FIRPTA: Flagged for Review

In the early 1980s, with overseas investors hovering over American farmland and commercial properties, Congress set in motion the Foreign Investment in Real Property Tax Act in an attempt to limit foreign acquisition of U.S. real estate.

Over 30 years later, FIRPTA, as it is known, is under the spotlight again, with the nation’s real estate industry eager to reform the legislation that requires of foreign investors a 10 percent withholding on the sale price of a property to ensure payment of taxes owed. Reforming the law, which also imposes a 35 percent capital gains tax on some property sales, it is argued, will further open up the U.S. real estate market to foreign investors.

Real estate’s most prominent tax professionals have their eye keenly focused on the arguments as they continue to work on behalf of clients to both better understand the implications of FIRPTA and devise creative ways to limit its impact on returns.

“The feeling is that FIRPTA cuts down on a community of enthusiastic buyers into U.S. real estate,” said Larry Varellas, managing partner of the tax group at Deloitte. “The market is smaller than it would be if FIRPTA was reformed.”

Both industry groups and members of Congress have moved to remove the restrictions in the U.S. tax code that, in their minds, discourages foreign investment in commercial real estate. In August, Kevin Brady (R-Texas) and Joseph Crowley (D-N.Y.) announced bipartisan legislation to reform FIRPTA, backed by the Invest in America Coalition, a lobby with prominent members such as the Real Estate Board of New York and Brookfield.

The proposed reform would increase the ownership cap that determines tax payments on particular transactions. Under current stipulations, FIRPTA requires investors pay tax if they sell shares in a real estate investment trust in which they own 5 percent or more. The proposal would increase that cap to 10 percent.

The proposal does not include changes to other components of FIRPTA, such as the taxes levied on foreign investors who sell a majority share of a property. A vote has not yet been scheduled on this proposal, but similar legislation proposed in 2010 passed through the House of Representatives before falling by the wayside in the Senate.

“Congress singles out no other industry with negative tax treatment as we do in the real estate industry,” Mr. Crowley said during a conference call announcing the legislation.

Indeed, foreign investors are not taxed in other asset classes, such as stocks and bonds, as they are in real estate.

“Foreigners are generally only taxed on income earned by a U.S. trade or business but not capital gains,” said Tim Larson, partner in charge of the tax department at Marcum LLP.

“On a comparative basis, if a foreign party owns stock in Google and sells it at a gain, that gain is not taxed in the U.S.,” Mr. Varellas noted.

Until the day when the tax code is reformed to become more hospitable to foreign buyers, tax professionals are required to work in overdrive to offer advice to clients on innovative deal structures and ways to limit the amount of tax withholdings.

With gains on stock free from capital gains tax restrictions, one of the most prominent ways for foreigners to make real estate investments is to do so through an REIT—with the caveat that those REITs be domestically controlled and predominantly used by U.S. investors.

“I think you’ll see that structure more and more so they can get their money out without paying a tax,” said Mark Bosswick, co-managing partner of Berdon LLP.

The REIT option is not without its complications and drawbacks. According to Mr. Varellas, in the case of private REITs, the sale of real estate within that REIT and the subsequent distributions to shareholders attributable to that sale are taxable under current rules. “That’s probably the most severe example,” he said. “There is momentum to get that rule changed.

Perhaps the most well-known and prohibitive stipulation of FIRPTA is that 10 percent of the gross proceeds of a property sale is withheld as a deposit against gains.

“Anytime a foreign person is selling real property, he has to withhold 10 percent of the sales price and hand that over to the IRS,” Mr. Larson explained.

However, problems arise when the 10 percent withholding does not accurately reflect forthcoming taxes.

“Let’s say you have a sale now in 2013 and you are over-withheld. Usually you have to wait to get the refund, and that can put financial pressure on sellers,” said Deirdre Joyce, international tax senior manager at Rothstein Kass.

That’s where the tax pros come in: There is an opportunity to reduce the withholding by petitioning the Internal Revenue Service for what is known as a withholding certificate.

“I worked with a couple of individuals this year who sold property, and, though FIRPTA applies, we go through a procedure whereby we petition the IRS for a reduced withholding certificate,” Mr. Larsen said.

Withholding certificates may be requested on behalf of a property transferor and are issued should the IRS determine a series of parameters are met, including that the amount withheld exceeds the maximum tax liability.

“More often than not, the transferor doesn’t have to withhold the 10 percent, because there’s ways to navigate around it,” Mr. Larsen noted.

For U.S. property owners trying to attract foreign capital, it can be a challenge to present deals that are structured in a way to make investment more appealing.

“Some foreigners won’t buy into U.S. real estate for this reason, and those that do have challenges and structural complexity to try to minimize the impact,” Mr. Varellas said.

Ms. Joyce noted some of her clients have attempted to tackle the problem by attempting to set up a hedge fund structure to attract foreign investment. Others might use a corporation so all property sales and taxes are handled at a corporate level.

Some prominent commercial transactions with foreign investors in recent months have used a minority-share joint-venture structure, which may have been motivated by the desire to minimize the impact of FIRPTA.

Among those deals was the sale of a 40 percent stake in the General Motors Building to the family of Chinese developer Zhang Xin and the Safra family of Brazil. The $1.4 billion deal, which closed in May, valued the trophy tower at approximately $3.4 billion.

“A lot of foreign investment comes from minority shares,” noted Matt Bonney, partner at Citrin Cooperman. “We don’t deal with FIRPTA much, because a lot of our foreign investment clients don’t have majority control.”

Though some tax professionals identify FIRPTA as a significant barrier to entry for foreign investors interested in the U.S. real estate market, others argue its impact is, in fact, minimal.

“I think its part of the cost of doing business,” Ms. Joyce said. “If someone doesn’t want to pay taxes on gains coming from the U.S., they shouldn’t make the investment.”

Indeed, where FIRPTA is truly evident as a deterrent is in the individual residential market.

“One place you do see FIRPTA is when you’re dealing with an individual buying second, third and fourth residences,” Mr. Bonney said.

Many other countries enforce similar systems, accountants noted, though the system in the United States was labeled both “imperfect” and “arduous” by industry insiders.

“In most countries, if you have investment in real estate, that’s going to be taxed locally,” Ms. Joyce added.

Despite differing opinions on the true cost of FIRPTA, all accountants agreed on one thing: Preparing for the inevitable is a key to success.

“I think it’s important that if someone is thinking about making an investment that they get advice ahead of time and make sure there aren’t any hidden surprises,” Ms. Joyce said. “There are opportunities to do planning and structuring.”

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