General Discussion of Taxation of Income from US Real Estate
In general, foreign persons engaged in a trade or business in the United States, are taxed on two categories of income:
Income effectively connected with the conduct of a trade or business in the US (ECI), and
Certain fixed and determinable annual or periodic (FDAP) income that is not effectively connected with the conduct of a trade or business in the US. This income includes US source wages, interest, dividends, rents and royalties, but generally does not include capital gains.
The main difference in taxation between these two categories is that ECI is taxed similar to US citizens at graduated rates on a net basis (gross income reduced by allowable deductions) and FDAP is taxed at a fixed rate on a gross basis (before allowable deductions).
For 2014, the US income tax rates for individuals and trusts are separated into tax brackets and range from 10% to 39.6%. Under current law, capital gains are taxed at a rate of 25% (to the extent of gain attributable to depreciation recapture) with the remainder taxed at 20%.
Rental income from real property located in the US and the gain from its sale will always be US source income subject to tax in the US regardless of the foreign investor’s personal tax status and regardless of whether the US has an income treaty with the foreign investor’s home country.
For purposes of this article, a foreign investor does not include noncitizens 1) lawfully admitted to the US as permanent residents (green card holders), or 2) physically present in the US for at least 183 days during any year, or a greater number of days over a three-year testing period.
US Trade or Business
In general, a foreign investor that engages in considerable, continuous, or regular and substantial business activity in the US is considered to be engaged in a trade or business within the US. Mere ownership of unimproved real property or residential property held for personal use (for instance, an apartment or condominium) does not create a US trade or business. Further, ownership of a single piece of property rented to one tenant on a net lease basis (i.e., where the tenant is required to pay all expenses connected with the real estate) does not give rise to a US trade or business. Leasing commercial buildings on a net lease basis may or may not create a US trade or business.
However, if a foreign investor or foreign corporation actively manages commercial or residential property and pays all expenses, taxes, and insurance, the activities constitute a US trade or business. In addition, a partner of a partnership that is engaged in a US trade or business under the above guidelines will also be considered to be engaged in a US trade or business. Conversely, an investor who owns shares in a corporation that is engaged in a US trade or business will not be considered to be engaged in a US trade or business by virtue of the investor’s share ownership.
Is the Real Estate Income Subject to the ECI or FDAP Regime?
Determining whether income is subject to the ECI or FDAP regime is important due to the differences in the tax withholding rates, the application of treaty benefits, and whether the foreign investor is taxed on a net basis or gross basis.
If it’s established that a foreign investor is engaged in a US trade or business, all items of income which are effectively connected with such business, less deductions attributable to such income, are subject to withholding at the highest statutory rate under §1446 (in 2014 is 39.6% for individuals and 35% for corporations).
The statutory rate of withholding for FDAP is a flat 30% on the gross amount of most types of income that is not ECI. The rate of this gross basis tax can in some cases be reduced or eliminated by a tax treaty or specific statutory exemption.
Generally, US source income is ECI if one of two alternative tests are met, either the business-activities test or the asset use test. The business-activities test looks to whether the activities of the US business are a material factor in generating the income. The asset-use test looks to whether the income is derived from assets used or held for use in the conduct of a US business. Both tests are applicable to income from real estate. For example, rental income earned on a building used in a US trade or business is ECI under these tests.
Net basis election
In instances where a foreign investor is not engaged in a US trade or business (e.g. the investment is raw land or net leased property), the FDAP regime would impose a 30% tax on the gross amount of rent (before allowable deductions).
However, a foreign investor may file a “net basis” election to be taxed on a net basis at graduated rates as if the income were ECI.1 This election can be beneficial, because the production of real estate income generally involves substantial expense. Upon making the election, the investor is relieved of the 30% tax on gross rents and is allowed to deduct expenses associated with the real estate, such as depreciation and interest. Often these expenses exceed income and therefore no US tax is due. This net basis election may be revoked only with consent of the Internal Revenue Service (“IRS”) and applies to all US real estate held at the time of the election, as well as to property that may be acquired in the future. Further, the net basis election applies to all income from real property that is located in the US and held for the production of income.
US Tax Implications of Foreign Partners in Partnerships Holding US Property
A partnership, whether domestic or foreign, general or limited, is a transparent entity and does not pay taxes in the US. The income and losses of the partnership flow to its partners and the partners are taxed directly on their share of the partnership’s income annually regardless of whether any income is distributed in the current year. Accordingly, each foreign partner of a US partnership must file a US income tax return.
Each item of income or deduction of a partner retains its original character which is determined at the partnership level. For example, rental income earned by the partnership that is treated as ECI is also taxed as rental income at the partner level.2 Similarly, gain from the sale of a US real property interest is taxed at the partner level as ECI.
Since the partners are taxed currently on their share of the partnership income, there is generally no additional US tax on distributions of profits from the partnership as there would be in the case of a corporation. On the other hand, the US imposes withholding on the foreign partners share of the partnership’s trade or business income to ensure collection of the tax owed, which is similar to the partnership making estimated tax payments on behalf of its foreign partners. These payments are applied to the partner’s tax liability for the period. Any over-withholding of the foreign partner’s regular tax liability has to be recovered by the partner through the filing of his own individual tax return.
Treaty Protection from Taxation
Most tax treaties provide that income from real property, including income from the direct use of the real property by the owner and the rental income for use of the property, is taxable in the country in which the property is located. For rental income generated from US real property, a foreign recipient may be subject to a 30% US withholding tax on the gross amount of the rental income (FDAP), unless a net basis election has been made to tax net rental income at a 39.6% rate or the net rental income is ECI.
Disposition of US Real Estate Investments
In general, the Foreign Investment in Real
Property Act of 1980 (“FIRPTA”) treats the gain or loss of a foreign investor or a foreign entity from the disposition of a US Real Property Interest (“USRPI”) as ECI. Consequently, such gain or loss will be included with the foreign investor’s other ECI (if any) and subject to US income tax on a net basis. In addition, gains from the sale of interests in partnerships, trusts, and US corporations that own primarily US real estate, are taxed as ECI regardless of whether the taxpayer is actually engaged in a US trade or business.
A USRPI is any interest, other than solely as a creditor, in real property (including an interest in a mine, well, or other natural deposit) located in the US or the US Virgin Islands, as well as certain personal property that is associated with the use of real property (such as farming machinery or hotel furniture).
USRPIs also include shares and other equity interests in a US corporation (other than solely as a creditor) that was considered to be a US Real Property Holding Company (“USRPHC”) at any time during the five-year period ending on the disposition of the interest. A US corporation generally will be considered to be a USRPHC if its assets are primarily USRPI. Therefore, it is not possible to avoid US tax on the disposition of real property by holding the property indirectly through a US corporation and selling its stock.
Foreign Account Tax Compliance Act (“FATCA”)
For the real estate industry, the new FATCA rules will impose additional challenges for US real estate investment vehicles because of the many complicated and diverse investment structures that have become common in recent years. With respect to US real estate funds, non-US investors are less likely to own real estate directly as they are adverse to US tax compliance requirements and seek to reduce the impact of FIRPTA on the ultimate disposition of the real estate. Such investors have sought the use of alternative investment structures, such as investment in US real estate through US and non-US corporations, investment in US real estate through a US REIT, and loans by non-US investors, to shield them from direct exposure to ECI and US tax compliance requirements. Because the FATCA legislation provides for a specific exception to ECI, however, the use of these ownership structures to avoid ECI treatment may now expose these investors to the reporting and withholding tax requirements under FATCA whether or not such income may be exempt from general gross basis US tax and withholding.
FATCA is generally effective beginning in 2014. Persons investing in US real estate funds and those who manage US real estate funds will need to understand when such investments give rise to withholdable payments and be able to analyze the application of the FATCA provisions and exemptions to the various structures used and the types of investors who are contributing their capital.
The complexities that exist with international real estate transactions are too numerous to detail here. There is a vast array of filing requirements applicable to each situation. In addition, the IRS imposes severe penalties for failure to file and failure to pay (among just a few). It is imperative that if you are doing business internationally, that you engage a knowledgeable tax advisor at Convergence who specializes in international taxation. Even simple transactions such as owning US real estate can involve onerous filing requirements. As a rule, US businesses are the withholding agent. As a withholding agent, if you fail to withhold, the IRS will assess the withholding agent for the amount that was supposed to be withheld, plus penalties and interest. Many foreign taxpayers mistakenly do not file a US tax return, and therefore significantly overpay their tax.
Should you have any questions about this topic of if we can improve your tax situation, please contact me at 303-951-2059 or firstname.lastname@example.org.
1 See IRS §§871(d) and 882(d).
2 See IRC §875(1).