The ultimate tax guide for the offshore investor seeking real estate in the United States. This is part 1 in the series, helping you understand what you can expect when investing in U.S. real estate.
Your friends have been telling you about it for years now. You have heard from your colleagues at work about how amazing it has been for them. Your sister-in-law mentions it every time you get together. And now, you have finally taken (or at least are thinking about taking) that jump. Investing in real estate in the United States is exciting, but the IRS has an eye out for those offshore investors, and you need to be aware of what to expect.
What's a FIRPTA?
The United States was concerned that offshore investors would conquer the U.S. real estate market and needed to put safeguards in place to avoid this situation.
The problem arises from a common international tax rule. Have you ever paid tax in the United States when you sold your shares in Facebook or Apple? Of course not! This is because offshore investors are generally exempt from capital gains from the sale of an asset in another country. If real estate was to be included in that general exemption, it would put the average American at a disadvantage relative to the offshore investor when investing in real estate or even when buying their first home.
In order to combat this disadvantage, the "foreign investment in real property tax act" - aka FIRPTA - was enacted.
FIRPTA and you
The general FIRPTA clause states -
"...gain or loss of a nonresident alien individual or a foreign corporation from the disposition of a United States real property interest shall be taken into account...as if the taxpayer were engaged in a trade or business within the United States during the taxable year and as if such gain or loss were effectively connected with such trade or business"
There are few key points to note here -
Gain or loss - All the implications of this tax event are relevant whether or not you came out on top or not.
From the disposition of a United States real property interest - This is not purely triggered from a sale. All "dispositions" are included, for example, sale, transfer, gift, contribution, etc.
As if such gain or loss were effectively connected with such trade or business - A FIRPTA event has the tax ramifications as other effectively connected income earned by non-U.S. persons.
This definition, which includes gain or loss and all "dispositions", pulls many more real estate related transactions into the FIRTPA tax regime. For example, s tax-free reorganization or certain distributions from real property holding companies. Additionally, the default for all corporations in the United States is to treat them as U.S. real property holding companies, subject to the FIRPTA tax regime.
So, if I sell my shares in the U.S. start-hi-tech company I founded, the United States can classify it as a real estate transaction??? In short, yes. There are certain exceptions and methods to rebut this assumption, however it is important to be aware of this issue in order to address the concern on time.
What does this mean for you?
Now that we understand what can potentially trigger a FIRPTA event, how does that impact you? There are two main points to look out for:
Tax liability and filing requirements - As noted, a FIRPTA transaction is considered as if the gain/loss is effectively connected to a trade or business in the United States. As discussed in a separate article - Investing in the United States - ECI vs FDAP - effectively connected income is taxed in the United States to the non-U.S. person on a net basis with the standard U.S. tax rates - 20% marginal rate for an individual, 21% for the corporate taxpayer. The transaction may also trigger state taxation. These events also require the investor to file a tax return in the United States.
FIRPTA withholding - The FIRPTA tax regime has 15% withholding requirement on the gross amount of the transaction. The withholding tax is treated as an advance on the tax payment due with the filing mentioned above, and any overwithholding will be refunded upon filing. Nevertheless, this can lead to highly skewed results. For example, assume you bought your investment for 1,000 and are selling it today for 1,100. The gain from this transaction of 100 should lead to a tax liability of 20 (20% capital gains rate x 100). However, at the time of the transaction, the buyer will need to withhold 165 (15% x 1,100). The difference will be refunded however you will need to wait to file the tax return in the following tax year - let's assume around April time - and then wait for the return to be processed and the money refunded - let's assume one month assuming no government shutdowns, pandemics, etc. This can mean many many months depending on when the transaction occurred in the prior year.
The next few articles will delve deeper into the world of FIRPTA and real estate investments to highlight some of the key features and concerns you should be aware of when investing in real estate in the United States. Stay tuned!
If you are investing in real estate in the United States on your own, investing through a fund, or even establishing your own real estate fund, understanding your tax ramifications for you and your investors is crucial. We are happy to help with navigating this complicated topic and look forward to hearing from you.
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