The Foreign Investment in Real Property Tax Act (“FIRPTA”) authorizes the IRS to tax foreign persons on the sale or disposition of a U.S. real property interest (“USRPI”). FIRPTA generally imposes a withholding obligation on the purchaser of a USRPI. That is, the purchaser is required to withhold tax on the payment for the property, although withholding may be reduced under certain circumstances.
Prior to FIRPTA, foreign persons were typically not subject to U.S. tax on the sale of U.S. real estate. By enacting FIRPTA, Congress intended to remove this perceived competitive advantage in favor of foreign investors in U.S. real property over their U.S. counterparts by requiring that non-U.S. persons pay tax on the disposition of U.S. real estate.
While U.S. persons are generally subject to tax on their income from all sources (foreign and domestic), non-U.S. persons are generally only taxed on a limited category of U.S.-source income, such as income that is effectively connected with the conduct of a U.S. trade or business (Effectively Connected Income, or “ECI”). Capital gains are generally sourced to the residence of the seller, and as such, under the general rule, a non-U.S. person’s sale of property generally results in foreign-sourced income.
Section 897 of the Internal Revenue Code (FIRPTA) treats gains and losses from a foreign person’s disposition of a “U.S. real property interest” (“USRPI”) as effectively connected with the conduct of a U.S. trade or business, thus converting the income into a category of income that is subject to taxation.
U.S. Real Property Interest
Section 897 defines the term “U.S. real property interest” broadly. It includes (i) an interest in real property (including an interest in a mine, well, or other natural deposit) located in the United States or the Virgin Islands, and (ii) an interest (other than an interest solely as a creditor) in a domestic corporation unless the taxpayer establishes that the domestic corporation was not a U.S. real property holding corporation (USRPHC) for a certain period.
The definition of USRPI includes any interest in the USRPI, with the exception of an interest solely as a creditor.
A USRPI specifically includes an interest in the following:
- Land and unsevered natural products of the land
- Improvements to real property
- Personal property associated with the use of the real property, such as movable walls, furnishings, and other personal property associated with the use of the real property
- Growing crops
- Wells and other natural deposits
- Oil and gas pipelines
- An option, a contract, or a right of first refusal to acquire any interest in real property (other than an interest solely as a creditor)
A corporation, whether domestic or foreign, is a USRPHC on a particular date if the fair market value of its USRPIs equals or exceeds 50% of the sum of the fair market value of its: (1) USRPIs; (2) interests in real property located outside the United States (foreign real property interests or FRPIs); and (3) other assets used or held for use in a trade or business.
Notably, an interest in a corporation is not treated as a USRPI if (i) the corporation did not hold any USRPIs on the date of disposition; (ii) all the USRPIs held by the corporation (during the applicable periods) were disposed of in transactions in which the full amount of any gain was recognized; and (iii) for dispositions after December 17, 2015, the corporation (or any predecessor) was not a Regulated Investment Company (“RIC”) or a real estate investment trust (“REIT”) (during the shorter of the applicable periods during which the interest was held).
Disposition of a USRPI
For FIRPTA purposes, this term means a “disposition” for any purpose of the Internal Revenue Code. This includes but is not limited to, a sale or exchange, liquidation, redemption, gift, or other transfers. A transferee purchasing U.S. real property interests from a foreign person, certain purchasers’ agents, and settlement officers are required to withhold 15% (10% for dispositions before February 17, 2016) of the amount realized on the disposition.
The disposition of an interest in a pass-through entity is taxed under IRC 897(a) to the extent that the gains are attributable to USRPIs held by the entities. These entities include partnerships, trusts, and estates. Gains or losses pass through to partners or beneficiaries.
Under certain circumstances, transfers that otherwise qualify for nonrecognition treatment may be subject to tax under FIRPTA. Dispositions may include the following:
- Gifts in which the adjusted basis of property transferred is less than the liabilities transferred
- Like-kind exchanges
- Changes in an interest in a partnership, trust, or estate
- Corporate reorganizations, mergers, or liquidations
- Involuntary conversions
Generally, FIRPTA imposes withholding at the rate of 15% on the amount realized on a disposition. However, if the amount realized is less than $1M USD, the withholding rate is reduced to 10%.