U.S. commercial real estate continues to be an attractive investment for foreign investors. Demand is pushing commercial real estate valuations up in cities worldwide, but the U.S. is still considered the No. 1 destination for foreign capital. As valuations increase, deal flow is increasing as well. According to Real Capital Analytics, the first six months of 2015 yielded $273.4 billion in deal activity in the U.S. commercial real estate sector, well ahead of the pace of activity in the first half of 2014.
The robust market is being fueled by low interest rates and the relative attractiveness of U.S. commercial real estate compared to other investment alternatives. While traditional U.S. investors continue to dominate the U.S. market, foreign interest in U.S. real estate is surging with investors from China and the Middle East demanding attention.
The Association of Foreign Investors in Real Estate’s (AFIRE) member firms have an estimated $2 trillion or more in real estate assets under management globally. AFIRE’s 2015 member survey was conducted by the James A. Graaskamp Center for Real Estate at the University of Wisconsin School of Business. In the recently published survey, 90 percent of respondents said they plan to maintain or increase the size of their U.S. portfolio during 2015. Also, member firms called the U.S. the most stable and secure country for real estate investment by more than 50 percentage points over any other country. Respondents predicted China will soon become the largest source of capital into the U.S. with 72 percent of respondents; they also predict this investment flow will be long-term and stable.
U.S. real estate professionals faced an increasing number of tax planning and reporting issues associated with foreign investors participating in their ownership groups, because the tax rules that apply to ownership and disposition of U.S. real estate owned by foreign investors are different from those applying to domestic investors. U.S. real estate professionals must be familiar with how the rules differ for foreign investors to remain compliant with federal tax laws affecting real estate transactions.
The manner in which a foreign investor will be taxed on income derived from an investment in U.S. real estate depends on whether the investor is considered engaged in a U.S. business by virtue of its investment. If the investor is considered engaged in a U.S. business, rental and other income derived from the real estate investment will be treated as income effectively connected with a U.S. business (ECI) and taxed, after allowable deductions, at graduated rates that apply to U.S. persons. If, however, activities associated with the investment don’t rise to those of a U.S. business, the foreign investor is subject to withholding tax at a flat rate of 30 percent (unless reduced by treaty) on the gross income received in connection with its investment, unless the investor properly elects to treat the income as ECI, if eligible.
Whether foreign investment in U.S. real estate constitutes a U.S. business is determined on a case-by-case basis. For example, foreign ownership of a single piece of U.S. real estate for which a tenant is responsible for repairs likely doesn’t rise to the level of a U.S. business. However, if a foreign investor, either directly or through an agent, takes part in regular and continuous activity in connection with a real estate investment (such as negotiating leases, collecting rent and performing repairs), the investor may be considered engaged in a U.S. business. Similarly, if a foreign investor holds an interest in a partnership that conducts U.S. business by virtue of its U.S. real estate activities, the investor will be deemed engaged in a U.S. business.
Being engaged in a U.S. business may trigger an obligation to file a U.S. tax return. For many foreign investors, this is an undesirable consequence of participating in a U.S. real estate activity. Proper tax planning, however, can create alternative ownership structures in which the foreign investor isn’t required to file a U.S. income tax return.
Foreign investors in U.S. real estate also are subject to a unique set of rules upon the disposition of a U.S. real property interest. The Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) addressed a perceived competitive advantage foreign investors in U.S. real estate held over domestic investors: Foreign investors not otherwise engaged in a U.S. trade or business generally were not subject to tax on U.S. source capital gains.
Prior to FIRPTA, foreign investors in U.S. real property could dispose of their property interest at a gain without tax consequences, while domestic investors were taxed on those capital gains. FIRPTA essentially requires gain realized by a foreign investor from the sale of a U.S. real estate interest to be treated as ECI (imposing taxes on such gain at graduated rates on a net basis). It also may impose a 15 percent withholding tax on the foreign investor’s gross proceeds of the sale of such real estate, as an advance payment of the investor’s U.S. tax obligation arising from the gain. The 15 percent withholding rate applies to sales after February 16, 2016; the rate was 10 percent for earlier sales. In addition, the rate is 10 percent when the purchaser plans to use the property as his or her principle residence and the value is less than $1 million.
In most cases, the withholding agent is the transferee or buyer. Withholding agents who fail to withhold the required amount may be liable for the tax. It’s very important for transferees or buyers to know whether the transferor is a foreign person prior to entering into the purchase transaction to protect themselves from this potential liability.
Foreign investment in U.S. real property is surging to record levels. To properly comply with U.S. tax rules, U.S. real estate professionals must be aware of the different treatment foreign investors receive when investing in U.S. real estate. Developers seeking to attract foreign investment also should consider structuring alternatives that cater more to the tax needs of a foreign investor.
If you have questions or concerns on how to structure and account for foreign investment in U.S. real property, contact your BKD advisor.