In 1980, the U.S. Congress passed the Foreign Investment in Real Property Tax Act, more commonly known by the acronym FIRPTA, to tax foreigners' gains on income from and sale of U.S. real estate and other real property. Before FIRPTA became law, the U.S. had no way to tax foreigners on these profits. Now, FIRPTA requires withholding from a foreigner's rental income as well as withholding from a foreigner's gains (or losses) upon disposal of U.S real estate.
FIRPTA regulations pose significant costs to foreign investors in U.S. real estate. For example, under FIRPTA, a foreign investor who holds U.S. real estate as a passive investment (i.e., with any type of net lease) must withhold 30 percent of the gross rental income, which includes expenses that net-lease tenants pay. In addition, when a buyer purchases U.S. real estate from a foreign seller, the buyer is responsible for ensuring that 10 percent of the purchase price is withheld. Although the seller owes the taxes, placing the onus on the buyer allows the IRS to collect its tax revenue when, after disposing of the U.S. real estate, the seller may have no connection to the US. The 10 percent withholding represents a significant cost to a potential foreign buyer of your property: upon subsequent sale of the foreigner's investment, he or she will have to transfer 10 percent of the sale price to an escrow account. This regulation is particularly costly to a foreign seller if the sale will be at a loss or if the foreign seller's tax liability will be less than the 10 percent withholding. The foreign seller can apply to the IRS for a reduction of the withholding; however, the IRS review can take up to 90 days, during which time the seller will not have access to the funds that exceed the amount he or she will ultimately owe in taxes.
Together, the withholdings on rental income and gain or loss from sale are substantial disincentives for potential foreign investors. All else being equal, global demand for U.S. real estate, and thus, global competition to purchase your commercial property, is lower than it would be without FIRPTA. The news is not all bad, though. In July, a bipartisan group of Senators introduced legislation that would allow greater FIRPTA exemptions for foreigners investing in real estate investment trusts (REITs). "Although the partial FIRPTA repeal proposed as part of the Real Estate Investment and Jobs Act of 2013 would not directly affect private real estate transactions, it is likely that sellers would experience benefits of a ripple effect throughout the real estate market," said Jack Rose, Chief Strategist for Breakwater Equity Partners. "For now, though, it is important for foreign owners to plan ahead because selling their commercial properties will require a substantial amount of capital and time."