Foreign investments in real estate: Executing the transaction and the unique tax laws involved

The combination of a weak dollar and a stable New York real estate market has led many foreign investors to consider adding New York properties to their portfolios. There are several options for how to make the investment and a set of unique tax laws specific to foreign investors. Adding to the complexity of the investment decision are the numerous income tax treaties that the U.S. has with other nations. These treaties modify and in some cases overrule the Internal Revenue Code. After deciding to invest, a foreign investor must decide the manner with which the property will be held. Their options include direct investment, using a foreign corporation or forming a U.S. corporation to own the investment. The investment itself can be actual ownership or an interest in an LLC/partnership that will own the property. Each of these decisions has its own set of reporting and filing requirements along with the potential impact on the ultimate taxes that will be due. During the life of the investment the taxation of the annual operations of the property is very similar to the taxation of a U.S. person. One key difference is the requirement that certain withholding rules be complied with. The disposition of the investment will present the investor with an additional set of reporting and filing requirements. Pursuant to code Section 897 dispositions of U.S. real property interests (USRPI) by a nonresident alien or foreign corporation are taxed as if they were income derived from a U.S. trade or business activity. This means that the gain on the sale is taxed in the U.S. In addition, the buyer is required to withhold 10% of the purchase price and remit it to the IRS as an estimated tax payment on behalf of the seller. The tax law requires the seller to file a U.S. income tax return reporting the sale and pay any additional tax due or request a refund of any excess withholding. Often the 10% withholding exceeds the ultimate tax due and the rules provide a remedy whereby the seller can avoid all or part of the withholding. To do this the seller must apply to the IRS for a withholding certificate showing the IRS why the withholding is too high and provide them with a calculation of what the correct withholding should be. The certificate can be applied for up to the day of the sale and must be presented to the buyer to relieve the buyer of the withholding requirement. If a seller has applied for a certificate but has not received a determination from the IRS the buyer can establish an escrow account to hold the 10% until the IRS completes its work on the application. The withholding and filing requirements are also applied to the sale of stock in certain corporations known as U.S. Real Property Holding Corps. (USRPHC). Any corporation, either foreign or domestic is a USRPHC if more than 50% of the total assets of the corporation are comprised of USRPI based on fair market values (FMV). Under an alternative test, the FMV of a corporation's USRPIs is presumed to be less than 50% of the fair market value of the aggregate of the assets discussed above if on the applicable determination date, the book value of the USRPIs held by the corporation is 25% or less of the book value of the aggregate of the corporation's assets that are included in determining whether a corporation is a USRPHC. There are also withholding requirements on domestic or foreign corporations that distribute a USRPI to its shareholders who are subject to the provisions of section 897. A distribution of a USRPI includes dividend distributions under Section 301, redemptions of stock, and distributions in liquidation. The unique aspects of ownership and disposition of US real property by foreign investors present their advisors many challenges. These advisors should be certain of their expertise before undertaking these types of engagements. Sandy Klein is a partner at Shanholt Glassman Klein Kramer & Co., New York, N.Y.