FOREIGN INVESTMENT IN U.S. REAL ESTATE - If not planned for, US taxation on ownership and disposition of real estate, ... • ECE&P = Earnings of Foreign Corp. from U.S. Trade or Business

FOREIGN INVESTMENT IN U.S. REAL ESTATE

Royse Law Firm, PC149 Commonwealth Dr.Menlo Park, CA [email protected]

www.rroyselaw.comSkype: roger.royse

http://www.rroyselaw.com/

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OUTLINE

1. Introduction and Importance of Real Property Investment by Foreigners

2. Taxation: Relevant Basics and Reporting

3. Relevant Entity Tax Issues

4. FIRPTA and Related Tax Rules

5. Federal Transfer Tax Considerations

6. Tying It All Together: Structuring Foreign Investment in U.S. Real Estate

7. California State and Local Taxes

8. (End) Takeaways

Unless otherwise

stated, all § references

are to the Internal

Revenue Code of

1986, as amended

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INTRODUCTION AND IMPORTANCE OF REAL

PROPERTY INVESTMENT BY FOREIGNERS

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SIZE OF THE MARKET• Numbers vary, but sources in general give a range of around

$50-80B volume in cross-border transactions in the U.S. yearly

• The U.S. has the world’s preeminent real estate market, with trading volume rising 25% in 2015 (to 39% of all global trading)– World property trading fell in 2015 by 2.4%, the first downturn in 6

years, as measured by $USD

• Cross-border investment rose by over 70% in the U.S., helping to offset a drop in domestic activity of 5%

• Overseas investors increased their market share from 10% to 18.1%, the highest on record

Sources

Cushman & Wakefield Capital Research Markets Publication Atlas Outlook 2016 (available online)

http://nreionline.com/finance-investment/foreign-investment-us-real-estate-assets-hit-record-high

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• External drivers: The U.S. real estate market is perceived as a (relatively affordable) safe investment. Contrast:– Economic uncertainty in China;

– The refugee crisis in Europe;

– Brexit; and

– The recession in Brazil

• Internal drivers: The U.S. real estate market has a favorable legal and economic environment. Key drivers include:– Congress’s continued easing of curbs on foreign real-estate investors;

– Low interest rates (which now seem likely to remain low);

– A relatively stable U.S. economy (which at least is reliable for parking capital); and

– The liquidity and transparency of the U.S. real estate market

WHY FOREIGNERS INVEST IN U.S. REAL ESTATE

Sources

http://nreionline.com/finance-investment/foreign-investment-us-real-estate-assets-hit-record-high

http://www.ibtimes.com/us-real-estate-attracting-more-foreign-investment-2016-new-york-city-remains-top-2247705

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• In the U.S., real estate is a tax-driven industry; it is not a coincidence the original tax shelters revolved so heavily around it– Domestically, like-kind rules, depreciation, interest deductions, loss

limitations, and other tax rules can make or break real estate ventures

– Foreign investors face all these usual rules, plus a bevy of additional rules covered in large part herein

• If not planned for, US taxation on ownership and disposition of real estate, as well as US tax reporting requirements, can be burdensome and greatly reduce the yields of a would-be real estate investor

IMPORTANCE OF THE TAX REGIME

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FEDERAL TAXATION:RELEVANT BASICS AND REPORTING

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INCOME TAX, GENERALLY

• Individual rates: 10%-39.6%,

– Plus employment or NIIT (if applicable)

– Individuals receive special reduced rates on long-term capital gains

• Corporate rates: 15%-35%

– Corporations do not receive reduced long-term capital gains rates

• International rules

– U.S. taxpayers taxed on worldwide income

– Foreign taxpayers taxed on certain U.S. related income

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NIIT AND SELF-EMPLOYMENT TAX• What is the net investment income tax (NIIT)?

– As part of the Affordable Care Act, a 3.8% surtax was added to the income tax system, intended to tax passive income of high income individuals, trusts, and estates

• Nonresident aliens are exempt from the NIIT. §1411(e)(1)

• Self-employment tax applies to salaries from corporations and allocations from partnerships– Does not apply to allocations to limited partners (in their capacity as

passive limited partners), or corporate distributions (including S-corporations, if not recharacterized as salary)

• Nonresident aliens are exempt from self-employment tax. §1402(b)– Can enter into an agreement to be covered under SSA §233

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INTERNATIONAL TAX FOR FOREIGNERS

Effectively Connected Income (ECI)

• Net income effectively connected with a U.S. trade or business (/permanent establishment, if treaty applies)

• Taxed at rates noted earlier

Fixed, determinable, annual or periodical (FDAP) income

• Gross income from activity not rising to level of trade or business—can include rents

• 30% withholding rate, may be reduced by treaty

• Does not cover gain on sales by foreigners

ECI Election for Foreign Holders of U.S. Real Property

• Allowed under IRC §§871(d) and 882(d)

• Why use it? Because net income approach generally more favorable when holding real property, due to income sheltering from, e.g., depreciation

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NOTABLE REPORTING REQUIREMENTS

• FATCA: – Non-US entities which are treated as foreign financial institutions

must perform reporting,

– If they do not, payors to such entities must withhold tax.

• §6038A proposed regulations: – Foreign owners of U.S. disregarded entities will have to report about

themselves, keep appropriate records for tax.

– Already considerable reporting for other foreign-owned U.S. entities

• FinCEN new reporting requirements: For title insurance companies in New York City and Miami, Dade County. – Such companies must file a FinCEN Form 8300 within 30 days of an

all-cash purchase of real estate worth over $3 million in Manhattan, or over $1 million in Miami, Dade County

– Identifies the purchasing entity and any individual who beneficially owns 25% or more of the purchasing entity.

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OVERVIEW OF

U.S. TRANSFER TAXES

APPLICABLE TO NON-RESIDENT NON-CITIZENS

Transfer Type General Tax Concept Applicable Tax Base

Lifetime Gift Tax on Transferor at 18% - 40% Property transferred with US situs (other than intangibles)

Bequest or Devise at Death

Tax on Estate at 26% - 40% of everything over $60,000 FMV

Property deemed “U.S. Situs” propertyBEWARE-This is non-intuitive analysis!

Generation-Skipping Transfer

Additional Tax on Transferor (whether during lifetime or at death) at 18% - 40%

Anything that is subject to Gift Tax or Estate Tax under the above rules

Gifts, Bequests, or Devises to Non-citizen Spouse

Estate or Gift Tax Applies per above unless transferred at death via Qualified Domestic Trust (QDOT) with U.S. Trustee

All “US Situs” assets transferred as per Estate and Gift Tax base rules above; except for lifetime gift under annual exclusion ($148,000 for 2016)

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RELEVANT ENTITY TAXATION BASICS

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BASIC ENTITY REGIMES

Other specialized entity regimes exist, but are beyond scope of presentation

LLC Corp.LLC or

Partnership

Disregarded Entity

As if directly owned

Partnership

1x tax, entity is for accounting

C-Corporation

2x tax (corp., dividend)

Tax Tax

Tax

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REAL PROPERTY IN CORPS. VS. PARTNERSHIPS

Issue C-Corporations Partnerships

Long-term capital gainsrates on disposition?

Not available Available

Ability to pull cash out tax free after, e.g., refinancing?

Not available Generally available

Ability to flow through losses?

Not available Available (but subject to many anti-loss rules)

Tax of owners during ownership phase?

No; corporation is taxed

Yes; but keep in mind there is typically very little net income from real property thanks to high amount of deductions

Domestically, almost always better to have a partnership as a real

property investment vehicle. Foreign investors? We will see . . .

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CORPORATE AND BRANCH PROFITS (BP) TAX

Foreign Person

Foreign Corp.

U.S. Corp.

When Foreign Corp.

dividends money, U.S. tax

system is irrelevant

When U.S. Corp dividends

money to Foreign Corp.,

there is a withholding tax

(FDAP)

When U.S. Corp earns

money from U.S. trade or

business, it is taxed

(domestic tax rules)

Example #1: CorporateForeign Person

[No U.S. Corp]

Same structure as

Example #1, except no

U.S. Corp.

Like Ex. #1, no U.S. tax

when Foreign Corp.

makes dividend

Unlike Ex #1, no U.S.

Corp, so no U.S.

withholding tax

Foreign Corp. taxed on

U.S. trade or business

earnings (ECI)

Example #2: Branch (in a world w/o BP Tax)

U.S. Trade or Business


Foreign Corp.

But branch profits tax does exist (example #2 cannot happen under modern

U.S. tax law), and causes rough parity between the two examples . . .

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CORPORATE AND BRANCH PROFITS (BP) TAX

Foreign Person

[No U.S. Corp]

Same structure as

Example #2

Like Ex. #1, no tax when

Foreign Corp. makes

dividend

Unlike Ex #1, no U.S.

Corp, so no withholding

tax. Instead, branch

profits tax applies

Foreign Corp. taxed on


earnings (ECI)

Example #3: Branch (with BP Tax)


Foreign Corp.

• The Branch Profits Tax essentially

creates a “simulated” U.S. Corp. for

dividend purposes

• Branch profits slightly worse than

corporate tax, because less control

of timing of dividend equivalents

• Core concept: Tax “dividend equivalent

amount” like dividend from U.S. Corp:• Dividend equivalent amount = (ECE&P)

– (increase in U.S. net equity)

• ECE&P = Earnings of Foreign Corp.

from U.S. Trade or Business

• U.S. net equity = Amount of money

deemed reinvested in U.S. Trade or

Business at start and end of year

• Branch profits tax triggers only if a

foreign corporation has net profit in a


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TRUSTS

• Only trusts used for certain non-active-business purposes will be given trust taxation– Else, may end up taxed as a corporation

• Trust for income tax purposes either treated as: – Disregarded entity (grantor trust), or

– Entity taxed under fiduciary income tax rules, which is taxed on income it does not distribute to beneficiaries

• Special trusts exist as well

• To discourage stashing income in foreign trusts, U.S. has penalty throwback rule on distributions from such trusts – Be careful

• Trusts under the fiduciary income tax rules may be able to create long-term capital gains where beneficiaries (e.g., corporations) would have had the ability to do so

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FIRPTA AND RELATED TAX RULES

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THE WORLD, PRE-FIRPTA

• Until 1980, a foreign person could, with planning, dispose of U.S. real property without incurring any U.S. tax liability.

• Gain on sale of U.S. real property was subject to U.S. taxation in two circumstances: – If the gain was ECI; or

– If the person was an individual present in the United States at least 183 days in the year, the gain would be subject to a flat 30% tax

• A foreign person could always avoid U.S. taxation by dealing indirectly in U.S. real property, through ownership interests of an entity holding U.S. real property

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FIRPTA—WITHHOLDING AND TAX EFFECTS

Foreign Investment in Real Property Tax Act of 1980 (FIRPTA)

• Income from disposition of U.S. Real Property Interest (USRPI) is ECI

• 15% gross withholding by buyer acquiring USRPI– This is not the final tax due—it is merely an advance payment

(potentially too high or too low)

– 10% gross withholding for dispositions before February 17, 2016

• Exemptions from FIRPTA withholding– Affidavit of non foreign status– Non recognition transactions– Qualified foreign pension fund

• 2015 addition

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DEFINING USRPIS AND USPRHCS

• USRPIs are non-creditor interests in real property, either direct or through an intermediary entity– “Real property” includes land, certain natural products and

improvements thereof, and personal property “associated with the use of the real property”

– Includes stock in a USRPHC

• A corporation is a U.S. Real Property Holding Corporation (USRPHC) if more than 50% of its assets (measured on a fair market value basis) are comprised of USRPIs at any time during a five-year period preceding the sale of its stock by its foreign owner– Cleansing exception: Interests in a USRPHC are not considered USRPI

if, at the time of the sale of the USRPHC interests, the USRPHC has disposed of all U.S. real property in one or more taxable transfers.

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NOTABLE WITHHOLDING MECHANICS

• IRC § 1445 imposes the FIRPTA withholding tax– 15% gross income advance payments

– Due 20 days after transfer date

• IRC § 1446 imposes withholding tax for a domesticpartnership that receives ECI allocable to its foreign partners – Tax is calculated at the partner’s highest statutory rate, based on net

ECI so allocated

– Withholding done quarterly

• §1446 preempts §1445 where both apply– This means you can essentially elect between two different

withholding regimes; choose the one that is best for you

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LIKE-KIND EXCHANGE TRANSACTIONS

• Section 1031 like-kind exchange transactions

– Permits tax deferral—a type of nonrecognition transaction

– U.S. property is only “like-kind” to other U.S. property, and foreign property is only “like-kind” to other foreign property

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FIRPTA STRUCTURING CONCERNS

• FIRPTA generally overrules non-recognition provisions (such as contributions to corporations or partnerships) and makes them taxable, unless:– The foreign transferor receives a USRPI in exchange for the

transferred USRPI;– The USRPI received in the exchange, immediately following the

exchange, would be subject to U.S. tax upon its disposition; and– The foreign transferor complies with certain IRS filing requirements

• FIRPTA regulations include specific exceptions to the general recognition rule as well

• Beware of §§367 and 7874 when performing structuring

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FEDERAL TRANSFER TAX CONSIDERATIONS

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ESTATE AND GIFT TAX RATES

Applicable to U.S. Citizens or

Domiciliaries*:

Year

Lifetime Estate

& Gift Tax

Exemption

Amount

Annual Gift Tax

Exclusion

regardless of

donee identity

or citizenship

Annual Gifts or

Testamentary

Bequests to

U.S. Citizen

Spouse

Annual

Exclusion Gift

to Non-citizen

Spouse

2014 $5,340,000 $14,000 Unlimited $145,000

2015 $5,430,000 $14,000 Unlimited $147,000

2016 $5,450,000 $14,000 Unlimited $148,000

*A domiciliary can be described, for this purpose, generally, as someone living in the U.S. with no

present intention to ever leave

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ESTATE AND GIFT TAX RATES

NON-U.S. DOMICILED NON-CITIZENS

Applicable to U.S. Situs Property

But, what about bequests to a

non-citizen spouse?

Year

Lifetime

Gift Tax

Exemption

Annual

Gift Tax

Exemption

Annual

Exclusion

Gift to

Non-U.S.

Citizen

Spouse

Exemption

for Gifts or

Bequests

to a U.S.

Citizen

Spouse

Estate Tax

Exemption

Applicable

Gift &

Estate Tax

Rates

2015 $0 $14,000 $147,000 Unlimited $60,000 18% - 40%

2016 $0 $14,000 $148,000 Unlimited $60,000 18% - 40%

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ESTATE TAX

• Foreign persons subjected to US estate tax only on US situs assets that they directly hold

• Planning point: Make sure foreign person holds only non-U.S. situs property. Consider using separate taxable entities as blockers (e.g., trusts, or business entities)

Asset Type Situs Rule (assumes no IRS re-characterization) Authority

Real property Location of real property §2103; §20.2104-1(a)(1)

Corporate stock Where corporation organized §2104(a); §20.2104-1(a)(5) and (f)

Partnership interest

Unknown; perhaps residence ofowner, or partnership’s trade or business, place of organization…

Rev. Rul. 55-701; Blodgett v. Silberman, 277 US 1, 1928; §20.2104-1(a)(3); §20.2105-1(c) (if in bearer form); OECD Model Estate and Gift Tax Treaty

Disregarded LLC interest

Unknown; presumably equivalent to direct ownership, but may be intangible with own situs per recent authority

Analogy to grantor of revocablegrantor trust / sole proprietorship; or Pierre v. Commissioner, 133 T.C. 24 (2009)

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GIFT TAX

Gift Tax

• Foreign persons are subject to US gift tax only on gifts of US situs tangible assets*

• Planning point: For foreign persons making gifts to US persons, consider converting tangible assets to intangible assets prior to gifting.

• IRS will not rule on whether a partnership interest is tangible or intangible for gift tax purposes

• Rev. Proc. 2016-7, § 4.01(29)

• Also unclear how disregarded entity interests are treated

*Gifts from certain U.S. expatriates are taxable to recipient, even if intangible asset.

Mom

Son

IRS

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GENERATION-SKIPPING TRANSFER TAX

Additional GST Tax

• Foreign persons are subject to an additional, GST tax on Generation-skipping transfer of U.S. situs assets by gift or inheritance.

• Annual Exclusions can apply, but No Exemption!

Mom

Son

Grandson

IRS

GST & GIFT

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INBOUND GIFT OR INHERITANCE

ASSET TRANSFER ISSUES

• Intangible Assets– Stocks, LLC & LP interests, patents, copyrights, etc.

– General rule—intangibles are located where the giver is located.*

• Tangible Assets– Real estate, equipment, automobiles, jewelry, artwork, etc.

– General Rule—tangible assets have situs where they are physically located.

• But, what about cash, currency, bank accounts, etc.?

*But watch out for corporate stock in estate tax context!

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TYING IT ALL TOGETHER:STRUCTURING FOREIGN INVESTMENT IN U.S.

REAL ESTATE (FEDERAL TAX ONLY)

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STRUCTURING FOREIGN INVESTMENT IN U.S. REAL ESTATE

Ownership Through Foreign Corp.Foreign Person

Foreign Corp.

U.S. Tax System Exposure for Foreign Corp. YES

Capital Gains Rate (20%) on Disposition of Real Property

NO

Withholding Tax on Repatriation of Funds from Foreign Corp.

NO

U.S. Tax-Free Disposition of Entity YES

Branch Profits Tax YES

Exposure to U.S. Estate Tax NO

Exposure to U.S. Gift Tax NO

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Ownership Through U.S. Corp. (USRPHC)Foreign Person

U.S. Corp.

U.S. Tax System Exposure for U.S. Corp and Foreign Person

YES


NO

Withholding Tax on Repatriation of Funds from U.S. Corp.

YES

U.S. Tax Free Disposition of Entity NO

Branch Profits Tax NO

Exposure to U.S. Estate Tax YES


Remember, cleansing exception can apply to allow

tax free sale (including liquidation) of USRPHC

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Foreign Person

Foreign Corp.

U.S. Corp.

Ownership Through Foreign Corp. and U.S. Corp. (a USRPHC)

U.S. Tax System Exposure for Foreign Person NO


NO

Withholding Tax on Repatriation of Funds from U.S. corporation

YES

U.S. Tax Free Disposition of Foreign Corp. YES


Exposure to U.S. Estate Tax NO


Cleansing exception applies, as in prior slide

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Foreign Person

Direct Ownership

U.S. Tax System Exposure for Foreign Person YES


YES

Withholding Tax on Repatriation of Funds NO

U.S. Tax Free Disposition of Asset NO


Exposure to U.S. Estate Tax YES

Exposure to U.S. Gift Tax YES

*May be minimized by high amount of deductions

(from depreciation, etc.) flowing through

*

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Ownership Through U.S. LLC or Foreign LLC (Disregarded Entity)

Foreign Person

U.S. or Foreign LLC



YES


U.S. Tax Free Disposition of Entity NO


Exposure to U.S. Estate Tax ?

Exposure to U.S. Gift Tax ?



*

39


Ownership Through U.S. LLC or Foreign LLC (Tax Partnership)

Foreign Person



YES


Tax Free Disposition of Entity / Asset NO




Foreign Person #2

U.S. or Foreign Tax Partnership

Use of U.S. partnership will result in §1446

withholding instead of §1445 withholding

*



40


Ownership Through Two Tiers of Tax Partnerships

Foreign Person



YES


Tax Free Disposition of Entity / Asset NO




U.S. Tax Partnership

Foreign Person #2

Foreign Tax Partnership

Top tier foreign partnership means better

arguments for favorable transfer taxation than prior

*



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ADVANCED STRUCTURING: EARNINGS STRIPPING

• Funding the operating entity with debt could reduce U.S. tax and create the opportunity to repatriate earnings to the foreign investors with minimal or no U.S. withholding tax

• Must be wary of:

• §163(j) (potential disallowance of interest deductions for low EBITDA corporations with 60% or more capitalization from debt)

• §385 proposed regulations (potential reclassification of debt as equity where, e.g., documentation improperly kept)

• Can plan into portfolio interest exception (0% withholding)

• Recipient cannot be “10% shareholder” of debtor. To avoid, design stock to exploit the fact that “10% shareholder” of a corporation defined as someone attributed 10% or more of the vote

• This trick does not work for partnerships, as their 10% shareholder definition is more stringent (as it looks to capital or profits interests)

• Remember, earnings stripping requires regular enough cash flow to pay debt (via, e.g., rent)

42


Earnings Stripping Technique Using Portfolio Interest Exception (PIE)

Foreign Person

Foreign Person #2

Foreign Tax Partnership

Foreign Tax Haven Corp.

U.S. Corp.

Trusted Unrelated

Foreign PersonRepayment

of Loan

• Capitalization of U.S. Corp. stays over §163(j)

thresholds

• Trusted Unrelated Foreign Person holds 91% of

vote, 1% of value, avoiding PIE 10% shareholder

restriction for Foreign Tax Haven Corp.

• U.S. Corp. takes low percent priority return in U.S.

tax partnership (in order to get income for stripping)

U.S. Tax Partnership

43

CALIFORNIA STATE AND LOCAL TAX

CONSIDERATIONS

44

CALIFORNIA NON-INCOME TAXES• The county in which real property is located will charge a

document transfer tax, due upon change of ownership• May trigger on restructuring

• Property tax reassessment triggers on most changes of ownership• May trigger on restructuring

• No California state inheritance or estate tax

• Sales and use tax generally not relevant

45

CALIFORNIA WITHHOLDING• Like FIRPTA, California’s FIRPTA, Rev. & Tax. Code § 18662,

requires buyers of California real property to withhold and remit tax. • Unless exception applies, tax must always be withheld

• Amount is 3 1/3% of gross, generally. Alternatively, the state will allow sellers to demand from buyers income tax withholding based on realized gain and maximum applicable tax rate.

• Many more exceptions for California’s FIRPTA than Federal

• California incorporates §1446 in Cal. Rev. & Tax. Code §18666, except that §18666 applies to all California-source income distributed by a partnership to out-of-California partners.

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INCOME CHARACTER AND RATES• California income tax does not distinguish between capital

gains, qualified dividends, and ordinary income, which reduces the benefits of structuring for capital gains• Still, due to U.S. federal tax, there remains a 15-20% difference

between capital and ordinary income tax rates

• Further, California income tax rate is better for corporations (maximum of 8.84% for C-corporations versus a maximum of 13.3% for individuals). This exacerbates the slightly better federal corporate tax rates (maximum 35%) compared with individuals (maximum 39.6%)• Not clear this superior first layer of tax is worth double taxation

47

SOURCE OF INCOME• Planners should look to convert California-source income to

non-California source. This is often achieved via inserting intangibles (e.g., mortgages, certain kinds of equity from entities) into the structure• Rents and gains from California-located real property, California-located

business income, are California-sourced

• Intangible income, for California income tax purposes, is typically sourced to location of owner, but may acquire a business situs in California and become automatically taxable in California

• It does not matter whether a corporation or partnership carries on business in California in determining where equity interests in the entities are sitused (although it does matter for sourcing partnership allocations)

• In some cases, C-corporations (and certain other entities) may need to consider California’s “unitary business” apportionment and allocation rules, as well as “water’s edge” rules

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TAKEAWAYS

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TAKEAWAYS

• Best tax structure:– Best for certainty to avoid transfer tax: Invest through a foreign

corporation

• This is very poor from an income tax perspective

– Best income tax: Use flow-through entities

• A top-tier foreign partnership may give good transfer tax results too

– Earnings stripping and intangibles can create further tax efficiencies

– Consider your preferred withholding between §§1445 and 1446

• Be careful when structuring due to pitfalls under:– California property and deed transfer taxes

– FIRPTA anti-non-recognition, §367, and §7874

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51

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149 Commonwealth Drive,

Suite 1001

Menlo Park, CA 94025

LOS ANGELES

445 S Figueroa St

31st Floor

Los Angeles, CA 90071

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135 Main Street

12th Floor

San Francisco, CA 94105

Menlo Park Office: 650-813-9700

CONTACT US

www.rroyselaw.com

@RoyseLaw

Documents

FOREIGN INVESTMENT IN U.S. REAL ESTATE - If not planned for, US taxation on ownership and disposition of real estate, ... • ECE&P = Earnings of Foreign Corp. from U.S. Trade or Business