U.S. real estate is an attractive investment for foreign persons, but the tax rules can be difficult to navigate without proper planning and organization. Taxation can vary depending on the reason for investing (e.g., personal use or rental property) and how the ownership of the real estate (e.g., directly or through a corporation or a partnership) is structured. The ownership structure of the real estate also impacts the foreign person’s U.S. federal income taxation upon disposition of the interest in the U.S. real estate.
Taxation of Rental Income
If a foreign person directly receives rental income from an investment in U.S. real property, then a 30% withholding tax is imposed on the gross amount of the rental payment unless reduced by an income tax treaty. A foreign person can make an election to be taxed on a net basis (i.e., gross rents less deductions including depreciation) using applicable U.S. income tax rates.
If the foreign person establishes a domestic corporation to own the real property, the rental income would be taxed at corporate tax rates but dividends from the corporation would be subject to a 30% withholding tax unless reduced by an income tax treaty.
If the ownership is through a foreign corporation that made the election, the net rental income can be taxed at the corporate rate of 21%, plus the potential imposition of a branch profit tax of 30%, unless reduced by an income tax treaty.
If a partnership were used to hold the real property, the partnership would be required to withhold on the foreign person’s distributive share of the income at the applicable U.S. income tax rate — 21% if the partner is a corporation and 37% if they are a non-corporate partner.
Disposition of Real Property
The Foreign Investment in Real Property Tax Act (“FIRPTA”) requires a withholding tax of 15% on the amount realized on the disposition of an interest in U.S. real property by a foreign person. If the buyer (the withholding agent) fails to withhold the tax from the foreign person, the withholding agent can be held liable for its payment.
The withholding tax is required to be reported and paid by the 20th day after the date of the sale using Form 8288, U.S. Withholding Tax Return for Dispositions by Foreign Persons of U.S. Real Property Interests. After the tax is withheld by the withholding agent, the foreign person must file a tax return at the end of the year to calculate the actual tax on the gain from the sale. At this time, they may have to pay additional tax or receive a refund, depending on the amount of tax withheld.
Ownership Structure
The ownership structure of the real estate determines withholding tax consequences. For example, if a foreign investor sells shares in a domestic corporation that holds real estate, a 15% withholding tax applies. If a domestic corporation sells real estate, a 21% tax on the gain applies with a potential withholding tax on the proceeds if distributed as a dividend.1
If a foreign investor sells shares in a foreign corporation that holds U.S. real estate, then no withholding tax is required unless the foreign corporation has made an election under Section 897(i) to be treated as a U.S. real property holding company. If a foreign corporation is the owner of the real estate and then sells the real estate, then a 15% withholding tax would apply on the sale with a potential for a branch profits tax.
Under a partnership structure, if the foreign investor sells their interest in the partnership, disposition of the partnership interest could be subject to a 10% or 15% withholding tax depending on the assets of the partnership.
Application for Certifcate of Reduced Withholding
If a foreign person believes they should qualify for a reduced withholding amount, they may request relief from the IRS by filing a Form 8288-B, Application for Certificate of Reduced Withholding before the date of the transaction. If the IRS agrees, the taxpayer will be issued a certificate of reduced withholding that can be provided to the withholding agent before on the date of the transfer. The IRS normally requires up to 90 days to process the application. However, due to COVID-19, they are experiencing a large backlog of mail, causing delays in processing applications. Therefore, it is important to note that the taxpayer should plan accordingly and consider allowing more than 90 days for the IRS to process their application.
If the foreign person provides notification in writing to the withholding agent that they have applied for a certification of reduced withholding before or on the date of the transfer, the withholding agent still is required to withhold 15% of the amount realized but is not required to pay over that amount to the IRS until the 20th day after the day that the IRS mails the withholding certificate or notice of denial.
How Can We Help?
For assistance or questions regarding nonresidents investing in U.S. real estate, please contact a member of Cherry Bekaert’s International Tax team.
Reference
1 If the domestic corporation were to liquidate, there is a possibility of the 15% withholding tax applies to the liquidation of the domestic corporation.
