The United States real estate market shows no indications of losing its attractiveness to foreign investors. Investing in real property in the U.S. is relatively easy, with no material restrictions on who can purchase it. The U.S. tax implications for foreign-owned real estate, however, often catch foreign investors by surprise.
Non-U.S. citizens or residents have to pay U.S. tax on rental income generated by their U.S. real estate. Furthermore, FIRPTA, a special U.S. tax law, ensures that foreign investors pay income tax when they sell their real estate. Luckily, with proper business structuring, foreign investors can avoid FIRPTA real estate tax and reduce their overall tax burden.
Tax on income from rental properties with foreign ownership
The United States taxes rental income sourced in the U.S., even when the property owner is not a U.S. person.
Foreign investors in U.S. real estate have two options when it comes to paying taxes on income from rental properties:
- The investor elects to have 30% withholding taken from each gross rental payment they receive. A withholding agent – usually the property manager – collects the tax and then forwards it directly to the IRS. If an income tax treaty exists between the U.S. and the investor’s country of residence the 30% withholding rate may be reduced.
- The investor agrees to prepare a U.S. tax return to report the rental income earned each year. (Just like a U.S. investor would need to do). To do so, the investor must apply for an Individual Taxpayer Identification Number (ITIN) using Form W-7 and submit it, usually when filing the tax return. A Form W-8ECI will also need to be filled out (called a NET election) and sent to the withholding agent, which is usually the property manager.
The second option requires more work. It does however allow you to deduct all ordinary and necessary expenses incurred while operating the rental property. Common deductible expenses include mortgage interest, real estate taxes, advertising, cleaning and maintenance expenses, and property management fees.
Any rental income left after deducting all qualifying expenses will then be subject to ordinary income tax rates, which may be far less than the standard 30% withholding rate of the first option.
FIRPTA real estate tax on sales of US real estate
Not all foreign investors wish to become landlords. Some find flipping properties much more attractive. However, taxation then becomes more complex for foreign owners of U.S. real estate, thanks to FIRPTA.
The Foreign Investment Real Property Tax Act (FIRPTA) imposes taxes on nonresident aliens and foreign corporations when they have Effectively Connected Income (ECI). This sounds complex, and it can be.
ECI is income that an individual or entity makes when engaged in a trade or business within the U.S. The gain from selling a U.S. property qualifies as such income.
And there is more to it, beyond just a sale of real property. The IRS taxes foreigners on the “disposition of U.S. real property interests”. What does that mean?
Simply put, the IRS taxes any sale or transfer of foreign-owned real estate and other related ownership. The tax applies not only to individuals who are non-U.S. citizens or residents but also to foreign companies.
Let’s look at the details and definitions.
What is U.S. real property interest, besides real estate?
U.S. real property interests are more than commercial or residential buildings. The term also encompasses land ownership, personal property associated with the use of real property such as vehicles, farm equipment, furniture, etc, permanent fixtures, and the stock held in a domestic holding corporation that owns real estate.
What is a disposition?
Surprisingly, this is any sale or transfer of a U.S. real property interest. What happens if no money exchanged hands as is the case in gifts and inheritances? The absence of monetary consideration is irrelevant to the IRS; it still considers it a disposition. This means even if you change the property title to the name of your child, you would have a taxable event.
FIRPTA tax rates vary for different types of ownership
FIRPTA withholding rates may vary depending on the ownership and the nature of the real property interest disposition.
Foreign individual, partnership, trust or estate
When a foreign person, partnership, trust or estate disposes of U.S. real property, the withholding will be 15% of the fair market value (sales price). However, the 15% automatic withholding for FIRPTA is not supposed to exceed the actual tax liability. The investor can apply for reduced withholding through form 8288-B requesting a withholding certificate.
A foreign corporation that disposes of real property and distributes to the foreign shareholder will withhold 21% of the gain from the sale.
If a domestic U.S. partnership disposes of real property there is no 15% withholding. However, the partnership must pay 35% of the gain that is allocable to the foreign partner.
Domestic U.S. corporations with foreign shareholders will not have any FIRPTA taxes imposed on the disposition of real property. Rather, it will pay corporate tax rates on the gain at the rate of 21%.
Example 1 – FIRPTA for individual investor
Marion, a nonresident individual, sells real property she owns in Washington State for $200,000. Her FIRPTA withholding will be $30,000 (15% rate x $200,000 fair market value of property.)
Example 2 – FIRPTA with LLC
Holland RE, LLC is a U.S. entity owned equally by Marion, a nonresident individual, and Jill, a U.S. Citizen. The LLC owns real property in Washington State and has decided to sell it for $200,000. The partners recognize a total gain of $60,000. There will be no mandatory FIRPTA withholding on the $200,000 fair market value of the property because the LLC is a U.S. entity. However, the LLC will be required to pay withholding tax in the amount of $10,500 which is 35% of Marion’s proportionate gain of $30,000 from the sale.
How does FIRPTA real estate tax work
The mandatory FIRPTA tax withholding is usually coordinated with the sellers and the escrow company. The escrow agent will withhold the prescribed amount and forward it to the IRS on the seller’s behalf.
To achieve this, foreign sellers must obtain tax identification numbers. Entities need to submit a Form SS-4 application to request an Employer Identification Number (EIN). For individuals, the process is a bit more complicated and involves applying for an Individual Taxpayer Identification Number (ITIN) using Form W-7.
Can foreign investors avoid FIRPTA tax
Foreign investors in high tax brackets or with short-term sales should consider structuring the investment with a tax-optimized business setup. If the foreign investors acquire and own the property through a U.S. C-corporation, they pay the corporate tax rate of 21% upon selling the property. After that, they can dissolve the corporation for total distribution with no dividend tax.
Furthermore, in some circumstances you can avoid FIRPTA if you sell the property at a loss. You need to advise the IRS not to withhold by filing a special application.
Understanding tax implications for foreign ownership of U.S. real estate and FIRPTA
As you can see there are many facets to real estate tax in the U.S.A. for foreign investors. This article provides a general overview of the tax implications imposed on foreign investors of U.S. real estate and is by no means all-inclusive.
Foreign investors must take into account important considerations before embarking on the purchase of U.S. real property. An in-depth analysis of income and estate tax consequences and your business structure is essential. There is no one-size-fits-all that will accommodate every investor’s unique situation.
To explore your best options, please schedule a consultation with one of our Global Expat Advisors.