In its continuing quest to stop tax abuse, the IRS recently issued FS-2005-16, which outlines two types of US real property transactions involving foreign (non-US) persons that the IRS views as abusive transactions designed to circumvent the US withholding tax. The two cases involve disposing of an option or a contract to acquire a US real property interest (USRPI) without remitting withholding tax, and a transfer of a USRPI by a foreign corporation to a foreign individual shareholder before it is sold to a third-party buyer. The fact sheet is intended to "remind all real estate and tax professionals of the withholding tax" applicable when a foreign person sells a USRPI. Under US tax rules, a buyer must inquire as to a seller's status as a US or foreign person, and a buyer--or anyone with control over the proceeds of sale, such as the real estate agent or the attorney who is handling the transaction--can be liable for the failure to withhold and remit the US tax.

Under FIRPTA, a foreign person (including a foreign corporation, company, partnership, trust, or individual) must pay US income tax on a gain on a USRPI's disposition. A USRPI includes many real estate interests, such as options for land, contracts to acquire land, leasehold interests, and condos and co-ops. The buyer generally must withhold and remit to the IRS 10 percent of the gross sales proceeds owing to the foreign person. The withholding is not a final liability, but it ensures that at least some tax is collected before proceeds from a USRPI disposition leave the United States' jurisdiction. The foreign seller must file a US income tax return to report the transaction and must pay any additional tax or receive a refund if the withholding exceeds the tax owing.

The first potentially abusive transaction described in the fact sheet involves options or contracts to buy real property that are sold before title to the real property is acquired. Although it may not be obvious to the parties that such an option or contract is a USRPI, the buyers must comply with the FIRPTA withholding procedures and the seller must file a US tax return and pay the related tax. The second transaction involves a seller taking advantage of the lower long-term capital gains rate for individuals (a maximum 15 percent federal rate if the property is held for more than one year) instead of the corporate capital gains rate (a maximum 35 percent federal rate). Foreign individuals often purchase US real property through a foreign corporation--historically, to avoid exposure to US estate tax (a tactic that may now prove ineffective). The fact sheet says that it is incorrect to claim that a shareholder, not the corporation, may report the gain from the sale and pay the tax. First, the foreign corporation may be treated as making a distribution to the foreign shareholder of the USRPI, a deemed sale that generates a corporate-level tax; in this case, it must withhold 35 percent (or other reduced rate) on the gain in the property. Second, the corporation may be treated as selling the USRPI directly to the third-party buyer, disregarding the transfer to the shareholder. Similarly, US corporate tax, not the lower individual capital gains tax, applies if the USRPI is owned by a US corporation unless its foreign owner can sell its stock rather than the USRPI.

No doubt the fact sheet was issued to put foreign persons on notice, but also to alert buyers and other withholding agents--especially the professionals involved in real estate transactions--to ensure that all persons involved in transfers of USRPIs by foreign persons are aware that the FIRPTA withholding tax regime has a long reach. The fact sheet also highlights that if a foreign purchaser acquires US real estate using a corporation to hold title, a much higher US income tax rate may be triggered when the property is sold, so long as the significant disparity between the individual long-term capital gains rate and the corporate tax rate continues. Foreign purchasers should consider using alternative structures to purchase US real property, such as a partnership, a trust, a tenancy in common, or individual interests, keeping in mind the possible exposure to US gift and estate tax issues as well as the income tax issues.