The role of REITs for foreign investors in US real estate

This item provides a high–level overview of how foreign persons are taxed in the United States generally and when they are required to file U.S. federal income tax returns. It then applies those concepts in the context of foreign investment in U.S. real estate and provides an overview of the rules of the Foreign Investment in Real Property Tax Act (FIRPTA), P.L. 96–499, which impose withholding tax and substantive tax burdens on foreign persons who dispose of a U.S. real property interest (USRPI). It concludes with an overview of tax structures commonly utilized by foreign investors for holding real estate investments, with particular emphasis on how a real estate investment trust (REIT) may offer unique advantages for foreign investors.

US taxation of foreign investors in general

Foreign persons, such as nonresident alien individuals, foreign corporations, and foreign trusts, are subject to U.S. tax on income connected to a U.S. trade or business (USTB), referred to as effectively connected income (ECI), and on passive U.S.-source income that is fixed, determinable, annual, or periodic (FDAP), such as dividends, interest, rents, and royalties (Secs. 871(a)(1)(A), 881(a)(1), and 1441(b)). Capital gains realized by foreign persons are generally not subject to U.S. taxation.

U.S.-source FDAP income paid to a foreign person is generally subject to a 30% gross withholding tax, assessed at the time of payment. If the foreign person is a qualified resident in a country that has an in–force tax treaty with the United States, the 30% withholding may be reduced or eliminated under the applicable tax treaty. Some exemptions may also apply to eliminate withholding on certain items of U.S.-source FDAP income, such as bank deposit interest paid to foreign persons and portfolio interest on certain debt obligations (Secs. 871(h) and 881(c)). In general, a foreign person who is not engaged in a USTB and only derives U.S.-source FDAP income is not required to file a U.S. tax return, provided the FDAP income was properly withheld upon at the source (Regs. Secs. 1.6012–1(b)(2) and 1.6012–2(g)(2)(i)).

A foreign person is subject to net–basis taxation on its ECI, generally in the same manner that a U.S. person is subject to taxation on its worldwide income. Under current law, a nonresident alien individual or a foreign trust is taxed on its ECI at graduated rates of up to 37%, and a foreign corporation is taxed on its ECI at a flat 21% rate. A foreign person itself does not need to conduct business operations within the United States to be considered engaged in a USTB. For example, a foreign person that is a partner in a partnership engaged in a USTB would be considered engaged in the partnership’s USTB activity (Sec. 875). Furthermore, a partnership that earns ECI is required to withhold on a foreign partner’s distributive share of such ECI, generally at the highest applicable tax rate (currently, 37% for individuals and 21% for corporations). A foreign person engaged in a USTB at any point in time during the tax year is required to file a U.S. federal income tax return irrespective of whether the person derives any income treated as ECI (Regs. Secs. 1.6012–1(b)(1)(i) and 1.6012–2(g)(1)(i)).

Application to investment in US real estate

Most foreign investors have a strong aversion to ECI or, more generally, being directly or indirectly engaged in a USTB, because it triggers a U.S. tax filing obligation. Although rental income generally constitutes FDAP income, in the context of U.S. real estate, it is often more favorable for such income to receive ECI treatment. This is because U.S. real estate investments typically generate taxable losses during the holding period, driven primarily by depreciation deductions. As noted above, FDAP income is subject to gross withholding tax, which means foreign investors would lose the benefit of claiming deductions to offset the gross rental income. ECI, however, is taxed on a net basis, which provides the foreign investor the benefit of offsetting the rental revenue with associated deductions. Losses generated from a USTB may also generate a loss carryforward that the foreign investor could potentially utilize to offset future ECI or ECI from other sources.

Many investors, both foreign and domestic, are not looking to hold U.S. rental real estate long term and simply earn rental income. Rather, they typically intend to dispose of their investment in U.S. real estate and capitalize on its value appreciation. Based solely on the foregoing discussion, both U.S. and foreign investors may consider investing in U.S. real estate directly or through a partnership. If the rental income is derived in the conduct of a USTB, both types of investors would accumulate losses during the holding period with respect to the rental activities. On exit, however, the foreign investor would escape U.S. taxation because capital gains recognized by a foreign person are generally not subject to U.S. tax. On the other hand, the U.S. investor would be subject to taxation on any gain recognized when disposing of the U.S. real estate. To address this disparate tax treatment and to level the playing field between foreign and domestic investors in U.S. real estate, Congress enacted FIRPTA.

FIRPTA: US taxation of foreign persons’ dispositions of US real property

FIRPTA treats gains or losses from a foreign person’s sale of a USRPI as ECI (Sec. 897). This means that, contrary to the general rule that foreign persons are not subject to U.S. tax in respect of capital gains, gains recognized on disposition of USRPIs are subject to U.S. federal income tax, and the foreign person is required to file a U.S. tax return as a consequence. As a means of ensuring compliance, FIRPTA also requires the buyer (transferee) of a USRPI to withhold 15% of the gross sale proceeds from a foreign seller and remit it to the IRS as a prepayment of the seller’s potential tax liability (Sec. 1445).

Though the concept of FIRPTA seems relatively straightforward, it is anything but that. The definition of a USRPI is far more expansive than what comes to mind when a layperson thinks of U.S. real estate. USRPI is defined as an interest in real property located in the United States or Virgin Islands and an interest (other than solely as a creditor) in any domestic corporation unless such corporation is shown not to be a U.S. real property holding corporation (USRPHC) during the five–year period preceding the date of disposition of such interest. A USRPHC is any corporation if the fair market value (FMV) of its USRPI is 50% or more of the sum of the FMVs of its USRPIs, foreign real property interests, and trade or business assets (Sec. 897(c)).

Outside some limited exceptions, FIRPTA will tax a foreign person on the disposition of a USRPI whether such property is held directly or indirectly through domestic corporations or partnerships. Proceeds realized by a foreign person in exchange for its interest in a partnership are, to the extent attributable to USRPIs held by the partnership, considered amounts received from the sale or exchange in the United States of such property (Sec. 897(g)). The FIRPTA rules also generally override nonrecognition provisions under the IRC (e.g., Secs. 351 and 721). A foreign investor caught unaware can trigger substantive tax and withholding tax under FIRPTA even when undertaking an internal restructuring where the investor still ultimately holds the underlying U.S. real property. Due to the far–reaching and complicated issues FIRPTA may present, it is imperative that foreign investors receive proper tax advice when contemplating investment in U.S. real estate.

Structuring foreign investment in US real estate: The REIT angle

Given all these complexities, a crucial first step in determing a tax–efficient investment structure is understanding the foreign investor’s investment objectives. A foreign investor who favors structural simplicity and who has no aversion to filing a U.S. tax return may prefer to own U.S. real estate either directly or through a partnership. A foreign investor whose primary concern is curtailing the risk of U.S. tax filings would generally prefer to hold U.S. real estate through a corporate “blocker,” even at the cost of lower returns on investment.

A REIT introduces an option for foreign investors entering the U.S. real estate market and may provide all the benefits of a “blocked” structure while sparing the investor from entity–level tax drag. In addition, as will be described in greater detail below, in certain circumstances, REITs may also afford a foreign investor the opportunity to exit through sale of the REIT stock without implicating FIRPTA.

A REIT is a domestic corporation that has elected special tax status under Subchapter M of the IRC (see, generally, Sec. 856). A REIT is generally subject to U.S. taxation in the same manner as any other domestic corporation but is allowed a dividends–paid deduction (DPD) in computing its taxable income. A REIT may also designate certain distributions as capital gain dividends (CGDs) which, as the name implies, has the effect of treating such distributions as long–term capital gains in the shareholder’s hands (Sec. 857(b)(3)). In order to benefit under this taxpayer–favorable regime, a REIT must satisfy specific technical qualifications with respect to its ownership, assets, and income. In addition, the REIT is required to distribute at least 90% of its net income (excluding capital gains) annually in order to maintain REIT status. REITs that distribute 100% of their income eliminate corporate–level tax via the DPD.

For foreign investors, investing in U.S. real estate through a REIT can offer numerous benefits. As a corporation, the REIT generally acts as a “blocker” and may insulate foreign investors from U.S. federal, state, or local tax filing obligations they might have if the U.S. real estate were held directly or through a partnership. The REIT may also afford more efficient taxation of rental income. As discussed previously, passive rental income from U.S. real estate generally constitutes FDAP income, which is subject to gross–basis taxation. FDAP treatment is often detrimental to foreign investors because they lose the ability to claim deductions, including depreciation deductions on the underlying property. Ordinary dividends from a REIT also constitute U.S.-source FDAP income to foreign investors, but ordinary dividends are limited to the REIT’s current or accumulated earnings and profits (E&P). Consequently, foreign investors indirectly receive the benefit of deductions against gross rental income when investing through a REIT because such deductions reduce the REIT’s E&P and, by extension, its ordinary dividends.

However, by no means does investment through a REIT guarantee foreign investors a lower tax burden or an exemption from filing a U.S. tax return. As noted, ordinary dividends from a REIT are considered FDAP income and are therefore subject to 30% withholding tax if paid to foreign investors. Foreign investors who are qualified residents in a jurisdiction with an in–force double–tax treaty with the United States may reduce this withholding under the applicable tax treaty, but ordinary dividends from REITs are generally subject to higher tax rates and special treaty qualifications. In addition, a CGD from a REIT that is attributable to a sale or exchange of a USRPI is taxable in the hands of a foreign shareholder as though the shareholder had directly disposed of the USRPI (Sec. 897(h)). Consequently, such CGDs constitute ECI in the hands of the foreign shareholder and are subject to U.S. withholding tax under the FIRPTA rules. In addition, the disposition of an interest in a REIT may also be subject to taxation under FIRPTA if the interest constitutes a USRPI, which will typically be the case for most REITs.

Above said, various exceptions may apply to mitigate the application of FIRPTA with respect to foreign investment in certain types of REITs. A CGD from a publicly traded REIT to a foreign investor is not subject to taxation under FIRPTA if the foreign investor did not own more than 10% of the REIT stock at any time during the five–year period preceding the date of distribution (Sec. 897(k)(1)(B)). A disposition by a foreign investor of stock in a publicly traded REIT will also not be treated as the disposition of a USRPI if the investor did not hold more than 10% of such stock during the five–year period preceding its disposition (Sec. 897(k)(1)(A)). An interest in a “domestically controlled” REIT (DCR) is also not treated as a USRPI; therefore, a foreign investor may generally dispose of its DCR stock without imposition of U.S. tax. A DCR is a REIT in which, at all times during the testing period (broadly defined as the five–year period preceding the date of disposition of its stock), less than 50% of the value of its stock was held directly or indirectly by foreign persons (Sec. 897(h)(4)(B)). Note, however, that the IRS issued final regulations in 2024 (T.D. 9992) that expanded “indirect” foreign ownership of REIT stock to include stock held by certain domestic corporations predominantly owned by foreign persons (so–called “look–through” corporations). The impact of these regulations may jeopardize DCR status of certain REITs that relied on such corporations to achieve “domestic control.”

If structured properly, investment in U.S. real estate through a REIT can eliminate a foreign investor’s U.S. tax filing requirements and minimize U.S. taxation on the foreign investor’s income. It is important for the foreign investor to work closely with its tax advisers during the subscription process to ensure the REIT has provided appropriate representations, such as maintaining DCR status, that will achieve the foreign investor’s desired tax outcome.

A tool for taking advantage of compelling opportunities

U.S. real estate offers compelling investment opportunities for foreign investors but also presents complex tax challenges. REITs stand out as potentially advantageous investment vehicles for foreign investors. They combine the benefits of corporate–level asset management with flowthrough tax treatment, allowing investors to access U.S. real estate markets while potentially minimizing exposure to U.S. taxation and filing obligations. In an environment where tax efficiency is as critical as investment performance, REITs may provide a powerful tool for foreign investors to navigate U.S. tax rules while capitalizing on the enduring strength of the U.S. real estate market.

Editor

Robert Venables, CPA, J.D., LL.M., is a tax partner with Cohen & Co. Ltd. in Fairlawn, Ohio.