International investors in U.S. real estate need to consider how their choices in investment structure can affect the U.S. income taxes and reporting requirements to which they may be subject. International investors with direct ownership or an investment in U.S. real estate through a partnership or other pass-through entity may be required to file federal, state, and local income tax returns. However, an indirect investment through a corporation may limit their U.S. tax filing obligations.
An investment in a domestic real estate investment trust (REIT) can prove to be a more beneficial investment structure for certain international investors. U.S. REITs are generally not subject to U.S. income taxation when certain criteria are met. Instead, the shareholders of the U.S. REIT are subject to U.S. taxation upon receipt of a distribution from the REIT. International investors in U.S. REITs may generally receive ordinary dividend income, capital gain distributions and return-of-capital distributions. An effectively managed REIT can prevent U.S. tax return reporting requirements for certain international investors and reduce U.S. taxation.
Overview of effectively connected income
Generally, when an international investor engages directly (or through a partnership) in a trade or business in the United States, all income from sources within the United States connected with the conduct of that trade or business is considered effectively connected income (ECI). ECI is taxed at the same graduated rates that apply to U.S. citizens, resident aliens and corporations, and international investors who receive ECI during the tax year will be subject to U.S. federal, state and local tax filing obligations.
The IRS requires certain kinds of investment income be treated as ECI if they pass either an asset-use or a business activities test. If the income is associated with U.S. assets used or held for use in the conduct of a U.S. trade or business, or if the activities of a trade or business conducted in the United States are a material factor in the realization of the income, the income is likely taxable ECI. Rental income from real estate used in a U.S. trade or business usually passes both tests and therefore is ECI. Additionally, any gain or loss from the sale or exchange of U.S. real property interests (whether or not they are capital assets) will likely be taxed as ECI.
The Foreign Investment in Real Property Tax Act of 1980
Any gains or losses from the sale or exchange of U.S. real property interests (USRPI) or of interests in U.S. real property holding corporations (USRPHCs) are taxed as ECI.
A USRPI is defined as an interest in real property located in the United States or the Virgin Islands and any interest in a domestic corporation, unless established otherwise. A USRPHC is any corporation where the fair market value of its USRPI is greater than or equal to 50 percent of the fair market value of its real property everywhere plus any other trade or business assets held for use. The disposition of a USRPI or USRPHC by an international investor is subject to income tax withholding.
REITs other than those that invest only in mortgages are typically USRPHCs; however, there are specific exceptions that can apply. For example, REITs that are controlled 50 percent or more by domestic investors are not USRPHCs and their international investors would not be treated as owning a USRPHC. Other exceptions exist for less than 10 percent owners of publicly traded REITs, qualified international pension funds and certain qualified shareholders. In order to ensure that they are able to take full advantage of the benefits that an investment in a REIT can provide, international investors should make sure they understand the specific type of REIT in which they are investing.
Corporation and REIT distributions
Both corporations and REITs make distributions that will generally be treated as either dividends, capital gains or return of capital to their shareholders. A dividend is any distribution of cash or property made by a corporation to its shareholders out of its earnings and profits from the current taxable year and then from accumulated earnings and profits from prior years. Additionally, a REIT may designate a portion of the dividend as a capital gain distribution, limited to the net capital gain recognized by the REIT during the taxable year. If there are no earnings or profits available for a distribution, the distribution is considered a return of capital for the shareholder and is therefore nontaxable to the extent the shareholder has basis in the corporate or REIT shares.
Certain income such as dividend and interest income may be considered as fixed, determinable, annual, or periodical (FDAP) income. FDAP income is generally all income that is not considered ECI, and international investors are subject to a flat 30 percent withholding tax on all FDAP income subject to reduction under a relevant income tax treaty. A corporation or REIT can earn income—pay any applicable federal, state and local taxes—then distribute FDAP dividend income to its international investors that will be subject to withholding. However, a REIT will be able to take advantage of a deduction for dividends paid to offset its taxable income, which means it can effectively re-characterize its rental income from ECI to FDAP without the burden of two layers of tax to which a regular C corporation may be subject.
Ordinary dividend income
Ordinary dividend income received from a U.S. REIT is generally subject to 30 percent U.S. withholding tax. This withholding tax can be reduced when an international investor qualifies for U.S. treaty benefits and provides valid and complete U.S. withholding tax documentation to the U.S. REIT. The withholding tax on ordinary dividend income is reduced to 15 percent in most U.S. income tax treaties. However, certain investors may be able to qualify for a 0 percent withholding rate on ordinary dividend income.
Capital gain distributions
REITs may elect to treat part of a distribution to an investor as a capital gain distribution when the REIT recognizes gain on disposition of U.S. property. Capital gain distributions to international investors are generally subject to U.S. income tax. U.S. REITs are generally required to withhold U.S. income tax at highest applicable rate on behalf of the international investor. Further, the receipt of a capital gain distribution generally gives rise to a U.S. income tax filing obligation for most international investors.
Gain on disposition of REIT shares
Generally speaking, international investors are subject to U.S. taxation on any gain realized on disposition of a U.S. REIT. However, if the REIT qualifies as a domestically controlled REIT, then the international investor may not be subject to U.S. taxation on the disposition of the REIT. REITs are considered domestically controlled when more than 50 percent of the ownership of the REIT is by U.S. persons.
Return of capital distributions
Similar to the gain on disposition of REIT shares, return of capital distributions that exceed basis in the stock are subject to U.S. taxation unless the REIT qualifies as a domestically controlled REIT.
