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FIRPTA amendments proposed to encourage foreign investment in U.S. real estate

Two senior members of the U.S. House Ways & Means Committee, one Republican and one Democrat, have introduced amendments to the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) that aim to encourage greater foreign investment in U.S. real estate.

Background on FIRPTA. In December of ’80, Congress enacted FIRPTA. It greatly revised the U.S. taxation of gain from the disposition of U.S. real estate by foreign investors.

Before the enactment of FIRPTA, foreign investors in U.S. real estate often paid no U.S. tax on gains arising from the disposition of such property, even if the property were held for investment or personal use. The disparity between the taxation of U.S. versus foreign investors in U.S. real estate was viewed by Congress as violating tax policy principles.

FIRPTA, set forth in Code Sec. 897 and the regs thereunder, generally operates by forcing a foreign taxpayer (i.e., a nonresident alien individual and foreign corporation) to pay U.S. income taxes (at the regular graduated rates) on the net gain derived from the disposition of a “United States real property interest” (USRPI).

The term “USRPI” includes any interest in real property that is located in the U.S. or in the Virgin Islands – e.g., land and buildings.

Furthermore, it includes an interest in a domestic corporation (other than an interest solely as a creditor), to the extent that the domestic corporation meets the definition of a “United States real property holding company” (USRPHC). (Code Sec. 897(a)(1) and Reg. § 1.897-1(c) ) An interest in a domestic corporation generally is presumed to be a USRPI, unless the taxpayer can establish (in a manner prescribed by IRS under regs) that such corporation was at no time a USRPHC during the 5-year period ending on the disposition of such interest.

The determination of whether a domestic corporation is a USRPHC is based on the percentage of USRPI’s held by such corporation. A USRPHC is any domestic corporation if the fair market value of its USRPI’s equals or exceeds 50% of the fair market value of the sum of its (i) USRPIs, (ii) interests in real property located outside of the U.S., and (iii) any other of its assets which are used or held for use in a trade or business. (Code Sec. 897(c)(2))

Application of FIRPTA to REITs. A real estate investment trust (REIT) is an entity that owns, and in many cases operates, income-producing real estate. Created by Congress in ’60, REITs were designed to provide a real estate investment structure similar to the structure that mutual funds provide for investment in stocks.

By the nature of its assets, a REIT would generally constitute a USRPHC, unless it is “domestically controlled” within the meaning of Code Sec. 897(h)(2). As such, the sale or other disposition of the REIT shares could be subject to FIRPTA.

Unlike a traditional corporation, a REIT is generally not taxed on its income and capital gains distributed to its owners, provided that it distributes at least 90% of such income to its shareholders each year as a dividend and certain other requirements are met. (Code Sec. 851, Code Sec. 852, Code Sec. 856, and Code Sec. 857(a)(1)) To prevent the avoidance of U.S. tax on the distribution of USRPIs by a REIT, certain distributions are subject to FIRPTA under Code Sec. 897(h)(1).

An exemption from FIRPTA applies to certain foreign shareholders of certain publicly-traded corporations. In particular, it applies to any class of stock of a domestic corporation that is regularly traded on an established securities market, but only if held by a person who, during the applicable testing period, did not actually or constructively own more than 5% of that class of stock. (Code Sec. 897(c)(3) and Reg. § 1.897-1(c)(2)(iii))

Furthermore, Code Sec. 897(h)(1) exempts from FIRPTA certain distributions that are made by a U.S. publicly-traded REIT to foreign taxpayers owning a 5% or less interest. The FIRPTA exemptions essentially provide relief to small foreign “portfolio investors.”

Proposed FIRPTA tax relief. On Apr. 30, 2015, Representatives Kevin Brady (R-TX) and Joseph Crowley (D-NY) re-introduced the Real Estate Investment and Jobs Act of 2015 (H.R. 2128) as part of efforts to modernize FIRPTA and encourage additional foreign investment in U.S. real estate.

With respect to REITs and their shareholders, the bill, among other things, doubles the 5% ownership threshold under the Code Sec. 897(c)(3) and Code Sec. 897(h)(1) exceptions (noted above) to 10%, granting relief to certain foreign shareholders of U.S. publicly-traded REITs. The 10% percentage threshold is in line with the definition of a portfolio investor under most U.S. income tax treaties.

In addition, under the bill, foreign pension funds investing in U.S. commercial real estate would be exempt from FIRPTA entirely.

“The U.S. is among the world’s best places to invest – but foreign investments in commercial real estate are sorely behind other industries because of uneven tax treatment. What’s clear is that the law that is on the books does more harm than good, and something must be done,” said Rep. Crowley.

Referencing a recent Association of Foreign Investors in Real Estate (AFIRE) member survey, Rep. Brady indicated that 76% of respondents said that FIRPTA tax relief would spur their investment in U.S. real estate.

The Senate Finance Committee passed a similar bill, S. 915, this past February.

References: For disposition of investments in U.S. real property, see FTC 2d/FIN ¶  O-10700; United States Tax Reporter ¶  8974; TaxDesk ¶  643,000; TG ¶  30551.