The Foreign Investment in Real Property Tax Act (FIRPTA) was enacted in 1980 to provide an exception to the capital gain sourcing rules with respect to foreign corporations’ or nonresident aliens’ gains on United States real property interests (USRPI). The FIRPTA withholding rules, which help enforce the taxation of the foreign investor’s gain from the disposition of an USRPI, have a significant impact on inbound investments in U.S. real property. This article provides a high-level overview of the FIRPTA rules as well as an overview of some exceptions to the FIRPTA rules.
Under Internal Revenue Code Section 897(a)(1), if a nonresident alien individual or a foreign corporation disposes of a USRPI, the gain or loss on that disposition will be treated as if it is effectively connected with a U.S. trade or business. A USRPI is defined in Section 897(c)(1)(A) as:
- An interest in real property located in the United States or U.S. Virgin Islands; and
- Any interest in a domestic corporation unless the taxpayer establishes that the corporation was not a U.S. Real Property Holding Corporation (USRPHC) during the shorter of the period in which the taxpayer held the interest or five-year period prior to the date of disposition (FIRPTA Period).
A USRPHC is defined in Section 897(c)(2) as any corporation if the fair market value of its USRPIs equals or exceeds 50% of the sum of the fair market value of its USRPIs, interests in real property located outside the United States, and any other of its assets which are used or held for use in a trade or business.
Generally, if a foreign person disposes of a USRPI, then the transferee is required to deduct and withhold 15% of the amount realized on the transaction under Section 1445(a). However, certain exceptions apply that could excuse a transaction from FIRPTA withholding. These exceptions are discussed in more detail below.
Exceptions to FIRPTA Withholding
There are several exceptions to the FIRPTA withholding rules. This article highlights a number of the most relevant exceptions to FIRPTA. In addition to the exceptions discussed in this article, there are other exceptions to the FIRPTA withholding rules that should be considered when analyzing a potential disposition of a USRPI.
Transferor is not a Foreign Person
If the transferor of a USRPI is not a foreign person, then FIRPTA should not apply on the disposition of a USRPI. However, unless the transferor certifies its non-foreign status, the presumption is that FIRPTA will apply to the transaction and the transferee would be required to deduct and withhold 15% of the amount realized on the transaction. In order for a transferor to certify its non-foreign status, it must provide the transferee with its name, address and tax identification number. Additionally, it must certify this statement under penalties of perjury.
Transferred Property is not a USRPI
Generally, if the property that is disposed of by a transferor is not considered a USRPI, no withholding is required under Section 1445(a). However, when the property that is disposed of is stock in a domestic corporation, the transferor must certify that the domestic corporation is not considered a USRPHC. To do so, the domestic corporation must issue a statement stating it has not been a USRPHC during the FIRPTA Period, or that it has cleansed its USRPHC status under Section 897(c)(1)(B). Under the cleansing rule, if a domestic corporation does not hold any USRPIs on the date of disposition, has disposed all of its USRPIs held at any time during the FIRPTA Period in transactions where the full amount of gain (if any) was recognized, and it was not a regulated investment company or real estate investment trust at any time during the FIRPTA Period, then the domestic corporation will cease to be treated as a USRPHC.
One of the most important exceptions to FIRPTA withholding is the exception for certain nonrecognition transactions. Under Treas. Reg. §1.445-2(d)(2), a transferee is not required to withhold on the transfer of a USRPI if:
- The transferor notifies the transferee that it is not required to recognize any gain or loss on the disposition of the USRPI by reason of a nonrecognition provision of the code; and
- The transferee mails a copy of the transferor’s notice along with a cover letter setting forth the name, address, and tax identification number of the transferee to the Internal Revenue Service within 20 days after the transfer of the USRPI.
A nonrecognition provision is defined in Treas. Reg. §1.1445-2(d)(2)(i)(B) as any provision of the Internal Revenue Code for not recognizing gain or loss on a transaction (such as Sections 351, 368 and others). The transferor notice requires that the transferor certify the following under penalties of perjury:
- The disposition is a nonrecognition transaction.
- The name, identifying number and home address of the transferor submitting the notice.
- The transferor is not required to recognize any gain or loss on the transaction.
- A description of the transfer.
- A summary of the law and facts supporting the claim that the transfer is subject to nonrecognition treatment.
The nonrecognition exception to the FIRPTA withholding rules does not apply if the transferor only qualifies for nonrecognition treatment with respect to part, but not all, of the gain realized on the disposition or if the transferee knows or has reason to know the transferor is not entitled to nonrecognition treatment on the disposition.
It is important to note that Section 897(e) and the applicable regulations provide exceptions to the general nonrecognition provisions that would apply to transfers of USRPIs pursuant to certain types of nonrecognition transactions, such as but not limited to Section 351, Section 368 and Section 332, unless additional requirements are met. The transferor would need to consider the Section 897(e) rules as well before being able to provide the certification noted above that the disposition qualifies as a nonrecognition transaction.
Overall, the FIRPTA withholding rules have a pervasive impact on inbound investments in U.S. real property. When a foreign corporation or nonresident alien individual disposes of its U.S. real property or a U.S. corporation, it is important to look at the potential application of the FIRPTA rules and any available exceptions with respect to the transaction.
Additionally, all filing requirements to document an exception to FIRPTA must be satisfied to establish the right to such an exemption. The filing requirements usually need to be met on a contemporaneous basis and not with the applicable tax return, and thus require attention by the parties as part of the planning for any USRPI disposition event.
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