30 November 2022 - Article
This article is produced by Withers real estate planning think tank, a group focused on innovative thinking and practical applications for our clients investing in US real estate.
Note: We published an update to this article. It is titled, ‘The IRS further targets foreign owners of US real property.’ Click here to view.
The Large Business and International (LB&I) Division of the Internal Revenue Service on September 14 announced a new international compliance initiative targeting foreigners selling interests in U.S. real property and subject to the “Foreign Investment in Real Property Tax Act (FIRPTA). This FIRPTA enforcement campaign joins a growing list of 57 active LB&I compliance campaigns, including others targeting foreign individuals, foreign businesses and other foreign taxpayers’ U.S. tax compliance. Further, over the past summer the LB&I announced that it is substantially increasing the number of audits within its global high-wealth industry group, which might well include audits in this FIRPTA compliance area.
About the IRS’s new FIRPTA enforcement campaign
FIRPTA taxes foreign persons on the disposition of their U.S. real property interests. Generally, the buyer/transferee is the withholding agent and is required to withhold 15% of the amount realized on the sale, file required forms, and remit the withholding tax to the IRS. The 15% FIRPTA tax is not a final tax, but, rather, a withholding tax that the foreign taxpayer credits against their calculated federal tax liability on their FIRPTA real estate gain. Through this new FIRPTA enforcement campaign, the IRS intends to increase FIRPTA voluntary compliance through issue-based examinations and external education and outreach.
Although foreigners generally are not subject to U.S. income tax on capital gains that are unrelated to the conduct of a business in the United States, the sale of a defined interest in U.S. real property (a so-called “USRPI”) is treated as income effectively connected with a U.S. trade or business, and therefore is taxable capital gain to the foreign seller. A USRPI can include a direct ownership interest in U.S. real estate, or stock of certain domestic corporations that, themselves, own substantial USRPIs. An interest in a partnership is also, in effect, treated as a USRPI to the extent that gain from the sale of a partnership interest is attributable to USRPIs owned by the partnership.
Diligence needed in reporting US real property activities of foreigners
Our own knowledge and experience indicates that FIRPTA compliance is an area rife with reporting and compliance errors, both by foreign investors and U.S. withholding agents. The reasons vary, but often relate to competing interpretations of overlapping areas of the applicable tax laws or a lack of knowledge of, or attention to, applicable, at times complex federal and state tax rules. As a result, we have seen substantial errors or omissions in reporting U.S. real property rental and development activities of foreigners. For example, subject to certain withholding exemptions which need to be claimed (if applicable), a tenant paying a foreign taxpayer or the foreigner’s agent for the rental of U.S. real property are required to withhold 30% of the gross amount of rent that the tenant pays, generally as a deposit against the foreigner’s ultimate federal tax liability on their U.S. rental business activities. This failure to withhold by tenants frequently results due to tenants’ inadequate diligence on their landlords’ identity as domestic or foreign. Additionally, while structuring an acquisition through one or more entities or trusts might benefit an investor’s income tax efficiency or estate planning goals, new issues can arise, such those involving a borrower and lender or those involving a shareholder’s use of company owned property. Taken together, there are traps for the unwary but solutions are often available for the diligent.
New campaign is part of IRS’s shift to issue-based examinations
The IRS compliance campaigns represent the IRS’ shift from entity-based to issue-based examinations, focusing on those issues that IRS has determined to present a risk of significant noncompliance. The IRS’ stated goal with its campaign initiatives is to improve tax return and issue selection and make the greatest use of limited IRS resources. Each campaign is addressed using one or more “treatment streams” that include issue-based examinations, soft letters encouraging voluntary self-correction, and stakeholder outreach.
FIRPTA planning and compliance advice
With proper guidance, foreign taxpayers can structure their holdings, dispositions and commercialization of U.S. real property investments and institute procedures for proper U.S. federal, as well as state, tax reporting and other associated compliance. Please contact any of the authors of this newsletter or your regular contact at Withers to discuss these FIRPTA planning and compliance matters or other cross-border U.S. tax planning considerations.
If you have any questions, please contact the authors or any member of Withers real estate planning think tank:
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