Foreign investors are often motivated to acquire U.S. real property when considering the opportunity for appreciation in value and a profitable return on investment.  There are different investment structuring alternatives that may attract foreign investors to the U.S. real estate market.  A common typical structure that has certain advantages is the U.S. blocker corporation.  The U.S. blocker holds the U.S. real property directly or through an LLC or a partnership.  The foreign investor acquires the stock either directly in the U.S. blocker or often times in a foreign corporation that owns stock in the U.S. blocker.  As an alternative to the U.S. blocker corporation structure, some foreign investors may decide to invest in a U.S. or foreign partnership that owns U.S. real property.  There are different advantages to the partnership structure as compared to the U.S. blocker corporation structure.

FIRPTA withholding tax can apply when a foreign investor sells a partnership interest in a U.S. or foreign partnership that is invested in U.S. real property.  The foreign investor’s sale of the partnership interest is treated as an indirect sale of the underlying U.S. real property held by the partnership.  The FIRPTA withholding tax liability is based on a percentage of the foreign partner’s gross sale proceeds from the sale of the partnership interest.  It is often possible that the foreign investor’s final U.S. federal tax liability on the gain from the sale of the partnership interest may be less than the FIRPTA withholding tax on the gross sale proceeds.  The gross sale proceeds typically include any cash received and debt relief from the foreign partner’s share of partnership liabilities assumed by the buyer.

The selling partner’s share of the partnership’s mortgage financing liability on the U.S. real property generally is considered to be included in the amount realized as part of the sale proceeds.  This may be somewhat unexpected and counterintuitive for many foreign investors because the FIRPTA withholding tax liability is increased with debt relief to the foreign partner.  The foreign partner’s share of the partnership liabilities generally gets washed out in the calculation of the taxable gain because the foreign partner’s outside basis in the partnership interest is also increased by the liabilities.  However, the foreign partner’s share of partnership liabilities does have an impact when calculating the FIRPTA withholding tax liability.

The following is a basic example.  For illustrative purposes, the example focuses on the U.S. federal tax liability.  The state and local tax consequences are not addressed.  A foreign partner’s outside basis is $7M in an interest in a U.S. or foreign partnership that is invested in U.S. real property.  The $7M includes $2M attributable to cash capital contributions to the partnership and the foreign partner’s share of net taxable income and loss earned by the partnership over the years since the partnership interest was acquired.  The $7M also includes $5M attributable to the foreign partner’s share of the partnership’s mortgage financing liability on the U.S. real property owned by the partnership.  Assume that the fair market value of the foreign partner’s partnership interest is $10M attributable to the appreciation in value of the partnership’s assets including U.S. real property.  The foreign partner sells the partnership interest for $10M.  The gross sale proceeds include $5M of cash and $5M of debt relief from the foreign partner’s share of the partnership’s mortgage financing liability on the U.S. real property assumed by the buyer.  The foreign partner’s FIRPTA withholding tax liability is $1.5M which is 15% multiplied times the $10M of gross sale proceeds including the cash and the debt relief from liabilities assumed by the buyer.  The foreign partner’s taxable gain is only $3M which is the $10M amount realized from the gross sale proceeds less the $7M outside basis in the partnership interest.  If the foreign partner is a foreign corporation then the actual U.S. federal tax liability on the gain is 21% multiplied times $3M plus any residual 30% U.S. branch profits tax on after-tax earnings if the foreign corporation continues to be invested in other U.S. assets.  As explained below, if the foreign partner is a foreign individual then the U.S. federal tax liability could be at the highest 37% tax rate on the taxable gain from the sale of the partnership interest which is treated as effectively income from a U.S. trade or business.  In either case, whether the foreign partner is a foreign corporation or a foreign individual, the U.S. federal tax liability on the taxable gain is less than the FIRPTA withholding tax liability on the gross sale proceeds from the sale of a partnership interest.

The U.S. tax reform legislation was enacted in December 2017.  The new tax law includes a rule that governs the U.S. tax consequences when a foreign partner sells an interest in a U.S. or foreign partnership engaged in a U.S. trade or business.  The new rule also applies when a foreign person sells an interest in a U.S. multi-member LLC that is classified as a partnership for U.S. federal tax purposes.  A foreign partner’s gain from the sale of an interest in a partnership engaged in a U.S. trade or business is now treated as effectively connected income from a U.S. trade or business.

Before the new law, the general rule was that a foreign individual partner’s gain from the sale of an interest in a partnership that held U.S. real property was characterized as capital gain subject to a lower U.S. federal tax rate.  The main exception to this general rule recharacterized the foreign individual partner’s gain on the sale as ordinary income subject to a higher U.S. federal tax rate if the U.S. partnership had assets that were unrealized accounts receivable or appreciated inventory.  With the new law, the foreign individual partner’s gain on the sale of an interest in a U.S. or foreign partnership that owns U.S. real property can be characterized as ordinary income subject to a higher U.S. federal tax rate.  Therefore, instead of a 20% U.S. federal capital gain tax rate for a foreign individual partner, the highest 37% ordinary income tax rate could potentially apply depending on the amount of the gain and the composition of the partnership’s U.S. trade or business assets.  For purposes of the new rule, U.S. real property interests held by a U.S. or foreign partnership are considered to be per se effectively connected U.S. trade or business assets.

A foreign corporation that is a partner in a partnership invested in U.S. real property is subject to a 21% U.S. federal tax rate on capital gains and income that is considered to be effectively connected with a U.S. trade or business.  For U.S. tax purposes, corporations are allowed to claim a five-year capital loss carryforward and a three-year capital loss carryback.  A 30% U.S. branch profits also may apply unless the foreign corporation disposes of all U.S. assets and liquidates its U.S. trade or business.

The IRS issued new regulations in December 2018 that explain the new rules to govern a foreign partner’s sale of a partnership interest.  The new regulations provide for some coordination with the FIRPTA rules.  Some additional guidance is still needed from the IRS to clarify the various U.S. withholding tax requirements.  For instance, there are now several different types of U.S. withholding tax that can apply.  FIRPTA withholding tax applies when a foreign partner sells an interest in a U.S. or foreign partnership that owns U.S. real property interests.  There is also a new U.S. withholding tax that will apply when a foreign partner sells an interest in a U.S. or foreign partnership engaged in a U.S. trade or business.  The IRS has yet to issue the regulations regarding the new U.S. withholding requirement on a foreign partner’s sale of a partnership interest.  Additionally, FIRPTA withholding tax theoretically applies when a U.S. or foreign partnership with foreign partners sells a U.S. real property interest.  As a practical matter, the gain from the partnership’s sale is characterized as FIRPTA gain which is treated as effectively connected income from a U.S. trade or business.  This effectively connected taxable income (ECTI) is subject to foreign partner withholding tax by the partnership which supersedes the FIRPTA withholding tax requirement.

This all may sound technically complicated and that is because it really is.  So what do all of these U.S. withholding tax rules mean for the foreign investor?  The FIRPTA withholding tax rules still apply to a foreign person’s sale of an interest in a U.S. or foreign partnership that owns U.S. real property.  It is possible to reduce the foreign partner’s FIRPTA withholding tax liability on the gross sale proceeds by filing a U.S. federal Form 8288-B FIRPTA withholding tax exemption certificate application with the IRS.  A reason why the IRS will grant the application is when the foreign partner can demonstrate to the IRS that the final U.S. federal tax liability on the gain from sale will be less than the FIRPTA withholding tax liability on the gross sale proceeds.  Even the final U.S. federal tax liability at the highest 37% tax rate on the gain for a foreign individual partner could be less than the FIRPTA withholding tax liability at a 15% tax rate on the gross sale proceeds from the sale of a partnership interest.  Certainly, for foreign corporations invested in partnerships, the final U.S. federal tax liability on the gain, even taking into account the U.S. branch profits tax, also will likely be less than the FIRPTA withholding tax liability on the gross sale proceeds.

The U.S. FIRPTA and other withholding tax rules are quite technical for foreign investors in U.S. real property.  It is always advisable to consult with a qualified U.S. tax professional who has experience with these investment structures and who has the capability to address the specialized U.S. international tax and multi-state tax requirements.

It is also advisable to consult with a qualified FIRPTA specialist who can help prepare the necessary documentation to file with the U.S. federal Form 8288-B FIRPTA withholding tax exemption certificate application.  The IRS requires certain information to be provided as support to grant the FIRPTA withholding tax exemption certificate.