Foreign Investment in U.S. Real Estate: Impact of Tax Reform Entity Selection, FIRPTA, Tax Concerns When Acquiring or Disposing of Ownership Interests Today’s faculty features: 1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions emailed to registrants for additional information. If you have any questions, please contact Customer Service at 1-800-926-7926 ext. 1. THURSDAY, MAY 17, 2018 Presenting a live 90-minute webinar with interactive Q&A Edward J. Hannon, Partner, Quarles and Brady, Chicago Cecilia (Ceci) Hassan, Partner, Baker & McKenzie, Miami
Transcript
Foreign Investment in U.S. Real Estate:
Impact of Tax ReformEntity Selection, FIRPTA, Tax Concerns When Acquiring or Disposing of Ownership Interests
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Foreign Investment inU.S. Real Estate: Impact of Tax Reform
May 17, 2018
Speakers
6
Cecilia (Ceci) HassanBaker McKenzie
Miami, Florida
Edward HannonQuarles & Brady, LLP
Chicago, Illinois
Topics
7
1. What are the U.S. income tax implications of purchasing U.S. real estate by foreign parties?
2. Compare and contrast U.S. income tax consequences if the purchaser is a foreign individual, a single member or multi-member domestic limited liability company, or blocker corporation.
3. How does the use of a foreign trust affect the U.S. income tax consequences?
4. Understanding the U.S. income tax reporting obligations if foreign investors acquire direct or indirect interests in U.S. real property.
5. FIRPTA compliance issues for sellers.
6. Summary of the 2017 Tax Law changes.
Overview of the U.S. tax rules that applyto foreign investors in U.S. real estate
8
1. Income Tax Costs
2. Applicability of Withholding Tax
3. FIRPTA
4. Estate and Gift Tax Exposure for the Foreign Owner
Possible objectives in representing ownersof U.S. real estate
9
▪ Minimize or eliminate U.S. income tax costs on rental income
▪ Minimize or eliminate U.S. income tax costs on sale
*In some circumstances, a lower rate may be available with the pass-through
deduction rate
**A lower capital gain rate is applicable for lower bracket taxpayers
***A 10% FIRPTA withholding rate is applicable to distributions by certain REITs.
FDAP withholding
11
▪ FDAP – fixed, determinable, annual or periodic
▪ In general, a 30% withholding rate on payments of FDAP income to foreign persons or entities
▪ In general, FDAP does not include income arising from a trade or business
▪ FDAP withholding can apply to rent (in certain circumstances) and will apply to dividends paid by U.S. corporations to foreign shareholders
Tax treaties and FDAP withholding
12
▪ Many U.S. income tax treaties call for a reduced rate of withholding on FDAP income
▪ The availability of treaty benefits can be subject to limitation
FIRPTA Withholding13
FIRPTA applies to a "United States Real Property Interest"
14
▪ Foreign Investment in Real Property Tax Act
▪ In very general terms, FIRPTA is a tax imposed on foreign persons selling U.S. real estate
▪ The FIRPTA rules also require the seller to withhold this tax at a rate of 15% for dispositions occurring after February 17, 2016
▪ The FIRPTA rule are in Code Section 897 and the withholding obligations are set forth in Code Section 1445
What is a United States Real Property Interest (USRPI)?
15
▪ An interest in real property (other than an interest solely as a creditor) located in the United States or the Virgin Islands. See 897(c).
▪ Interest in a domestic corporation unless taxpayer establishes not a USRPHC in past 5 years
▪ United States Real Property Holding Corporation (USRPHC). See 897(c)(2)
▪ USRPHC is defined as any corporation if the FMV of its USRPIs equals or exceeds 50% of the FMV of (1) its USRPIs, (2) its interest in real property located outside the United States, plus (3) any other of its assets which are used or held for use in a trade or business
What is a United States Real Property Interest (USRPI)? (continued)
16
▪ What about partnership interests?
▪ Code Section 897(g) provides that an interest in a partnership is treated as a USRPI only to the extent that the gain on its disposition would be attributable to USRPIs
▪ For purposes of Code Section 1445, an interest in a partnership is treated as a USRPI in its entirety if 50% or more of the value of gross partnership assets consist of USRPIs and 90% or more of the value of the gross partnership assets consists of USRPIs plus cash and cash equivalents
What can be a USRPI?
17
▪ Land, buildings, and other related permanent structures located in the United States
▪ Unsevered minerals and natural deposits
▪ Co-ownership interests in real property located in the United States
▪ Leasehold interests in real property located in the United States
▪ Life estates in real property located in the United States
▪ Remainder interests in real property located in the United States
▪ Options to acquire interests in real property located in the United States
▪ Stock in U.S. real property holding corporations
U.S. Real Property Holding Company
18
USRPHC is a U.S. corporation that holds USRPIs having a fair market value that is 50% or more of the sum of the fair market values of the following:
▪ USRPIs owned by the U.S. corporation,
▪ interests in real property located outside of the United States, and
▪ Other assets used in the U.S. corporation's trade or business
The testing period to determine if a U.S. corporation is a USRPHC is generally five years. See Code Section 897(c).
19
Withholding under Code Section 1445
▪ Except as otherwise provided in Code Section 1445, under Code Section 1445(a), if a foreign person disposes of a USRPI (as defined in Code Section 897(c)), then the transferee is required to deduct and withhold a tax equal to 15% of the amount realized on the disposition
▪ Exceptions to Code Section 1445(a)
▪ Transferor provides non-foreign affidavit
▪ Property acquired by transferee used as a residence, and does not exceed $300,000
▪ Code Section 1445(e) – Certain distributions and other dispositions
▪ In some cases withholding applies on the basis of gain realized
20
Code Section 1446 – Withholding tax applies at partnership level
▪ Applies to a partnership that has effectively connected taxable income (ECTI) for year, and
▪ Any portion of such income is allocable to a foreign partner
Effectively connected income (ECI)
▪ Non-resident aliens are taxed in the United States on a net basis on their ECI. See Code Section 871(b)(1)
▪ Foreign corporations are taxed in the United States on a net basis on their ECI. See Code Section 882(a)(1)
21
Dispositions of USRPIs generate ECI
▪ Gain or loss from the disposition of a USRPI is taken into account as if the taxpayer were engaged in a trade or business within the United States during the taxable year and as if such gain or loss were effectively connected with such trade or business
Income from USRPIs other than dispositions (e.g., rental income)
▪ Determine whether US trade or business exists
▪ If US trade or business exists, is the income effectively connected? If yes, see Code Section 871(b) or Code Section 882(a)
▪ If US trade or business does not exist, then general rules for US source income apply
Consider withholding certificates
22
▪ File Form 8288-B (application, with supporting documents)
▪ If satisfied, certificate is issued by the IRS
▪ Allows reduction or elimination of withholding
▪ Certificate of non-foreign status
▪ Escrow arrangement?
Considering a disposition? Non-recognition provisions
23
▪ "Dispositions" – not defined in Code Section 897
▪ Broadly defined to include:
▪ Sales and exchanges
▪ Capital contributions
▪ Entity distributions
▪ Transfers in connection with mergers
▪ Gifts ... But only if there is boot or liabilities in excess of basis
Dispositions/non-recognition
24
▪ Dispositions generally include non-recognition transactions unless:
▪ Non-US person receives USRPI in exchange for USRPI (hot for hot)
▪ USRPI received in exchange would be subject to US tax upon disposition and
▪ Reporting requirements satisfied
▪ Certain foreign corporations eligible for treaty benefits may elect to be treated as a US corporation for these purposes (Code Section 897(i))
Overview of the FIRPTA non-recognition rules
25
▪ Code Section 897(d) and (e) restrict a foreign person's ability to rely on a non-recognition provision in connection with a transfer of a USRPI
▪ Code Section 897(d) applies to distributions of USRPIs by foreign corporations
▪ Code Section 897(e) applies to transactions in which a foreign person exchanges a USRPI for another asset
▪ Confusingly, when a foreign corporation that is a party to a reorganization transfers a USRPHC interest to another corporation that is a party to the reorganization, the rules of Code Section 897(e) and Treas. Reg. § 1.897-6T apply before the rules of Code Section 897(d) and Treas. Reg. § 1.897-5T
Overview of the FIRPTA non-recognition rules
26
Applicable regulations (Treas. Reg. §§ 1.897-5T and 1.897-6T) have been modified or supplemented by seven different notices (some of which modify other notices in the series):
1. Notice 2006-46 (providing rules relating to inbound merger transactions, foreign-to-foreign non-recognition transactions, and the FIRPTA toll charge);
2. Notice 99-43 (providing rules relating to single-entity reorganization transactions involving a "former" USRPHC);
3. Notice 89-85 (providing rules relating to certain distributions of USRPHC interests by foreign corporations and Code Section 897(i) elections);
Overview of the FIRPTA non-recognition rules (continued)
27
4. Notice 89-64 (providing rules relating to the application of Article XIII(9) of the Canada-U.S. Income Tax Convention to certain non-recognition exchanges involving USRPIs);
5. Notice 89-57 (providing rules relating to the filing requirements that must be satisfied by a foreign person that transfers a USRPI in a non-recognition transaction);
6. Notice 88-72 (providing rules applicable to the disposition of interests in partnerships that own USRPIs);
7. Notice 88-50 (announcing the IRS's intention to treat a domestication of a foreign corporation as an inbound F reorganization that involves a deemed transfer of assets (including USRPIs) owned by the foreign corporation).
Choice of entity
28
▪ No entity (personal use property)
▪ Single member limited liability company
▪ Disregarded entity for U.S. income tax purposes
▪ Foreign corporation
▪ Multi-member limited liability company
▪ Treated as a U.S. partnership for U.S. income tax purposes
▪ U.S. corporation
Ownership of U.S. real property by foreign individuals
29
▪ Rental income will be subject to U.S. income tax at regular rates or at FDAP withholding rates
▪ FIRPTA withholding on sale proceeds
▪ Gain on the sale of the property will be subject to U.S. income tax at capital gain rates
▪ Ownership of U.S. real property will subject the foreign individual to U.S. estate tax and U.S. gift tax
▪ U.S. individual tax returns (IRS Form 1040) to be filed by the foreign individual
Ownership of U.S. real property by a foreign corporation
30
▪ Rental income subject to U.S. income tax at corporate rates if U.S. income tax return filed. Branch profits tax may also apply
▪ FIRPTA withholding on sale proceeds and the gain on sale of the property subject to U.S. income tax at corporate rates
▪ No exposure for owners of foreign corporation to U.S. estate tax or U.S. gift tax
▪ No U.S. tax imposed on sale of stock of foreign corporation
▪ No FIRPTA withholding on sale of stock of foreign corporation
▪ Filing of U.S. income tax return for foreign corporation (IRS Form 1120F) will require disclosure of owners
Ownership of U.S. real property through a U.S. corporation
31
▪ Rental income subject to U.S. income tax at regular corporate rates
▪ Gain on sale of U.S. real estate subject to U.S. income tax at regular corporate rates
▪ Exposure to U.S. Estate Tax
▪ Dividend distributions subject to U.S. withholding tax
▪ FIRPTA withholding on sale of the stock
▪ Sale of stock could be subject to U.S. income tax in somecircumstances
Summary
32
U.S. Tax
Imposed on
Rental
Income
U.S. Tax
Imposed on
Sale Gain
FIRPTA
Withholding
U.S. Estate
and Gift Tax
Medicare
Tax
U.S.
Withholding
on
Distribution to
Foreign
Owner
U.S. Tax
Returns Filed
Direct
Ownership or
Single Member
LLC
Foreign
Corporation
Multi-Member
LLC
U.S. Corporation
Using Foreign
Trust
Advanced Planning Structures33
Dual corporate structure
34
Income tax
▪ US HoldCo will be subject to corporate tax on its net income
▪ 21% flat US federal rate, 3% to 8% state corporate tax rates
▪ Foreign HoldCo will be subject to US tax on its gross income
▪ Dividends and Interest from US HoldCo (30% withholding)▪ Rates could be lower if US income tax treaty applies▪ Portfolio interest not subject to withholding
▪ Disposition of US HoldCo
▪ Subject to tax if US HoldCo is a USRPHC▪ Not subject to tax if all USRPIs sold and pursuant to liquidation
Estate tax
▪ Does not apply to stock in Foreign HoldCo
US
HoldCo
Foreign
HoldCo
USPRIs
NRA
100%
100%
Two-tier partnership structure
35
Income tax
▪ All items of income, gain, loss, deduction, credit "flow-through"
▪ Single layer applies at the partner level
▪ Withholding tax on ECI to foreign partners
▪ Withholding tax is credited at the partner level
▪ Long-term capital gains rate 20%
▪ Ordinary income rates up to 37%
▪ With pass-through deduction rate could be 29.6%
Estate tax
▪ Situs of partnership interest remains unclear
▪ But see Grecian Magnesite case to extent not repealed
PRS
FPS
USPRIs
NRA
99%
99%NRA 2
1%
NRA 2
1%
U.S. trust structure
36
U.S. Trust
▪ Structure as nongrantor trust
▪ Structure as exempt trust (U.S. estate tax)
▪ Single layer of tax (at either trust or beneficiary level)
▪ Consider multiple trusts to facilitate distributions
▪ Long-term capital gains rate of 20%
▪ Ordinary income tax rates up to 37%
LLC
USPRIs
100%
U.S. Trust
Leveraged blocker
37
Capital structure
▪ US HoldCo funded with combination of debt and equity
▪ If treaty applies, reduced withholding on interest
▪ If treaty does not apply, use "park-the-vote" structure(see red text)
▪ Portfolio interest not subject to withholding tax
Deductibility of Interest▪ Revised Section 163(j)
▪ Electing Real Property Trade or Business exception
▪ Section 163(j) limitation does not apply to a real property trade or business as defined in Code Section 469(c)(7)(C)
▪ Any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business
LLC
US
HoldCo
USPRIs
Foreign
HoldCo
Interest
Loan
Leveraged blocker – partnership below
38
Electing Real Property Trade or Business
▪ Is U.S. corporation engaged in a real property trade or business?
▪ Both Section 469(c)(7)(C) and 163(j) are silent on attribution of trade or business from partnerships to partners
▪ Does it matter if C corp owns GP vs. LP vs. co-MM interest?
▪ Conference report to the TCJA provides "a corporation has neither investment interest nor investment income within the meaning of 163(d) [and] interest income and interest expense of a corporation is properly allocable to a trade or business."
▪ Interest expense of the US HoldCo is allocable to some trade or business. Here, the interest expense is allocable to the trade or business of the JV partnership because the debt was used to acquire such interest in the JV
Alternative [blue text] – back-to-back
▪ Interest income of US HoldCo is carved out of the limitation Section 163(j) limitation otherwise is applied at partnership level
JV
US
HoldCo
SPE
Foreign
HoldCo
Interest
Loan
Interest Loan
USPRIs
Mezz debt
U.S. trust with portfolio debt
39
U.S. Trust
▪ Preferential capital gains rates (not huge advantage)
▪ Structure as nongrantor trust
▪ Structure as exempt trust (U.S. estate tax)
▪ Consider multiple trusts to facilitate distributions
▪ Must analyze section 163(j)
Portfolio Debt
▪ U.S. LLC is disregarded (borrower is US Trust)
▪ No 10% shareholder rule for a trust
U.S. LLC
▪ Makes borrowing easier than directly at trust level
LLC
U.S. Business /
USPRIs
100%
U.S. Trust
Portfolio Debt
NRA2 (not spouse)
NRA1
Additional considerations
40
Jurisdiction of individuals and entities
▪ Local country considerations (income tax, withholding tax, foreign tax credits, etc.)
▪ Consider overall effective rate on operating income and income from dispositions
▪ Will a US income tax treaty apply?
▪ FATCA and CRS considerations
Additional considerations (continued)
41
Capital structure
▪ Debt vs. equity
▪ Access to cash
▪ Estate tax considerations
Reporting
▪ How sensitive is the ultimate beneficial owner to filing a US income tax return?
▪ Information reporting may apply regardless of structure
What Has Changed Under the2017 Tax Law?
42
Partner–level deduction to reduce the effective tax rate
43
▪ Multi-member limited liability companies that elected to be treated as partnerships for income tax purposes and S corporations are flow-through entities for income tax purposes.
▪ Under prior law, the income of such entities would flow-through to the owners and be subject to income tax as if received directly by the owner and subject to income tax at the owner's applicable income tax rates (i.e., ordinary rates or capital gain rates).
▪ Under the new tax rules, a more complex rule applies for determining the tax rate at which flow-through income is taxed.
The Partner–level deduction can lower the effective tax rate on flow-through income
44
▪ For tax years beginning after December 31, 2017, owners of flow-through entities that are individuals are entitled to an owner-level deduction equal to 20% of flow-through income that is "qualified business income."
▪ Trusts and estates are also eligible for the 20% deduction.
How the Deduction Works
45
What is "Qualified Business Income"?
46
In order for the deduction to apply, the flow-through income must be "qualified business income." To be treated as "qualified business income" (i) it must be effectively connected with a trade or business conducted in the United States and (ii) the items of income, gain, loss and deduction must be with respect to a qualified trade or business (i.e., not a professional services business).
Qualified business income does not include investment type income (e.g., capital gains on investment property or non-business interest income).
The W-2/Tax Basis Limitation
47
The deductible amount for each qualified trade or business is limited to the lesser of (i) 20% of the taxpayer's qualified business income for that particular qualified trade or business or (ii) the greater of (x) 50% of the W-2 wages for that qualified trade or business, or (y) the sum of 25% of the W-2 wages for that qualified business plus 2.5% of the tax basis of all qualified property of that qualified trade or business.
Example
48
Qualified Business Income $500,000
W-2 Wages of the Entity $150,000
Depreciable Property Used in the Qualified Business $1,000,000
20% Deduction $100,000
W-2 Limitation
(50% x $150,000)
$75,000*
Combined Limitation
(25% x $150,000) + (2.5% x $1,000,000)
$62,500
*This is the amount of the deduction allowed
The 20% deduction does not apply to the following trades or businesses
49
Performance of services that consist of investing, investment management, trading or dealing in securities, partnership interests or commodities is not a qualifying trade or business.
Other businesses not eligible for the 20% deduction
50
▪ Any business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services and brokerage services.
▪ This term also includes any business whose principal asset is the reputation or skill of one or more of its employees.
How does this apply to commercial real estate?
51
▪ Is activity a trade or business?
▪ Is activity ineligible (i.e., brokerage services, investment management)?
▪ What constitutes a business whose principal asset is the reputation or skill of one of its employees?
Limitations on the deductibility of state taxes
52
▪ Until 2025, the deduction for state and local taxes by an individual is limited to $10,000
▪ Holding interest in S corporations, limited liability companies and limited partnerships will cause this limitation to come into play
▪ The $10,000 limitation could cause owners of flow-through entities to face higher tax costs with respect to state income taxes imposed on the business activities of the flow-through entity
Overview of the interest expense limitation rules
53
For tax years beginning after December 31, 2017, the amount allowed as a deduction for business interest expenses is limited under Code Section 163(j) to 30% of the taxpayer's "adjusted taxable income."
For partners of partnerships and members of limited liability companies, the limitation is applied at the partnership level.
How is the Limitation Measured?
54
Definition of "adjusted taxable income" for purposes of Code Section 163(j):
▪ For taxable years ending before January 1, 2022 – EBITDA
▪ For taxable year thereafter - EBIT
Exemptions from the interest expense limitation rules
55
An exemption applies to a business that has less than $25 million of average annual gross receipts for the three preceding years.
The limitation does not apply to real estate debt in some circumstances
56
The business interest expense limitation rules of Code Section 163(j) do not apply to any real property development, construction, acquisition, rental, operation, management, leasing or brokerage trade or business if an election is made to treat the trade or business as an "electing real property trade or business."
Code Section 163(j) provides that the IRS is to issue specific rules for making this election.
Practice Tip
57
▪ The making of this opt-out election will have collateral tax consequences related to depreciation.
▪ The making of this opt-out election will also preclude use of the 100% deduction for certain tangible personal property.
The New Bonus Depreciation Rules
The ability to immediately expense tangible personal property acquired after September 27, 2017
59
▪ Under prior law, a taxpayer could claim "bonus depreciation" in the year that tangible personal property was acquired if the following conditions were met:
▪ the property must be depreciable tangible personal property that has a depreciable life of less than 20 years; and
▪ the original use of the property must begin with the taxpayer (the "Original Use Requirement");
▪ If those conditions were met, the bonus depreciation deduction that the taxpayer could claim in the taxable year in which the property was placed in service was equal to 50% of the qualifying property's cost basis.
The New 100% Expensing Rules
60
▪ Code Section 168(k) was amended to increase the amount of bonus depreciation that may be claimed in the tax year in which the qualifying property is placed in service to 100% of the cost basis of the property.
▪ Code Section 168(k) was also amended to eliminate the "Original Use Requirement."
▪ Under the changes to Code Section 168(k), property placed in service after September 27, 2017 and prior to January 1, 2023.
Limitations on the 100% Expensing Benefit
61
▪ No bonus depreciation is allowed if the taxpayer previously owned the property at any time prior to September 27, 2017.
▪ No bonus depreciation is allowed if the property is acquired from a related party.
▪ No bonus depreciation is allowed if the property is acquired in a tax-free transaction (i.e., tax-free capital contribution or like kind exchange).
▪ No bonus depreciation by any "electing real property trade or business" as defined in new Code Section 163(j)(7)(A).
Eligible Property?
62
▪ Cooling, heating, lighting, electrical, plumbing or ventilation systems
▪ Permanent floor coverings
▪ Fire protection and alarm systems
▪ Ceiling not needed for building stability or support
▪ Building security systems
▪ Items that are not structural components
Net Operating Losses
63
▪ Prior law: Net operating losses could be carried back two taxable years and carried forward 20 taxable years
▪ Current law: The net operating loss carryback has been eliminated
▪ Current law: Losses incurred in taxable years ending after 2017 can offset up to 80% of current year taxable income
New Withholding Rules
64
▪ 1446(f) Special rules for withholding on dispositions of partnership interests.
▪ If any portion of the gain on any disposition of an interest in a partnership would be treated under Code Section 864(c)(8) as effectively connected with the conduct of a trade or business within the United States, the transferee shall be required to deduct and withhold a tax equal to 10 percent of the amount realized on the disposition.
▪ Does "any disposition" cover Code Section 721 contributions?
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