U.S. Real Estate Market Trends
The U.S. real estate market has been experiencing a significant increase in the demand for residential real estate due to a growing population of people looking to buy homes or invest in real estate properties. The aftermath of the COVID-19 pandemic normalized remote work and led to underutilized office spaces and high commercial real estate vacancy rates, particularly office spaces, in certain major U.S. markets, according to RCLCO’s Sentiment Survey.
Historically, there has always been significant foreign investment in U.S. real estate, but there has also been an increase in outbound investments in foreign real estate. Both outbound and inbound real estate can be attractive investment options for investors, depending on their investment goals and preferences. These types of investments are subject to local market conditions, economic fluctuations and regulatory changes that can impact the investment’s performance.
In the ever-changing investment landscape of the domestic and international tax world, real estate investors must adapt accordingly and stay current on the latest regulations and reporting requirements to make educated decisions about their investment and real estate strategies.
Considerations for Inbound Real Estate Foreign Investors
Inbound real estate investment is typically focused on residential properties, commercial properties, or even real estate investment trusts (REITs) in a specific country or region. REITs are growing in popularity in the U.S. market because they allow individuals to invest in real estate properties without directly owning them. International investors tend to view the U.S. real estate market as a stable investment opportunity.
Prior to making any investment, investors must determine which holding structure best suits their needs. Several options are available for structuring the investments. The most common include direct ownership by the individual, direct investment through a limited partnership or single-member LLC, indirect investment through a U.S. C corporation, or indirect investment through a non-U.S. corporation blocker. Each structure should be evaluated for a variety of factors, including the type of income to be generated by the investment, plans for repatriation of earnings, and the ultimate disposition of the asset.
When a foreign individual or a company makes an inbound investment, the income that they generate will be taxed in the U.S. in one of two ways. First, U.S. source income, which is fixed or determinable, annual or periodical (FDAP), is subject to withholding tax at a 30% rate (or perhaps less if a tax treaty is in effect). FDAP income includes dividends, interest, rents, royalties and gains on investment property. Second, income that is effectively connected with a U.S. trade or business is subject to income tax at the regular individual or corporate tax rates. If a foreign person makes an investment in real property in the U.S., the Foreign Investment in Real Property Tax Act (FIRPTA) provisions treat any gain from the sale or exchange of the property as U.S. source income subject to income tax at the regular tax rates. These rules include provisions that require withholding tax on sale proceeds paid to foreign sellers. The FIRPTA tax is withheld by the buyer, often to the surprise of foreign investors at the closing table.
Inbound international investors also need to consider any property, state and local taxes, or reporting requirements that may be required by the state or local government where their asset is located. To encourage growth and investment, some states and local governments offer tax credits and incentives; however, these are typically negotiated and/or granted prior to acquisition. Therefore, it is imperative to research all possible investment strategies and understand all the ramifications so that no money is left on the table.
Outbound Investment Factors for U.S. Investors
As the global real estate market continues to evolve, U.S. investors are increasingly turning their attention towards emerging markets beyond the U.S. border. Emerging markets offer opportunities for outbound investors to diversify their portfolios beyond the U.S. real estate market, spread their risk, and invest in high-growth markets. This can lead to benefits from the different market conditions and economic trends in other countries while also providing a layer of asset protection.
However, investing in outbound real estate also comes with its own set of challenges and considerations. U.S. outbound investors may face legal and regulatory complexities and potential currency risks. They will likely need to rely on local partners or property management companies to handle their real estate properties’ day-to-day operations and maintenance. Thorough research and collaboration with experienced local real estate professionals within the emerging market should be conducted before making such an imperative investment decision.
Outbound real estate can offer certain tax advantages, such as lower property taxes or favorable investment regulations; however, U.S. investors must also consider certain tax hurdles of outbound real estate investments. Some hurdles that should be further examined are:
- The limitation on certain foreign expense deductions
- The differences between U.S. and foreign tax rates and the impact on the U.S. investor
- Foreign property ownership structure and additional reporting requirements, where applicable (e.g., Form 5471, Form 8858, FBAR)
- The limitation on the deferment of gains on exchanges of foreign properties (1031 exchanges)
Let Us Guide You Forward
Both outbound and inbound real estate can be attractive investment options for investors, depending on their investment goals, risks, and strategies. At Cherry Bekaert, we help our clients navigate the ever-changing tax law and the potential consequences of U.S. and international tax. It is vital for investors to understand and effectively plan for their global tax obligations proactively. Our International Tax Services group works with both outbound U.S. investors and inbound international investors by providing an array of services in the initial planning strategy and implementation, direct and indirect tax and regulatory advisory, cross-border transactions, and other areas of support.
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