Foreign Investment in U.S. Real Estate

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1 Foreign Investment in U.S. Real Estate AICPA Federal Real Estate Tax Conference June 24, 2011 Washington, DC Brian O Connor, Venable LLP Steven Schneider, Goulston & Storrs P.C

2 Speaker Biography Brian O Connor is a partner in the Baltimore and DC offices of Venable, where he provides sophisticated tax and business advice to publicly traded and closely held businesses and their owners. His practice focuses on foreign and domestic tax matters for partnerships, LLCs, both C and S corporations, REITs, and RICs. Mr. O Connor is also an Adjunct Professor at the Georgetown University Law Center LL.M. program, teaching Drafting Partnership and LLC Agreements. Steven Schneider is a partner in the DC office of Goulston & Storrs, where he concentrates on the tax aspects of commercial transactions, with a concentration in the taxation of pass-through entities such as partnerships, S corporations, and REITs. He also has significant experience in crossborder issues, real estate, investment funds, tax policy and tax controversy. Mr. Schneider is also an Adjunct Professor at the Georgetown University Law Center LL.M. program, teaching Drafting Partnership and LLC Agreements. American Institute of CPAs 2

3 Taxation of Foreign Investors Generally, foreign investors in the U.S. are taxed under one of two regimes: Income which is not effectively connected with U.S. trade or business ( passive income ), taxed on a gross basis at 30%, subject to exclusions and treaty provisions. Significant exception for portfolio interest (requires lender to satisfy a less than 10% relatedness test). Income effectively connected with U.S. trade or business (ECI), generally taxed on a net basis at applicable regular individual or corporate U.S. tax rates.

4 Non-ECI What is it? Dividends Interest (unless payee is in the trade or business of lending) Rents (if not ECI) Royalties Other fixed, determinable, annual or periodic (FDAP) income

5 How Non-ECI is Taxed The 30% tax on gross income is imposed by withholding by the payor The foreign investor does not need to file U.S. tax returns but if claiming treaty benefits needs a U.S. tax identification number This withholding rate is often lower for certain types of Non-ECI under tax treaties (often 0%, 5% or 15% for dividends and interest) REIT dividends are usually treated less favorably in tax treaties than other dividends

6 ECI ECI is income generated from engaging in a trade or business, directly or through a tax pass-through entity, in the United States. Whether the investor is engaged in a U.S. trade or business is a question of fact If an investor owns and manages real estate in the United States, the investor is generally engaged in U.S. trade or business. If the investor owns only triple-net leased property, then likely the investor is not engaged in U.S. trade or business (but may make election to tax as ECI) Investor will need to file tax returns and pay income taxes in the U.S. (and often in the state where a property is located)

7 FIRPTA Under the Foreign Investment in Real Property Tax Act ( FIRPTA ), gains or losses from the disposition of a United States Real Property Interest ( USRPI ) are treated as effectively connected with a U.S. trade or business. IRC 897(a)(1). The tax imposed by FIRPTA is enforced by withholding by the buyer (generally at a 10% gross rate). IRC 1445(a). Special rules for withholding by Partnerships IRC 1446

8 FIRPTA TAXES disposition of USRPI Real estate U.S. Real Property Holding Corporation ( USRPHCs ) Equity Kicker Loans? The following are NOT USRPHCs: Foreign Corporate Stock Straight Debt Publicly Traded Stock/Publicly Traded Partnership (which is an entity taxed as a corporation) Domestically Controlled REIT

9 FIRPTA WITHHOLDING 10% of Amount Realized -Even if Loss, Withholding is Required Exemptions Non-Foreign Affidavit Non-USRPHC Affidavit Exemption or Reduced Rate Certificate - Form 8288-B Sales Price <$300,000 + Transferee Residence Regularly Traded Stock Withholding Under Special Partnership Rules IRC 1446

10 Partnership Withholding A U.S. partnership is required to withhold at the highest marginal rate on the partnership s ECI allocable to a foreign partner (e.g., generally 35%, lower for certain capital gains to non-corporate partners). IRC 1446; Reg Under FIRPTA, if the domestic partnership disposes of USRPI, it must withhold at the 35% rate (15% where allowed by IRS) for any taxable gain from the disposition allocable to a foreign partner. IRC 1445(e) (Note 1446 trumps 1445 (Reg (c))

11 State Taxation Many states also have an income tax, usually based on the federal tax rules with some changes from state to state. In most states with an income tax, if owning real property directly or indirectly creates ECI, a state income tax is also imposed. This often is enforced through withholding mechanisms. If there is a state income tax usually the foreign investor will be required to file a state tax return. If there are multiple non-resident investors, in many states it is possible to file a composite return.

12 Options for Investing in U.S. Real Estate

13 Direct Ownership Option Foreign Investor(s) Single or multiple member limited liability company (see next page) real estate Only one level of taxation Taxed at applicable tax rates for individuals, 15% capital gains rate progressive rates on income up to 35% for corporations, progressive rates up to 35%* Estate Tax for Individuals Privacy Concerns *Additional Branch Profits Tax for Foreign Corporations

14 Blockers-Generally The purpose of using blocker entities is to isolate the investor from being considered as conducting trade or business in the U.S. (and thus having ECI and having to file tax returns). The cost of blockers is 2 levels of taxation, except for real estate investment trust (REIT) blockers.

15 Domestic Corporation Structure Foreign Investor(s) U.S. Corporation Dividend withholding tax Sale of Stock is Taxable Estate tax for individuals No Branch Profits Tax Limited Privacy Real estate or ownership in passthrough or disregarded entities owning real estate

16 Foreign Corporation Structure Foreign Investor(s) Foreign Corporation Branch Profits Tax Sale of Stock is Tax Free (but no step-up) No Estate tax Limited Privacy Real estate or ownership in passthrough or disregarded entities owning real estate

17 Dual Corporation Structure Foreign Investor(s) Foreign Corporation U.S. Corporation Real estate or ownership in passthrough or disregarded entities owning real estate Dividends withholding tax No Branch Profits tax Sale of Stock of Foreign Corporation is Tax Free (but no step-up) Sale of Property and Liquidation of U.S. Corporation - One Level of Tax No Estate Tax Privacy

18 Earnings Stripping: IRC 163(j) Using leverage to reduce taxable income of the corporate blocker But 163(j) suspends excess interest expense (e.g., interest expense that exceeds 50% of adjusted taxable income) if the debtto-equity ratio of the corporation exceeds 1.5 to 1 (i.e., debt exceeds 60% of assets)

19 Leverage Without Interest Stripping Foreign Investor $40 Million Equity U.S. Corp. $60 Million Debt (10%) Real Estate = $100,000,000 NOI = $10,000,000 Dep. = $2,000,000 Int. Exp. = $6,000,000 Taxable Income = $2,000,000

20 Leverage With Interest Stripping Foreign Investor $25 Million Equity U.S. Corp. $75 Million Debt (10%) Real Estate = $100,000,000 NOI = $10,000,000 Dep. = $2,000,000 Int. Exp. = $7,500,000 Allowable Int. Exp. After 50% NOI Interest Stripping Limitation = $5,000,000 Taxable Income = $3,000,000 Carry Over Interest = $2,500,000

21 REITs What is a REIT? Like mutual funds for real estate. Tax benefits of a REIT If an entity qualifies as a REIT, to the extent it distributes all of its net taxable income, it pays no tax on its net taxable income. Capital gains are treated separately from net operating income. If distributions are made of capital gains (in addition to net operating income distributions), then the REIT will not pay any capital gains taxes.

22 REITs (cont d) There are many technical rules that must be complied with in order to qualify as a REIT Some Material Requirements Must have at least 100 shareholders Its shares must be freely transferable It cannot be closely held 5 or fewer shareholders cannot hold more than 50% of the value of outstanding stock. This test is applied on a look-through basis until individuals and certain entities, primarily private foundations, are reached.

23 Foreign Investors in REITs Foreign Investors are not considered as engaged in U.S. trade or business REIT distributions are treated as dividends to extent of E&P, subject to withholding at 30% or reduced treaty rate Some treaties impose 10% - 15% rate on dividends received from REITs Capital gain distributions subject to FIRPTA Sale of domestically controlled REIT stock no FIRPTA

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25 For further information contact: Steven Schneider Goulston & Storrs, P.C. Washington, DC Brian J. O Connor Venable LLP Baltimore, MD BJOconnor@Venable.com American Institute of CPAs 25

26 Circular 230 Pursuant to IRS Circular 230, please be advised that, to the extent this communication contains any federal tax advice, it is not intended to be, was not written to be and cannot be used by any taxpayer for the purpose of (i) avoiding penalties under U.S. federal tax law or (ii) promoting, marketing or recommending to another taxpayer any transaction or matter addressed herein. American Institute of CPAs 26