From a U.S. federal income tax perspective, the main obstacle facing foreign persons who invest in U.S. real estate is the Foreign Investment in Real Property Tax Act (FIRPTA), more specifically section 897. Under this provision, any gain recognized by a foreign person on the disposition of a “United States real property interest” (USRPI) will be treated as if such gain were effectively connected to a U.S. trade or business and, therefore, subject to U.S. federal income tax at the graduated rates that apply to U.S. persons.
One possible strategy to avoid FIRPTA involves the use of a shared appreciation mortgage (SAM). In a typical SAM arrangement, a lender provides a developer with a loan bearing a below-market fixed rate of interest, plus a share of the profit on a subsequent disposition of the property.
Foreign persons typically are not subject to U.S. federal income tax on U.S. sourced capital gains unless those gains are effectively connected to a U.S. trade or business. A USRPI is broadly defined as 1) a direct interest in real property located in the U.S., and 2) an interest (other than an interest solely as a creditor) in any domestic corporation that constitutes a U.S. real property holding corporation.
But simply owning a USRPI does not necessarily lead to any adverse tax consequences under section 897. Rather, a non-U.S. taxpayer will be subject to tax under that provision only when the USRPI is “disposed of”, as stated in Reg. 1.897-1(g). Taxpayers may attempt to use debt instruments with contingent interest features to avoid IRC section 897.
WITHHOLDING ON U.S. SOURCE INTEREST
By characterizing the contingent payment in a SAM as interest (and not a disposition of a USRPI) for tax purposes, section 897 regulations potentially allow non-U.S. taxpayers to avoid U.S. federal income tax on gain arising from the sale of U.S. real estate, if structured correctly. Specifically, non-U.S. taxpayers are generally subject to a 30 percent withholding tax (unless reduced by treaty) on certain passive types of U.S. source income, including interest. An important exception to this rule exists for “portfolio interest”, which is exempt from withholding tax in the U.S.
There are, however, a number of exceptions to portfolio interest, including certain “contingent interest” (section 871(h)(4)(A). Therefore, a payment on a SAM that is otherwise treated for U.S. federal income tax purposes as interest will not qualify for the portfolio interest exemption if the payment is contingent on the appreciation of the financed real property.
Currently, there are at least 11 jurisdictions that have concluded income tax treaties with the U.S. that contain provisions that entirely eliminate U.S. withholding tax on interest, including contingent interest, paid from the U.S. to the respective treaty jurisdiction: Czech Republic, Finland, Germany, Hungary, Iceland, Norway, Poland, the Russian Federation, the Slovak Republic, Sweden, and Ukraine.