What is FIRPTA? Our Guide to the Foreign Investment in Real Property Tax Act

The PropertyClub Team
May 23rd 2020
FIRPTA: Learn about the Foreign Investment in Real Property Tax Act, withholding certificates, exemptions, and how to minimize your tax liability.

The U.S. real estate market is considered by many to be the most significant tax haven in the world. Many foreign investors, driven by unstable political and economic conditions in their own countries, have turned to the U.S. real estate markets to invest their capital. Specifically, real estate in New York City has seen a massive rise in foreign investments in the past few years. This rate of foreign investment is likely to continue growing together with the ever-increasing value of NYC real estate.  

While investment rates in NYC real estate continue to rise, there are still many tax and legal roadblocks that must be navigated in a well-planned manner to maximize Return on Investments (ROI). Many individuals might find themselves losing significant money due to poorly planned investments that frequently overlook or ignores regulations. For example, issues often occur after the property sells, or after the property has passed through an estate, leaving the owner with a hefty tax bill.

On the flip side, a well-planned real estate investment strategy may drastically reduce or even eliminate U.S. taxation from ownership and the sale of real estate in the U.S.  

The four main things that everyone must plan for when investing in New York City real estate are 1) taxation of operating income and gains from the sale, 2) repatriation of profits, 3) taxation upon death, and 4) privacy and reporting requirements. However, the best strategy for each individual will also consider the client’s home country, plans, goals, and the reason the client has an interest in the NYC real estate market.  

Direct Ownership

The most basic and cost-effective way to invest in U.S. real estate is via direct ownership. This means that an individual has purchased and is holding real estate under their name. While this approach may be the most straightforward, it also presents the least amount of long-term benefits. For example, the owner will be exposed to liability, taxes on the estate, withholding tax, and state withholding tax, all tax reporting regulations, and the Foreign Investment in Real Property Tax Act (FIRPTA).

For example, a foreign investor may purchase real estate in New York City as a rental property. During the transaction, a 15% FIRPTA tax will be withheld from the buyer. The withholding acts as an advance on U.S. taxes. There will also be a N.Y. state tax of 8.82% that is deducted from the capital gains from the property sale. The seller’s taxes must then be filed on the year in which the transaction took place. If the seller is also a foreign investor and their taxes are lower than what was withheld by the FIRPTA tax, they will receive a return on their taxes.

If this property were held for less than one year, it would be subjected to the normal state and federal income taxes. However, if the property was held for more than one year, a capital gains tax of up to 20% applies. This is on top of state taxes, such as the N.Y. state income taxes of 8.82%. There is also a 3.8% Medicare Tax that might apply, depending on the situation. 

All foreign investors that hold rental properties in New York City that are actively being rented and producing income are also subjected to a passive investment tax. This fee is a 30% flat tax on the gross income generated from the rental property. There are no deductions permitted on this fee unless the holder is actively managing the property within the USA. If this is the case, standard income deductions will apply. Also, tax treaties may apply to this scenario, depending on the residency of the property holder, which may slightly reduce the 30% withholding tax. 

Foreign individuals will also be subject to federal estate tax on property within the USA. This means that all foreign individuals holding property in the USA under their name will be forced to pay a tax that can range up to 55%. As a result of these drawbacks, direct ownership is only chosen by a small percentage of NYC foreign real estate investors.

Domestic Limited Liability Company

Acquiring New York City real estate via a limited liability company (LLC) is, in many ways, similar to direct ownership. By default, an LLC is a pass-through entity and subject to many of the same tax consequences as individual investors. However, the significant difference is that LLCs protect the individual more from personal liability on loss associated with the property. This is why an LLC is often a vehicle of choice for small-time foreign investors in NYC real estate markets. 

In short, the LLC provides the best income tax treatment and protection against liability for an individual investor’s assets. Additional privacy protections can even accompany it since the property will not be registered under an individual’s name. Unfortunately, the major drawbacks for individual foreign investors still exist with an LLC: federal and state estate taxes if/when the investor dies while holding the property. 

Domestic Corporation

It is relatively rare for a foreign investor to utilize domestic corporation as a vehicle for real estate investment. In most cases, this type of investing strategy is advised against because it doesn’t prevent many of the significant drawbacks of foreign investments, such as estate taxes. This is because, when an individual dies, shares of stock in U.S. corporations are considered part of their U.S. estate. A domestic corporation will also increase capital gains tax rates and taxation upon repatriation of profits. 

The benefits of this approach include liability protection, and it prevents the individual investor from having to file annual U.S. returns. The regulations for this entity are slightly different if anyone individual owns 20% or more of the corporation or 50% or more of the corporation’s voting stock. Tax information on these individuals must be reported directly to the U.S. government.

U.S. Blocker Structure & Avoiding FIRPTA Withholding Requirements

The term “U.S. Blocker structure” refers to the ownership of a domestic corporation by a foreign corporation. The benefits of this vehicle for foreign real estate investment include the elimination of estate taxes and the elimination of FIRPTA withholding requirements. This creates a framework for both individual privacy and asset protection. 

To avoid estate taxes, the individual investor must establish a foreign corporation that owns 100% of the U.S. corporation, which owns the N.Y. real estate. Since the foreign investor does not directly own shares of a U.S. corporation, this type of holding will not be considered a part of their estate upon their time of death. 

Similarly, FIRPTA withholding requirements can also be circumvented because the seller of the real estate is a U.S. corporation, rather than a foreign entity. Unfortunately, the U.S. corporation will still be subject to a high capital gains tax when sold. The repatriation of profits to foreign shareholders will be subject to a flat tax of 30%. As noted previously, this tax rate may be adjusted if applicable tax treaties exist with the investor’s country of residency.

Leveraged Corporate Structure

Leveraged ownership is typically only recommended as a vehicle for foreign real estate investment if the investment is being made on a large enough scale. Generally, a foreign individual will benefit from self-financing their investment in U.S. real estate. This is because this type of structure is a bit more expensive and complex than the other structures previously described.

The loan can generate tax deductions for the U.S. entity that owns real estate when a foreign investor loans part of the investment to acquire real estate in the United States. When the U.S. entity deducts this interest, this lowers the effective U.S. tax rate. If this transition is appropriately planned and executed, the debt can produce an interest income to the investor that would be excluded from U.S. withholdings and income taxes. 

The leveraged corporate structure investing strategy may be beneficial in some scenarios, mainly when it employed at scale. However, it requires careful planning, inclusion of complex tax provisions, portfolio interest exemption regulations, and income stripping rules. The attorney fees associated with this type of planning will significantly eat into the ROI of a smaller-scale real estate investment.  

Bilateral Tax Treaties Can Provide FIRPTA Exemptions

There are currently 68 countries that hold bilateral tax treaties with the United States. Under these treaties, a reduced tax rate is realized for residents of participating foreign countries.  These reduced tax rates are applied to various types of income sources and often include real estate income. That being said, most tax treaties between the U.S. and other countries have been amended to conform with FIRPTA, and as time has passed the FIRPTA exemptions many treaties have provided in the past have slowly been eliminated.

A reduction in U.S. taxes and withholdings from a bilateral tax treaty can significantly shape the ROI for a foreign real estate investment. However, the exact agreement outlined within the bilateral tax treaty will vary considerably among each participating country. As a result, careful planning, and a complete understanding of the terms of the treaty must be understood before pursuing a real estate investment strategy under such terms.