II. Principal Tax Planning Objectives

For the most part, a foreign individual cannot escape U.S. income taxation of his income from U.S. real estate. However it is possible to escape estate taxation. Therefore, the principal tax planning objective with respect to foreign individuals investing in U.S. real estate is to avoid the U.S. estate tax without causing tax problems that would not otherwise arise under direct ownership.

Aside for tax minimization planning, a major concern is managing the tax withholding obligations of the special U.S. tax rules that apply to foreign persons, called “FIRPTA” (Foreign Investment in Real Property Tax Act of 1980).

III. Who Is a Foreign Individual?

A. In general. For this discussion, a “foreign individual” is someone who is both of the following:

1. an alien, that is, an individual who is not a citizen of the United States, and

2. depending on which tax is the subject of concern, either:

a. income tax - a “nonresident” alien;

b. estate tax- a “non-domiciled” alien, or more technically, a “nonresident not a citizen of the United States.”

B. Special income tax rules to determine whether alien is “resident” or “non-resident” of the U.S.

Generally, an alien is a “resident alien” for income tax purposes if either:

1. he holds a “green card” (an Alien Registration Receipt Card”) granting permanent residence in U.S.), or

2. he meets the “substantial presence” test, which is essentially a day-counting test: generally, if the number of days present during the current year, plus 1/3 of the number of days present during the first preceding year, plus 1/6 of the number of days present in the second preceding year equals or exceeds 183 days, he is a nonresident alien. However, there are several important exceptions (not discussed here).

If the alien does not meet either of these tests, he is a “nonresident alien” (“NRA”) for income tax purposes, referred to here as “a

foreign individual” or “foreign person.”

C. Definitional problems under the estate tax.

Unlike for the income tax, Congress has never adopted specific rules for determining “domicile“ for purposes of the estate tax. The best we have is an IRS regulation that states:

A person acquires a domicile in a place by living there, for even a brief period of time, with no definite present intention of later removing therefrom.

Basically, this is a “we know it when we see it” test.

So, for this discussion, a “foreign individual” is an individual who is an “alien” and who is a “nonresident alien” for income purposes and a “non-domiciled alien” for estate tax purposes.

IV. Basic Rules of Taxation Of Foreign Individuals Investing in U.S. Real Estate

A. The Income Tax.

1. Rental income - rental income from U.S. real property earned by a foreign person is taxable under either of following regimes:

a. withholding - the default method is that the lessee (or the management agent) is supposed to withhold and remit to the U.S. Treasury 30% of the gross amount of rent, with no deductions (the 30% rate is generally notreduced by tax treaties). As long as the withholding is performed (and reported), the foreign lessor has no obligation to file a U.S. tax return.

b. “net basis” taxation – if the rental activity constitutes a “trade or business,” or if the foreign individual makes a special election to treat the rental activity as a trade or business, no withholding is required but the foreign owner/lessor is required to file a U.S. income tax return. Tax is paid on the rental income at normal tax rates (currently up to 39.6%), and – this is important – deductions are permitted. Thus, while the “marginal” tax rate is higher – 39.6% as opposed to 30% -- net basis taxation generally results in a lower “effective” tax rate because of the deductions. However, if a tax return is not timely filed, the deductions will be denied.

A. The income tax (continued):

2. Gain on sale – these are the famous“FIRPTA” rules, which essentially have two parts:

a. taxation of gain – foreign persons are generally exempt from U.S. taxation of capital gains, but gains on the sale or other transfer of U.S. real property is taxable and must be reported with a U.S. income tax return. There are some exceptions, however:

(i) gifts –there is no amount realized on a gift, so no FIRPTA taxation, however, might be subject to U.S. gift tax;

(ii) exchange for another U.S. real property interest – in a transaction that is generally non-taxable, such as a contribution by a foreign person of a parcel of U.S. real estate into a U.S. corporation that he owns and the real estate comprises at least 50% of the corporation’s assets.

The other part of FIRPTA is:

b. withholding - generally, on the sale of U.S. property by a foreign person, the purchaser (whether U.S. or foreign) must withhold and remit to the U.S. Treasury 10% of the gross “amount realized”, which usually means the price paid for the property. There are some exceptions:

(i) personal residence of value no greater than $300,000 - if the buyer will use as his residence for at least 50% of time during the first two years of purchase and the “amount realized” is no greater than $300,000, no withholding is required. Foreign seller is still required to report his gain on U.S. income tax return.

(ii) withholding certificate obtained – withholding can be reduced or eliminated if the seller applies for (generally with Form 8288-B) and obtains from the IRS a “withholding certificate,” if actual tax on gain is less than 10% of gross.

B. The estate (and gift) tax.

1. The estate tax - the estate tax is imposed on a foreign decedent’s taxable estate at rates of up to 40% (currently), although there is a tax credit equivalent to a value of $60,000. For a foreign deceased, the “taxable estate” generally consists of “U.S.-situs assets,” which generally includes U.S. real property and ownership interests in U.S. entities, with some still-unsettled rules concerning pass-through entities such as partnerships

2. The gift tax is a close relative of the estate tax, imposed on the value of gifts made prior to death. However, there is a big exception that does not apply to the estate tax: intangible assets, including stock of corporations, are not subject to the gift tax, when the donor is a foreign individual. This provides planning opportunities.

V. Basic Planning Alternatives.

As noted above, the main tax planning concern for foreign individuals investing in U.S. real estate is to avoid the U.S. estate tax without causing tax problems that would not otherwise arise under direct ownership. Some of the problems that could arise:

(i) imposition of the gift tax on putting a structure in place to avoid estate tax;

(ii) losing the availability of the 15%/20% long-term capital gain rate under the income tax by using a corporation; and

(iii) multiple tiers of income taxation which could arise if using a corporation as part of the plan.

Basic Planning Alternatives (continued).

A. Using a foreign (non-U.S. corporation - holding U.S. real estate through a foreign corporation in a non-tax jurisdiction (commonly referred to as a “tax haven”) avoids the U.S. estate tax simply because stock of a foreign corporation is not considered to be a “U.S.-situs” property.

1. Benefits - simplicity, flexibility.

2. Disadvantages:

a. possible imposition of the U.S. “branch profits” tax, which applies only to foreign corporations;

b. the loss of 15%/20% long-term capital gain rate, since corporations pay ordinary rates (up to 39.6%) on capital gains; and

c. dealing with succession issues, how to pass the stock upon death.

Basic Planning Alternatives (continued).

B. Using an irrevocable trust - irrevocable trusts are commonly used in U.S. estate planning, but foreign individuals are often leery of turning over control to a third party “trustee”.

1. Benefits- avoids the disadvantages of using a foreign corporation, especially the loss of the 15%/20% income tax rate on gains.

2. Disadvantages:

(a) inflexible - in order to avoid inclusion of trust assets in the U.S. taxable estate of the trust creator, the trust must be irrevocable;

(b) very limited beneficial interest and control retained by creator.

C. Taking a chance - the foreign individual can simply take a chance that he will dispose of the property before being

hit by a bus.

VI. Risks to “withholding agents.”

A. Obligations of “withholding agents” – in the context of foreign owners of U.S. real estate, a “withholding agent” is a party that is required to withhold a portion of a payment to a foreign person and remit the withheld portion to the U.S. Treasury. Withholding obligations will generally arise on rental paymentsand/or on proceeds on the sale of the property.

B. Penalties for failure to withhold – can be “draconian”: the agent can be responsible for the tax, as well as for interest and extensive penalties for failure to withhold and report the payment and withholding.

C. Penalties for failure to provide notice of false statement or certification – on sales of real estate, there are also penalties for failure to notify parties to a transaction if, for example, a foreign seller provides a “certificate of non-foreign status” and the agent knows that the seller is a foreign person. The class of persons to whom this obligation applies is broader than the

class obligated to withhold.

D. Who is a “withholding agent”? The definition of “withholding agent” differs somewhat based on whether the withholding is for rental payments or for the proceeds of the sale of real property:

1. Rental payments - the IRS regulations define “withholding agent” for this purpose rather broadly:

“Any person, whether U.S. or foreign, that has the control, receipt, custody, disposal, or payment of an item of income of a foreign person subject to withholding” [Reg. Sec. 1.1441-7(a)(1)].

The regulations contemplate that there can be multiplewithholding agents with respect to any particular payment, but withholding by one relieves the others from any obligation or liability.

Thus, if a property manager for commercial real property collects rental payments from tenants in Houston and remits the rent to a foreign owner, both the tenant and the manager are “withholding

agents.” If the manager withholds, however, the tenant is off the hook.

D. Who is a “withholding agent”? (continued) :

2. FIRPTA withholding - for the most common FIRPTA transaction, the sale of real property by a foreign owner, the IRS regulations provide simply that the transferee is the withholding agent. This greatly reduces the number of people who might be held responsible for the 10% withholding tax, at least with respect to IRS penalties, but there could be lawsuits if a realtor for a buyer or a title company failed to advise the buyer of his FIRPTA withholding obligations.

More significant in the FIRPTA context is the previously-mentioned obligation of both “transferor’s agents” and “transferee’s agents” to notify both the parties involved and the IRS if the agent has actual knowledge that a certificate of non-foreign status is false. (As a practical matter, this should include “have good reason to suspect that the certificate was false but did nothing about it”.) An agent for a foreign corporation seller is deemed to know that the corporation is a foreign person.

E. How to know whether the payee/recipient is a “foreign person” As with the definition of “withholding agent,” the rules for identifying a foreign payee differ somewhat based on whether the withholding is for rental payments or for the proceeds of the sale of real property:

1. Rental payments - the IRS has complex “presumption” rules in this regard, but frankly, most lessees have no idea what these rules are and instinctively rely on the “we know one when we see one” method, that is, if the lessor has a U.S. address and does not speak with too strong an accent, the lessee assumes that there is no special reporting and withholding requirement, especially if the lessee is an individual leasing the property for his personal use. The lessee is often right. Nevertheless, if he (the lessee) is wrong, he is potentially liable for the 30% withholding tax plus interest and penalties. The best way to be safe is for the lessee to require one of the following forms from the lessor (as long as the lessor does not have actual knowledge that is form is false):

(i) Form W-9 – the form requires the lessor to provide a U.S. social security number (or “individual taxpayer identification number”) and a promise by the lessor that he is a U.S. person;

(ii) Form W-8BEN – the lessor promises that he is a foreign person and is therefore subject to 30% withholding; or

(iii) Form W-8ECI – the lessor promises that he is a foreign person, but also swears that the rental activity is a “trade or business” (including by making a “net basis election”) and that he will dutifully file a U.S. income tax return to report the rental

income, thereby relieving the lessee of the obligation to withhold.

E. How to know whether the payee/recipient is a “foreign person.” (continued).

2. FIRPTA withholding – as with withholding on rental payments, a buyer of U.S. real estate can take a chance that the seller is not a foreign person, but if it turns out that the seller is a foreign person and the buyer did not withhold, the buyer will be liable for the 10% withholding amount plus interest and penalties. The more prudent buyer –and his realtor who is advising him – will insist on one of the following written instruments, on which the buyer can rely if he has not actual knowledge that it is false:

(i) a certificate of non-foreign status – an IRS regulation sets forth what such a certificate must contain, including the individual seller’s social security number. If the buyer requests such a certificate but the seller does not provide it, the buyer should presume that the seller is foreign and do the withholding, so says the IRS; or

(ii) a withholding certificate issued by the IRS – which eliminates or reduces the withholding. If the seller has requested such a certificate but has not received it by the time of closing, there are special rules as to what the buyer must do;

(iii) if a foreign seller is able to convince the buyer to rely on the $300,000 personal residence exception, the agent of the buyer should obtain an “affidavit of intent” from the buyer whereby the buyer acknowledges that he must comply with the rules for use of the property as a personal residence for the time required and intends to so use the property.

This list is not exhaustive, but covers most transactions in which realtors are involved.

BOTTOM LINE:

In this modern, globalized economy, especially in Houston with its very large multi-national population, a real estate agent faces substantial exposure to either being personally liable for withholding tax or to liability to his/her client for failing to protect him/her from such tax liability. As with other such professional risks, this risk can be minimized with attention to the rules, proper due diligence, and a good insurance policy.

THE END