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Update on foreign investment in US real property

Investment in US real property by non US investors has been significant for several decades, and is expanding dramatically in dollar value and the countries of the major investors. Investors from new venues, such as China and Russia, have joined investors from traditional venues, such as Europe and the Middle East. This article is designed to provide a basic introduction to the framework for investment, particularly for the new entrants.

The Basics. Real estate is regulated and taxed by the US federal government, and also by states, cities and other localities. Except for taxation, the federal government has a limited role in the development and ownership of real estate; this is largely reserved to state and local governments, although real estate laws are generally consistent among the states. Substantial taxes are levied at all levels of government. However, due to the use of depreciation and interest deductions, and the favourable treatment of capital gains, real estate is generally considered a tax advantaged form of investment.

Most land is owned by private parties in fee and in perpetuity, and can be freely traded with a limited government involvement. While ground leases are widely used, they are not required by law.

The acquisition and disposition of real estate is largely unregulated, and the operation of real estate is lightly regulated (except for development, land use and a few areas of public policy concern, such as rental of residential real estate). Most regulation is ministerial, and is neutral as to the nationality of investors. Under ordinary circumstances, there are no controls imposed on capital movements into and out of the US.

Investors have a wide choice of investment structures and vehicles (for example, corporations, partnerships, limited liability companies, trusts). The limited liability company has become a favoured and flexible choice since its first adoption in 1977, but may not be recognized by laws in other countries. Investment vehicles can be quickly and easily formed. Ownership can generally be kept confidential in the ordinary course, using appropriate structures and investors can generally be shielded from personal liability through the use of intermediary investment vehicles. Investors who do not invest through appropriate structures can become liable for US estate tax (for individuals) and other personal liabilities and become subject to the jurisdiction of US tax authorities.

There are exceptions to the general rule that non US investors can invest on par with domestic investors. First, there are laws of general application, such as the Patriot Act and anti-money laundering and embargo laws that prohibit targeted foreign investors from investing or restrict capital flow. Second, licensing for particular businesses, such as liquor licenses, mining and agriculture, may restrict foreign ownership. Third, banks and other intermediaries have adopted "know your customer" laws that require disclosure and complicate cross-border transactions. Fourth, there are reporting requirements specific to non-US investors in real property, but the filings are generally confidential and not burdensome.

Tax. Foreign investors should pay particular attention to tax structuring, which should be addressed before any investment is made and should, to the extent feasible, reflect the full range of the investor's contemplated activities, not just an initial investment. The primary concern relates to taxation of income (including withholding), at the federal level, although the reach and complexity of state and local taxation is increasing. Unlike US citizens and permanent residents, foreign investors are only taxed on their US sourced investments. Some threshold issues relating to this complicated topic:

The Federal regime taxes passive income (for example, interest, dividends and rentals under net leases) differently than active income. The former is generally taxed at a 30% withholding rate; the latter is taxed consistent with rules for US taxpayers. The withholding rates and other rules will be ameliorated, and sometimes eliminated, by any applicable tax treaty rules. There is no single strategy that best addresses tax efficiency on a global basis, and any strategy needs to be tailored to the actual investor, and its other concerns, including non-tax issues. Increasingly, use of tax treaties has been limited to taxpayers with a significant nexis to the treaty counterparty (the "anti-Treaty shopping" rules). However, use of blockers, affiliate debt and other devices can materially reduce the effective rate of taxation. It is often possible to structure investments as debt (or debt with equity characteristics), and thereby to achieve more favourable tax results, such as reduction or elimination of taxation (including FIRPTA). Use of real estate investment trusts (REITs) can reduce taxes, but REIT investments may be subject to FIRPTA on disposition.

Other taxes, generally at the state and local level, can be significant - transfer tax, mortgage recording tax, real property tax and sales tax - but these are levied without regard to the nationality of ownership.

A significant, and particular, concern for foreign investors is the FIRPTA tax imposed by the Foreign Investment in Real Property Tax Act of 1980, which imposes a tax on gain realized from direct and indirect transfers of US real property interests by a foreign person, calculated at regular tax rates. FIRPTA is enforced by withholding on payments or distributions to the foreign person holding the direct or indirect interest, generally at the rate of 10%. The withholding obligation extends to distributions by an entity to its foreign owners, and is an issue for the repatriation of profits. Withholding is waived if the parties follow a specified procedure to calculate the actual tax due.

The Rest. This is only a brief introduction to a very large topic. Good luck!.