The Foreign Investment in Real Property Tax Act (FIRPTA), passed in 1980,
resulted in three Code sections –sections 897, 1445 and 6039C- which respectively provide the operative tax rules, tax withholding rules and information reporting rules for foreign persons acquiring or disposing of a U.S. real property interest (USRPI). An underlying premise of FIRPTA is that a foreign person (generally defined as a nonresident alien, foreign corporation, or foreign partnership, estate or trust)
should not have the ability to avoid tax on the disposition of U.S. real property by using an entity structure or some Code nonrecognition provision. FIRPTA has several technical provisions that outline circumstances under which foreign person will be subject to tax on the sale of a USRPI and imposes requirements on a foreign person that transfers a USPRI in a transaction that would otherwise qualify for nonrecognition under the Code.
The highly technical nature of these FIRPTA provisions have resulted in an area of tax law that is not always easily applied, with several traps for the unwary that have made various areas of FIRPTA the subject of uncertainty and criticism among those of us who work with such provisions.
Moreover, since inception, FIRPTA has also been highly criticized for creating barriers to foreign investment in U.S. real estate. House Ways and Means Committee Chairman Kevin Brady and Congressman Joseph Crowley, along with Senators Mike Enzi and Bob Menendez have been successful in ushering in some changes to modernize various aspects of FIRPTA which culminated in some key FIRPTA changes embodied in the recent enactment of the Protecting America from Tax Hikes Act (PATH Act) of 2015 on December 18, 2015 (commonly referred to as the latest “extender bill”).
In addition, after the “mortgage bubble burst” of 2008-2010, real estate prices in the U.S. have now experienced a period of recovery in many parts of the country, making real estate-related gains (including gains recognized from foreign sellers) much more commonplace than seen during recent “Great Recession” years in which prices were in decline or only beginning a recovery. As real estate prices continue to climb, FIRPTA is again becoming increasingly relevant.
This article will discuss some of the basic provisions of FIRPTA and some recent PATH Act changes to them.
General Rules Under FIRPTA and PATH Act Changes
Foreign persons are generally not subject to U.S. tax on gains from the sale or exchange of a capital asset unless the gain is effectively connected with the conduct of a U.S. trade or business. However, IRC §897 creates an exception to this rule by requiring the foreign seller to treat such gain, recognized upon disposition of a USRPI, as gain that is effectively connected. Accordingly, foreign sellers are taxed on such “FIRPTA gains” at graduated tax rates applicable to them.
Such gains are generally subject to mandatory tax withholding under IRC §1445 as a tax collection measure. Generally, this withholding amount has been 10% of the sum of the total cash paid (or that will be paid), the FMV of other property transferred (or to be transferred) and the amounts of any liabilities assumed by the transferee (including those liabilities to which the property is subject). However, the PATH Act augments IRS collection efforts on foreign sales of property by increasing this FIRPTA withholding rate from 10% to 15%, (effective for dispositions made 60 days after PATH’s December 18, 2015 effective date).
There are various exceptions to mandatory FIRPTA withholding, including certain instances in which a property is transferred that is to be used as a principal residence by the purchaser. Under current rules, if such a property is transferred for an amount realized that is less than $300,000, FIRPTA withholding is unnecessary. The PATH Act retains this $300,000 principal residence exemption, and also creates a reduced level of withholding on such properties that are over the $300,000 threshold but under $1,000,000 in amount realized. For such higher-value properties, the increase in the standard FIRPTA withholding rate from 10% to 15% will not apply; instead, the lower 10% rate is retained. This will appear as an additional subsection to existing Code section 1445(c).
Moreover, foreign corporations recognizing gains through a distribution of a USRPI to shareholders, (including through a liquidating distribution or redemption) are subject to a 35% tax withholding rate. Under IRC §884, foreign corporations operating businesses in the U.S. may also be subject to a branch profits tax (equal to 30% of the “dividend equivalent amount”), in addition to U.S. corporate income tax under IRC §882.
Central to the application of FIRPTA are some key definitions unique to FIRPTA that involve what a U.S. real property interest is that is subject to FIRPTA rules. A U.S. real property holding corporation (USRPHC) is defined as any corporation in which the FMV of USRPIs exceeds 50% of the FMV of the aggregate of its USRPIs, foreign real estate interests and other trade or business assets. The detailed rules that are used to determine whether a corporation meets this 50% test are found in Treas. Reg. §1.897-2.
A USRPI is defined as an interest (other than solely a creditor interest) in real property located in the U.S. or U.S. Virgin Islands. “Real property” includes land as well as:
- Growing crops, timber, mines, wells that have not been severed from the land
- Improvements, such as a building or other inherently permanent structure, and
- Personal property associated with the use of real property (such as movable walls or furniture)
A real property interest also includes a USRPHC interest unless the taxpayer can establish that it did not meet the 50% test during the 5-year period ending on the date it disposed of the USRPI (or shorter period during which it actually held that interest if it held the interest for less than 5 years). This is commonly referred to as the “5-year rule.”
Generally, Treas. Reg. §1.897-1(c)(1) treats a USRPHC interest as a USPRI subject to FIRPTA’s effectively connected gain condition unless the 5 year test is met. In addition, a USRPHC interest will not be treated as a USRPI if one of the following exceptions are met:
- The “cleansing exception”
- The “publicly traded exception” or
- The “domestically controlled qualified investment entity (DCQIE) exception
Qualifying under one of these exceptions is important because it removes the gain from the sale of a USRPI, (such as shares in an investment vehicle such as a REIT or RIC that is classified as a USRPHC and USRPI) from FIRPTA income tax and tax withholding requirements.
Under the cleansing exception, a USRPHC interest is not considered a USRPI if the corporation does not own any USPRIs and all past USRPIs held by the corporation were disposed of in a manner where the full amount of any taxable again was recognized. The Code also provides that if a corporation is classified as a USRPHC due to its interests in subsidiaries that are USRPHCs, the cleansing exception may be met if the subsidiaries dispose of their USRPIs in fully taxable transactions in which the gains are recognized. Currently, this cleansing provision may be used by entities wishing to rid themselves of the USRPI status (thereby eliminating the need to adhere to FIRPTA’s requirements) by disposing of all assets in taxable transactions. With successful tax planning, this can be accomplished in a manner that minimizes adverse tax consequences. However, the PATH Act precludes REITs and RICs from using this cleansing provision for tax years beginning after the PATH Act’s effective December 18, 2015 date.
The publicly traded exception has also been eased through PATH Act FIRPTA changes. Until the PATH Act’s December 18, 2015 enactment date, the publicly traded exception is available for shares that are regularly traded on an established securities market and owned by a shareholder who owns no more than 5% of that class of shares if that shareholder owned no more than 5% of the FMV of equity in that class during the shorter of either their holding period for that class or for the 5 year period ending on the date the stock is sold. Note that if the 5% threshold is exceeded, it is possible sell enough shares of the class to fall below the 5% threshold and wait for a 5-year period before selling the shares under this exception in a tax free sale. The 5% ownership rule includes direct or indirect ownership, using application of a modified version of the IRC §318 constructive ownership rules. The PATH Act makes it easier for REITs and foreign investors to take advantage of this exception from FIRPTA requirements by increasing the 5% maximum to a 10% maximum. This serves to bring FIRPTA rules in this area into parity with the definition of a portfolio investor used in many U.S. tax treaties. In addition, publicly traded foreign corporations and partnerships in countries having a comprehensive tax treaty with the United States also having an information exchange agreement may own and sell any amount of publicly traded REIT stock without triggering FIRPTA gain and withholding issues. If any investors in such entities, however, exceed the 10% ownership threshold, there will be a reduction in the FIRPTA exemption using a formula based on the proportionate ownership of the more-than-10% owner. This change is also meant to attract additional foreign investment in U.S. real estate interests while easing the triggering of FIRPTA restrictions. These changes to FIRPTA will appear as new IRC §897(k).
The DCQIE exception indicates that a USRPI does not include an interest held by a foreign person in a domestically controlled qualified investment entity (QIE). A REIT qualifies as a QIE. Until the beginning of 2015, a QIE also included a RIC which would otherwise be considered a USRPHC regardless of whether the publicly traded or DCQIE exceptions applied. The PATH Act now makes RICs permanently qualify as QIEs, and makes this qualification retroactive to January 1, 2015. In addition, this exception means that gains resulting from the sale of stock in a DCQIE (such as a REIT or RIC) is not subject to FIRPTA income taxation or tax withholding requirements.
A QIE is “domestically controlled” if, at all times during a testing period, less than half of the value of its stock was held “directly or indirectly” by foreign persons. The relevant testing period is either the 5 year period ending on the disposition date, or the period shorter than 5 years that the REIT or RIC actually existed if there is less than a 5 year history for the REIT or RIC.
The “directly or indirectly” provision specifically mentioned in the rules defining the key terms for this exceptionhas posed substantial uncertainty in the past to practitioners working with these rules, because “directly or indirectly” has never been actually defined, nor is there a clear reference, as in many other Code sections, to the constructive ownership rules of IRC §318. Legislative history provides no guidance, either, on the meaning of “directly or indirectly” originally intended here. Yet another issue with this exception is that an entity, such as a REIT, frequently lacks necessary information about the degree of ownership of certain shareholders to know whether the requirements of this exception have been met. The PATH Act serves to rectify the uncertainties that belie this exception by providing new rules of presumption that are used to determine whether the REIT or RIC is domestically controlled. Shareholders owning less than a 5% of stock in a QIE, including a REIT or RIC, regularly traded on an established U.S. exchange will be treated as U.S. persons unless actual knowledge to the contrary on part of the QIE exists. In addition, REIT or RIC stock owned by a publicly traded REIT or RIC that meet specific provisions will have a presumption of foreign ownership unless the “parent” REIT or RIC owning the stock is domestically controlled, which will cause its owned stock to be considered held by a U.S. person. If such stock is not publicly traded, it will be treated as owned by a U.S. person in proportion to the U.S. person-held stock of the “parent” REIT or RIC. Generally, these new rules become effective on the December 18, 2015 PATH Act enactment date, and a technical amendment makes relevant rules retroactive to January 1, 2015. The new rules should provide publicly traded REITs and their shareholders the ability to rely on this FIRPTA exception with greater clarity.
New Exemption for Qualified Foreign Pensions and Retirement Plans
The PATH Act exempts from FIRPTA a USRPI held by a qualified foreign pension fund. This new exemption reflects Congressional desire to place U.S. and foreign pensions on a more comparable tax playing field for U.S. real estate investment holdings and remove FIRPTA barriers to the investment in U.S. real estate by foreign pension funds. To qualify for the exemption, foreign pensions must meet several factors. The pension fund generally must be either tax-exempt or at least tax-reduced in its home country, or contributions to it must be deductible in its home country by participants contributing to it. Further, the foreign pension fund must have been established under foreign laws, and established to provide retirement benefits for participants who are current or former employees, without a single participant having more than a 5% interest in assets or income of the plan. The pension must also be subject to government regulation and provide annual information reporting to participants. As a result of this PATH Act change, this new qualified foreign pension fund will appear as a new subsection under IRC §897 as IRC §897(l).
PATH makes some rather substantial changes to FIRPTA which are generally taxpayer-friendly and which have been designed make FIRPTA less of a barrier to foreign investment. These changes will generally be favorable to REITs, RICs, foreign investors and private equity funds that focus on U.S. real estate investments. FIRPTA will likely continue to evolve and obtain amendment in various areas, but these changes for 2016 should be received well by REITs, RICs and their investors. It remains to be seen whether these PATH Act changes will encourage further investment in U.S. real estate by foreign investors through a meaningful reduction in FIRPTA barriers.
 P.L.96-499, 96th Congress, 2d Sess. (1980), 1980-2 CB 509, 524.
 Treas. Reg. §1.897-9T(c).
 IRC §§871(b), 881(a).
 Code section IRC §1445(e) and underlying regulations address the FIRPTA tax withholding rules associated with distributions. A lower tax treaty rate of withholding tax may apply.
 The dividend equivalent amount is generally the foreign corporation’s effectively connected earnings and profits for the tax year with adjustments made for changes in the value of the equity of the foreign corporation’s U.S. trade or business. The effectively connected earnings and profits amount is reduced for increases/reinvestments in U.S. net equity, or increased for a decrease/divestment in U.S. net equity during the year. See. IRC §884(b) and Treas. Reg. §1.884-1(b).
 IRC §884. The purpose of the branch profits tax is to provide equal tax treatment to an incorporated subsidiary of a foreign corporation and a branch office when the incorporated subsidiary and branch office conduct business in the U.S. and seek to transfer U.S. profits back to the foreign parent (ie. expatriate profits). Dividends paid by the incorporated subsidiary to the parent are generally subject to a 30% tax, but use of a branch office (unincorporated) would not attract the 30% dividend tax. The 30% branch tax equalizes tax treatment for the incorporated subsidiary and branch office.
 IRC §897(c)(1)(A)(i).
 Treas. Reg. §1.897-1(b).
 Treas. Reg. §1.897-1(c)(1).
 IRC §897(c)(1)(B)(i)(II).
 For an excellent article of the use of the 5 year waiting period, see Blanchard, FIRPTA in the 21st Century-Instalment Two: The 5% Public Shareholder Exception”, 37 Int’l Tax J. 44, Jan. 11, 2008.
 IRC §897(c)(6)(C). In addition, the definitions of “established securities market” and “regularly traded” are provided in Treas. Reg. §1.897-1(m) and Treas. Reg. §1.897-9T(d)(1), respectively.
 The conference report simply states that: “In the case of REITs, which are controlled by U.S. persons, sales of the REIT shares by foreign shareholders would not be subject to tax (other than in the case of distribution by the REIT).” H. Rept. No. 96-1479, 96th Cong., 2d Sess. (Nov. 26, 1980). For a discussion of the uncertainty created by the lack of clear guidance on the meaning of “directly and indirectly” and the conclusion that the IRC §318 constructive ownership rules were never meant to apply to this exception, see https://www.skadden.com/sites/default/files/publications/Publications1423_0.pdf
 See PATH Act, Sec. 322 for further details on these amendments.