REAL ESTATE & TAX
U.S. TAXATION OF FOREIGN INVESTMENT
IN U.S. REAL ESTATE
I
nvestments in U.S. real estate by non-U.S. residents
have increased in recent years due to lower interest
rates and reduced tax rates on capital gains. The tax
treatment of non-residents buying and selling U.S.
real property is different in significant ways from the usual
tax treatment of non-residents investing in or conducting
business in the United States. This article discusses: (i) the
general U.S. tax rules that apply to non-residents investing in
the United States, (ii) how the Foreign Investments in Real
Property Tax Act affects the tax treatment of investments in
real estate, and (iii) the available structures for non-U.S. in-
vestors buying and selling U.S. real estate.
OVERVIEW OF TAXATION OF NON-U.S. RESIDENTS
The U.S. tax treatment of a foreign citizen depends on
whether the non-U.S. investor is a resident or a non-resident of
the United States. A foreign citizen who is resident in the
United States is taxed on worldwide income similar to a U.S.
citizen. When computing taxable income, a resident is
generally entitled to claim the same deductions and personal
exemptions available to a U.S. citizen. By contrast, a non-
resident generally is taxed only on his or her income from
SPAIN HASTINGS WARD CAREY & CHAMBERS
By Doug R. McCullough
U.S. sources and is entitled only to limited deductions.
A U.S. “resident" is defined as a foreign citizen who meets
either of two tests: (i) the lawful permanent resident test, or
(ii) the substantial presence test. A foreign citizen who is a
lawful permanent resident under U.S. immigration laws is
considered a resident for U.S. income tax purposes. Under
the substantial presence test, a foreign citizen will be consid-
ered a resident for tax purposes if:
(a) The foreign citizen is physically present in the United
States for at least 31 days during the current calendar
year, and
(b) The sum of the number of days of presence during
the current calendar year, plus one-third of the days in
the United States during the first preceding calendar year,
plus one-sixth of the days in the United States during the
second preceding calendar year, equals or exceeds 183
days.
Effectively Connected Income. If a non-resident is en-
gaged in a U.S. business, all items of income which are effec-
tively connected with such business (“effectively connected
income” or “ECI”), less deductions attributable to such in-
come, are subject to federal income taxation at ordinary tax
rates.
1. Effectively Connected Fixed Determinable,
Annual or Periodical Income. ECI that is “fixed determin-
able, annual or periodical” (“FDAP”) income, such as inter-
est, dividends, rents, or royalties, earned by a non-U.S. inves-
tor or foreign corporation is subject to tax, with appropriate
deductions, at ordinary rates. To avoid withholding on such
income, a person conducting a U.S. trade or business will be
required to file certain forms with withholding agents each
year.
2. Non-Effectively Connected FDAP Income. Unless
reduced by treaty, non-U.S. investors and foreign corpora-
tions are subject to a 30% withholding tax on most items of
U.S. source FDAP income that is not ECI.
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 REAL ESTATE & TAX
CAPITAL GAINS FROM ASSETS OTHER THAN
U.S. REAL ESTATE
A non-U.S. investor generally is not taxed on the sale of capi-
tal assets, i.e., assets acquired and held for investment or use
in a business, unless the capital assets are U.S. business assets
or real property interests.
Gains from the sale of capital assets are exempt from U.S. tax
if the gains are foreign source. Any gains from the sale of
real estate located outside the United States are considered to
be foreign source. Sales of stock and other personal property
generally are sourced by the residence of the seller. Thus,
when a non-resident sells personal property, the resulting
capital gain will be treated as foreign source income which is
not subject to U.S. tax.
U.S. FEDERAL INCOME TAX RETURN FILING REQUIRE-
MENTS
Unless the full tax was withheld at source, a non-resident in-
dividual or foreign corporation will be required to file a U.S.
income tax return if the non-resident individual or foreign
corporation had U.S.-source income or was engaged in a U.S.
business.
SALE OF U.S. REAL PROPERTY INTERESTS
The withholding tax rules enacted under the Foreign Invest-
ment in Real Property Tax Act (“FIRPTA”) require the buyer
of a U.S. real property interest (“USRPI”) sold by a non-U.S.
investor to withhold 10% from the gross selling price of the
property. The withholding tax is the mechanism for the IRS
to collect taxes, but does not represent the final determina-
tion of the tax liability (discussed below).
There is a presumption that every seller is a foreign person
subject to withholding tax unless proof to the contrary is pro-
vided to the buyer. Usually, the proof is furnished in the
form of a “non-foreign certification” signed by the U.S. seller
certifying that the seller is not a foreign person.
In certain situations, such as when the tax due on the trans-
feror’s gain from the sale is less than the withholding, the
non-U.S. seller may submit a Form 8288-B, “Application for
Withholding Certificate for Disposition by Foreign Persons
of U.S. Real Property Interests”, to request a reduction or
elimination of withholding on a transfer of the property.
Publications from the Internal Revenue Service (“IRS”) state
that the IRS generally will act on a completed withholding
certificate application within 90 days of the request. The
SPAIN HASTINGS WARD CAREY & CHAMBERS
regulations permit the seller to request an early refund of the
amounts withheld if the request for an early refund is com-
bined with an application for a withholding certificate.
USRPI. A U.S. real property interest (“USRPI”) is:
- Any interest in real property located in the United States
or the U.S. Virgin Islands; or
- Any interest in any U.S. corporation, unless the non-U.S.
investor establishes that such corporation was never a U.
S. real property holding corporation (“USRPHC”) during
the prior five-year period (or, if shorter, the period during
which the non-U.S. investor held the interest).
The term USRPI does not include an interest in a domesti-
cally controlled real estate investment trust (“REIT”). A do-
mestically controlled REIT means a REIT in which, at all
times during the relevant testing period, less than 50% of
the value of the REIT stock was held directly or indirectly
by non-U.S. persons.
USRPHC. A domestic corporation will be considered a
USRPHC if the fair market value of its USRPIs equals or
exceeds 50% of the sum of its worldwide real property as-
sets and any other assets used in its business. Shares of a
corporation that are traded on an established securities mar-
ket will not be a USRPI except with respect to a person who
holds more than five percent of such class of stock.
Exceptions to FIRPTA Withholding Requirements.
No withholding is required if:
- The seller provides an affidavit that he or she is not a for-
eign person;
- The items disposed are shares of a corporation that are
regularly traded on an established securities market;

- The items disposed are shares of a domestic corporation
that provides an affidavit that such domestic corporation
has not been a USRPHC during the testing period; or
- A personal residence is acquired by an individual pur-
chaser for use as his or her residence and the amount re-
alized does not exceed $300,000, or $500,000 in the case
of married individuals filing jointly.
Election to be Treated as Domestic Corporation. Gen-
erally when a non-U.S. investor disposes of a USRPI, the
buyer must deduct and withhold tax equal to 10% of the
gross amount realized on the disposition. In some circum-
stances, a foreign corporation that disposes of a USRPI may
make an election to be treated as a domestic corporation for
withholding tax purposes.
Upon making this election, the foreign corporation could
avoid the 10% withholding on disposition of the USRPI.
The foreign corporation would still be liable for corporate
income tax on the disposition of the USRPI, but the corpo-
rate income tax may be less than the withholding 10% of the
gross proceeds. The payment of the corporate tax would be
deferred until the due date of a regular estimated corporate
income tax payment.
Determining the Tax owed; Capital Gain Rates. As
stated above, the withholding tax is the mechanism for the
IRS to collect taxes, but does not represent the final determi-
nation of the amount of tax owed on a sale of the property
by a non-U.S. investor. For property held for more than 12
months, a non-U.S. person, whether an individual or business
entity, is taxed on its net gain from the sale of U.S. real prop-
erty at long-term capital gain rates.
Assets held by an individual for more than 12 months are
taxed at a maximum rate of 15% upon disposition. Assets
held by a corpo-
ration are taxed
at rates between
15-35% upon
disposition. Cur-
rently, there is
no rate differen-
tial for corpora-
tions between
ordinary income
and capital gains.
The amount of
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REAL ESTATE & TAX
tax withheld offsets the amount of tax that the non-U.S. in-
vestor actually owes on the sale of the property. If an indi-
vidual owns and disposes of the property within 12 months
of acquiring the property, the individual will be subject to tax
at the higher ordinary tax rates.
Holding Period. The holding period for determining
whether capital gain qualifies as long-term does not begin un-
til title passes to the property, rather than merely making an
earnest money contract payment. Such considerations
should be taken into account if a non-U.S. investor is consid-
ering reselling the real estate shortly after acquiring it.
STRUCTURING INVESTMENT IN U.S. REAL ESTATE
The choice for non-U.S. investors structuring investments in
U.S. real estate is typically between direct ownership by an
individual and ownership by a domestic or foreign corpora-
tion.
Direct Ownership by Non-U.S. Investor.
Upon the sale of long-term capital assets, a non-resident indi-
vidual would pay U.S. income tax at a maximum rate of 15%.
Direct ownership by an individual will not result in dividend
withholding tax or BPT, because those taxes only apply to
corporations.
The two disadvantages of direct ownership by an individual
are: (i) the requirement that the non-U.S. investor file a U.S.
income tax return, and (ii) the exposure to U.S. estate tax.
The filing of a U.S. income tax return is something that some
non-U.S. investors may be reluctant to do, even if the alterna-
tive structures result in a higher tax bill.
Ownership by Domestic Corporation. If the property
were held by a domestic corporation the corporation's in-
come, both rental income and gain from the sale of the prop-
erty, would be subject to tax at a maximum rate of 35%. If
the domestic corporation makes dividend distributions to its
non-U.S. shareholders, a withholding tax at a rate of 30%
would be imposed, unless reduced by treaty.
Ownership by Foreign Corporation. Non-U.S. investors
may be attracted to foreign corporate structures to own U.S.
real estate which allows them to avoid filing U.S. income tax
returns individually, protects against the U.S. estate tax, and
gives them anonymity. This structure may, however, come
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 REAL ESTATE & TAX

with a higher tax cost compared to owning U.S. real property
directly as an individual.
If income producing property were held by a foreign corpo-
ration, its taxable income would be subject to a tax at ordi-
nary corporate rates. Instead of a withholding tax on distribu-
tion, a branch profits tax (“BPT”) at the rate of 30% would
apply. The BPT is designed to equalize the U.S. tax treatment
between a non-resident operating in the United States
through a domestic corporation and a non-resident operating
in the United States through a
branch of a foreign corporation.
Unlike the dividend withholding
tax, the BPT applies regardless
of whether earnings are distrib-
uted. Thus, the BPT could be
imposed earlier than the with-
holding tax on dividends.
An interest in a foreign corpora-
tion is not a USRPI, regardless
of how much U.S. real estate the
corporation owns. The sale by a
non-U.S. investor of shares in a
foreign corporation that owns a
USRPI is completely exempt
from U.S. income taxation. The disadvantage of holding U.S.
property in a foreign corporation is that it may be difficult to
convince a buyer to purchase shares of the foreign corpora-
tion in order to acquire the underlying property. The buyer
likely would be buying stock of the foreign corporation with
a built-in U.S. tax liability and would probably insist on a re-
duced purchase price for the shares.
Holding U.S. property through a foreign corporation is more
common when the property is expected to be owned by a
family for multiple generations. Because no sale is anticipated
for many years, the difficulty in finding a willing buyer would
be put off to a later date.
Real Estate Business Activities. The ownership of U.S.
real property by a non-U.S. investor by itself will not consti-
tute the conduct of a business in the United States. If the real
estate investment is not treated as a business, the gross rents
paid to the non-resident owner would be subject to 30%
withholding tax as non-ECI. Foreign corporations or non-
residents may make an election to treat their U.S. income as
ECI, and pay a tax on their net income at ordinary rates.
This election would enable the investor to deduct its real es-
tate business related expenses.
ESTATE TAX IMPLICATIONS
For U.S. estate tax purposes, the
gross estate of a non-resident
consists of all U.S. property in
which the decedent had an inter-
est at death. Direct ownership of
U.S. assets, such as U.S. real es-
tate or shares of a corporation
organized in the United States,
would subject the non-U.S. inves-
tor to U.S. estate taxes if the in-
vestor still owns such assets at
the time of his or her death.
STATE AND PAYROLL TAXES
This article has not addressed any state taxes on the disposi-
tion of real property interests or state or federal payroll taxes
related to employees in the real estate business. These issues
should be addressed with your tax counsel before finalizing
any transaction or implementing any business plan.
CONCLUSION
The best choice for structuring investment in U.S. real estate
will depend on a number of factors and depend on the
unique circumstances of each individual investor, but the
complex tax rules in this area should always be included
among the factors considered before finalizing any invest-
ment structure.

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