreign shareholders in the REIT also enjoy a number of tax benefits. First, the sale of stock in the REIT is not taxed in the U.S. if the REIT is publicly traded and the selling shareholder holds 5 percent or less of the REIT.
Additionally, such 5 percent or less shareholders are not subject to FIRPTA withholding on dividend distributions out of the REIT attributable to U.S. real estate. Note, however, that other withholding regimes may apply to such distributions.
Finally, proceeds from the sale of stock in a public or private REIT are not subject to FIRPTA so long as the REIT is “domestically controlled” when more than 50 percent of the REIT is owned by U.S. people.
Non-U.S. people looking to invest in real estate in Florida will do well to factor FIRPTA hurdles and REIT solutions into their investment strategy.