Foreign Investment in U.S. Real Estate

• May 25, 2023
• Carey M. Heyman, CPA

Earlier this year, the IRS issued proposed regulations that could threaten how non-U.S. investors invest in real estate funds, private equity funds and other tax structures.

The Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”) requires any gain realized by a non-U.S. investor from the sale or other disposition of a U.S. real property interest to be subject to tax on that gain at regular U.S. federal income tax rates as if they were a U.S. person. The FIRPTA tax is enforced by requiring the purchaser or other transferee of a U.S. real property interest from a foreign person to withhold an applicable percentage, usually 15%, of the gross proceeds and remit such tax to the Internal Revenue Service.

Foreign investors have generally preferred to invest in U.S. real estate through domestically-controlled qualified investment entities, which permits the disposition of those investments through sales of equity interests in the domestically-controlled qualified investment entity, as gains from such sales are generally exempt from FIRPTA withholding. A qualified investment entity is considered “domestically controlled” if less than 50% of the interests in the value of its stock is held directly or indirectly by non-U.S. persons during the testing period (generally, the five-year period preceding the relevant disposition). 

Existing regulations define “non-U.S. persons” as nonresident alien individuals, foreign corporations, foreign partnerships, foreign trusts, or foreign estates. The proposed regulations clarify that qualified foreign pension funds, and certain entities owned by qualified foreign pension funds, are considered foreign persons for the purposes of determining whether a qualified investment entity is domestically controlled.

The proposed regulations also introduced new concepts of “look-through persons” and “non-look-through persons”. Under the proposed regulations, only a “non-look-through person” is treated as holding stock of a qualified investment entity in order to determine domestically-controlled status. Any stock of a qualified investment entity held through “look-through persons” would be treated as held proportionately by the look-through person’s ultimate owners that are non-look-through persons.

Although domestic C Corporations are generally considered “non-look through persons” under the proposed regulations, there is one major exception: A non-public domestic C Corporation is treated as a look-through-person if foreign persons hold, directly or indirectly, 25% or more of the fair market value of the corporation’s outstanding stock. Any qualified investment entity stock owned by that corporation would then be treated as owned by its shareholders in determining whether the qualified investment entity constitutes a domestically-controlled qualified investment entity (the “Look-Through Rule”). This would be a significant change from current practice and would disallow one common structuring technique used by non-U.S. investors: the use a “blocker domestic C Corporation” to shield from FIRPTA taxes.

It is expected that the proposed regulations will only apply to transactions occurring on or after the regulations become finalized, but there is always a chance that the regulations could be retroactive and impact existing investment structures.  Mike Smith can help foreign investors and real estate fund sponsors determine whether they might be affected by the regulations and whether any action is needed. Please reach out for more information.  

Thank you Mike for the very informative article!

Tags: FIRPTA, Foreign, QIE, Qualified Investment Entity, Real Estate, Federal and state taxation, including proposed regulations, Industry best practices, Industry trends/analysis, Year-end tax planning | Comments Off on Foreign Investment in U.S. Real Estate