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Tax Planning for Foreign Real Estate Investors
2016 was a hot year for foreign-owned U.S. real estate investment. It may be dampened somewhat this year by recent capital outflow restrictions imposed by foreign governments, namely China. But there are many foreign investors that have been encouraged by recent political changes in the U.S. to invest in U.S. real estate. Tax planning should be at the forefront for any foreign persons intending to invest in U.S. real estate for residential or commercial lease. Structuring options will be covered in a different topic.
Two Types of US Tax Regimes
Income earned by nonresidents (individual or corporation) falls under one of two types of tax regimes.
FDAP Income: Fixed or Determinable Annual or Periodical gains, profits, and income (i.e., basically investment income) from U.S. sources. Such income is taxed on a gross basis at a flat 30% rate (or lower treaty rate).¹
ECI Income: For a nonresident (individual or corporation) that is “engaged in a trade or business” in the US, the net income that is “effectively connected” is taxed in the same manner as income earned by a U.S. resident.²
For those with FDAP income, the tax is withheld at the source by the U.S. payor, very similar to the PAYE system used in many countries. Those with ECI income must file a U.S. tax return and tax is imposed at graduated rates (maximum of 39.6%). However, unlike FDAP income, ECI income is taxed on the net income (i.e., after deductions).
FDAP vs. ECI
Investment properties can be structured to fall under either regime. The optimal choice depends on various factors, but here’s an illustration that shows the sometimes harsh tax treatment under the FDAP regime:
Lessee pays $1,000 rent to the owner. Owner incurs $500 of expenses related to the property.
Gross rental income = $1,000
Withholding tax = $300 (30% of $1,000)
Owner gets net profit of $200 ($1,000 rent – $500 expenses – $300 withholding)
Effective tax rate = 60% ($300 tax / $500 net rental income)
Now let’s take a look at the tax treatment under the ECI regime with the same facts:
Lessee pays $1,000 rent to the owner. Owner incurs $500 of expenses related to the property.
Gross rental income = $1,000
Net Rental Income – $500
Tax (assume highest marginal rate of 39.6%) = ~$200
Effective tax rate = 39.6% ($200 / $500)
Note that the above does not include depreciation which would lower the effective tax rate even further. It also assumes the highest marginal rate; the applicable rate may be lower. Clearly in this scenario (and usually in most) the investor is better off under the ECI regime.
When does Leasing Activity Fall under the ECI Regime?
The general rule is that renting one property to one tenant under a net lease does not make the foreign owner engaged in trade or business and therefore the income is not ECI. Rental of many tenants, on the other hand, would be considered as engaging in trade or business.
Election to be considered ETB: Under IRC § 871(d), a nonresident may make an election to treat “income from real property which is located in the United States and…held for the production of income…to treat all such income as income which is effectively connected…with the conduct of a trade or business in the U.S. by that taxpayer.”
If the leasing activity falls under the ECI regime, the investor will file a U.S. tax return reporting the net income. And a Form W-8ECI should be provided to the lessee to prevent withholding of tax.
Sale of U.S. Real Estate
At some point the foreign investor may want to sell the property. Any gain from the sale of a “United States real property interest” (USRPI) is taxed as if the foreign seller is engaged in a trade or business in the U.S. and the gain is effectively connected income.
The gain is taxed at the same rates as applicable to U.S. residents and can qualify for long-term capital treatment. Like-kind exchange can apply if the property is exchanged for a qualifying U.S. property.
Withholding: The buyer of a U.S. property sold by a non-resident must withhold 10% of the amount realized on the sale to remit to the IRS. However, the seller may get an exemption or a reduced withholding rate by filing Form 8288-B prior to the sale.
¹I.R.C. § 871(a) (individuals) and 881 (corporations)
²I.R.C. § 871(b) (individuals) and 882 (corporations)
³See Pinchot v. Commissioner, 113 F.2d 718, 719 (2d Cir. 1940).