29 September 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.
It was a great opportunity, so we bought. Only later did we realize that the structure might not have been optimal. This might be a good time to restructure.
Statements like this may be especially true for non-US investors and their advisors, who might find the US tax system challenging to understand. Moreover, opportunities can be fleeting, and there isn’t always time for detailed tax planning before an acquisition must be closed. For non-US investors in particular, the complications of the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”) can make a post-acquisition reorganization in a good market cost prohibitive. However, in a down market, some opportunities might surface.
It has been observed by some valuation experts that prices for commercial and mixed use properties in the metro-New York and tristate areas have dropped substantially in value during the first half of 2020. Although the market had been softening even prior to 2020 and this downward trend was arguably initially attributable to an inevitable market correction after almost a decade of rapidly rising valuations (due in large part to the increasing attractiveness of urban areas as places to live, work, and play), continuing uncertainty and market slow-down, which has been accelerated by the ongoing Covid-19 pandemic, has had a big impact on commercial and mixed use properties. In particular, properties underpinned by “non-essential” retail and hospitality tenants have been sailing in rough waters lately. While this can be hard for the industry, it presents a unique opportunity for many investors to restructure their US real estate holdings and thereby reposition themselves to potentially save substantial US income and estate taxes in the future.
FIRPTA – Lowering the Hurdle
Generally speaking, FIRPTA governs the taxation of US real estate transfers when such real estate is owned by nonresident aliens (“NRAs”) or non-US corporations (“ForCos”). Subject to a small number of exceptions, any disposition of a United States Real Property Interest (“USRPI”) by an NRA results in (i) a deemed sale of the property at fair market value, (ii) a mandatory withholding of 15% of the fair market value of the property and (iii) substantial reporting requirements. Although NRAs generally are not subject to US income tax on capital gains that are unrelated to the conduct of a business in the United States, the sale of a USRPI is treated as income effectively connected with a US trade or business, and therefore is taxable capital gain to the NRA. A USRPI can include a direct ownership interest in US 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.
FIRPTA withholding may be eliminated or reduced, however, if there is no underlying tax liability (or a reduced tax liability). In that circumstance, it is possible to apply for a certificate from the IRS that expressly permits the elimination or reduction of FIRPTA withholding (a “Withholding Certificate”). Decreases in US real estate market values have made the Withholding Certificate exception particularly useful.
The IRS may issue a Withholding Certificate where the tax liability is expected to be a less than the normal 15% of fair market value withholding. If the Withholding Certificate is requested before the disposition but has not been granted at the time of the disposition, withholding must still be done, but it need not be reported and paid over to the IRS until 20 days after the Certificate is ultimately granted or denied. Since the IRS can take a number of months (often the suggestion is 90 days) to issue a Withholding Certificate, advance planning is necessary to take full advantage of this exception.
In the case of a transfer of an interest in a partnership that holds one or more USRPIs, it is sometimes also possible to obtain a certificate from the partnership to eliminate withholding. FIRPTA withholding is only required on the disposition of a partnership interest if the fair market value of the partnership’s USRPIs constitute 50% or more, and the fair market value of its USRPIs together with its cash and cash equivalents constitute 90% or more, of the total fair market value of its gross assets. Where a partnership interest is transferred and FIRPTA withholding is reduced or eliminated by a Withholding Certificate, there is an alternative withholding regime that can apply where the partnership is engaged in a US trade or business. Withholding under the alternative regime is 10% of fair market value, unless an exception applies.
Is a Reorganization Worthwhile?
For taxpayers with little or no gain in their US real property, a Withholding Certificate could potentially allow the tax-free, or nearly tax-free, transfer of US real property to a more efficient structure. Additionally, an NRA may have tax losses from the property available to offset gains, due mainly to depreciation deductions taken for US tax purposes, even if the property has historically generated positive cash flows. In such case, the upfront cost associated with a restructuring may be minimal, relative to the long-term benefits. In deciding what structure is optimal in a particular situation, careful consideration must be given to both federal estate and income tax treatment of each structure, as well as any local transfer or property taxes that may be triggered by a reorganization.
Additionally, investors will want to consider whether and how to position (or reposition) their real estate assets, including giving consideration to the tenant mix, and how they want to manage such assets. For example, leasing a building to a single tenant in a triple net arrangement, in which the tenant is solely responsible for insurance, maintenance, and real estate taxes for the building, would result in no income to owner (other than, of course, the fixed rent). However, putting all eggs into one tenant basket may be a risky proposition even in the best of times, but particularly in times of economic uncertainty and in the days of Covid-19. The same caveat goes for properties that are heavily concentrated with pure retail and/or restaurant tenants – such businesses are more likely to be highly impacted, for example, when the economy goes south or, as we are currently seeing, in a pandemic situation in which they are deemed “non-essential” and compelled by law to close. Months of reduced or no rent payments in turn causes the value of the underlying real estate to decline. A mixed-use building that includes residential tenants and focuses more heavily on “essential businesses” (i.e., grocery stores, pharmacies, liquor stores, etc.) may give an investor more stability, as at least some of those residential tenants and most (if not all) of those commercial tenants are more likely to sustain their cash flow even in times of economic uncertainty and unrest.
Estimating US Estate Tax Risk
An NRA who owns US real estate will generally have to pay US estate tax on his or her death if that real estate has more than $60,000 in net equity. The federal estate tax rate is currently 40% and many states also impose a state estate tax with rates as high as 16%. As the real estate market recovers, this represents a significant tax exposure for many NRAs. This is particularly true since NRAs often cannot qualify for large US mortgages, and therefore tend to have significant equity in their properties.
A number of structures can be used to eliminate US estate tax risk, the most common of which is to hold the USRPI through a ForCo. In general, stock in a ForCo is not subject to US estate tax. A transfer of direct ownership of a USRPI by an NRA to a ForCo generally results in immediate US taxation of the built-in gain, which is why a down market can create an opportunity to make such a transfer at minimal tax cost. Another option is to own the property through a US or non-US trust which, if irrevocable, should insulate a family from US federal or state estate tax.
Estimating US Federal Income Tax Exposure
US income tax liability is also impacted by the holding structure selected.
For example, owning a USRPI through a ForCo can, in some cases, completely avoid US income tax on a disposition because the sale of ForCo stock will not trigger any US income tax for the NRA. Another NRA may be willing to purchase ForCo stock because it avoids the cost associated with forming a new holding company and, in some cases, avoids local property transfer tax costs. The corporation, of course, still has the original acquisition cost basis in the underlying real estate, so it is “pregnant” with a large US capital gain. Unrelated buyers may also be concerned with liability associated with ForCo, given that it is not a newly formed entity. For these reasons, the buyer may expect a discount on the purchase price, but such a discount may be less than the applicable tax on the built-in gains.
If the holding structure uses corporations, two levels of US tax may apply. A common holding structure is a ForCo owning a US corporation, which in turn owns the property. This is often referred to as a “stack,” since ForCo is “stacked” on top of the US corporation. If stock in ForCo is sold, as explained above, there is no US capital gains exposure. If the real estate is sold at a gain, the US corporation is subject to federal income tax on such gain (currently at a rate of 21%), as well as any applicable state or local income tax. Additionally, a non-liquidating distribution from the US corporation to ForCo will be taxable as a dividend, which is generally subject to 30% withholding unless reduced by an applicable income tax treaty. If ForCo owns and sells the property directly, the so-called “branch profits” may apply. The branch profits tax essentially replicates the withholding tax applicable when sale proceeds are distributed by the US corporation to ForCo in a stack structure. The branch profits tax can sometimes be reduced or eliminated by an applicable US income tax treaty. In a stack structure, a liquidating distribution from the US corporation to ForCo generally is not subject to US withholding tax. For that reason, stack structures are sometimes set up with a separate US corporation for each property, so that sale proceeds can be distributed free of withholding tax from each corporation following the sale of the underlying property. Consideration needs to be given, however, to the personal holding company and accumulated earnings taxes in cases where a US corporation has taxable income that is not currently distributed out to ForCo.
Estimating US State and Local Tax Exposure
Any modification of the holding structure should also account for state and local tax consequences. Some states impose different rates of income tax on corporations and individuals (e.g., California taxes corporations at an 8.84% rate, while individuals are taxed at graduated rates of up to 13.3%). This needs to be taken into account, for instance, in comparing corporate and trust structures. The impact of a restructuring on state and local transfer and property taxes must also be considered. In many locales which impose stamp or transfer tax on the sale of real property or may reassess the property for property tax purposes following a sale, there is an exception for transfers which do not alter the ultimate beneficial ownership of the real estate, but the requirements of such exceptions must be strictly complied with. Additionally, if the property has declined in value, it is possible that there would not be an increase in assessed value for property tax purposes.
Reviewing the Opportunity
Where property values have suffered a momentary decline in fair market value, it is likely that a qualified appraiser would find that recently purchased property has returned to acquisition cost (or lower). If there is little to no appreciation in US real estate, it is a reasonable time for non-US investors to transfer their US real estate to a proper structure. By doing so they will be able to reduce or even eliminate US income taxes on the ultimate sale of that property and shelter their assets from US estate tax. The planning strategies outlined above may eliminate these taxes, essentially making them optional. Finally, in light of current market conditions, investors may, as part of the same process, want to consider how to position their real estate assets in a way that allows them to maximize the income potential, even in times of uncertainty.
If you have any questions, please contact the authors or any member of Withers real estate planning think tank:
- Josefina Colomar | Partner, New York
- William J. Kambas | Partner, New York, New haven, Greenwich
- Bryan H. Kelly | Partner, Los Angeles
- Stephen Nerland | Partner, London
- Paul Sczudlo | Partner, Los Angeles
- Sandra Viana | Partner, Divisional CEO of the private client and tax division, New York
- Vasiliki Yiannoulis-Riva | Partner, New York