It is Time to Modify FIRPTA

The commercial real estate market needs money. We need investment dollars to pour into the market. Should we encourage foreign investment? Do we really care where the cash comes from? As Jerry McGuire’s client  said, “Show me the money”! FIRPTA creates a speed bump for foreign capital. It may be time for a change.

The Foreign Investment in Real Property Tax Act (FIRPTA) is a statute that requires that a seller, who is a foreign person, permit a withholding of a part of the selling price (generally 10%) against the United States gains taxes that the foreign person will owe on capital gains earned on the sale of  real property.

A foreign person, for federal income tax purposes, is generally any person who is not either a resident alien or a United States citizen.  If an owner of real property is an entity formed outside of the United States, it is also deemed a “foreign person” under the IRS code.

The FIRPTA law creates a tremendous disincentive for foreign entities to invest in domestic real estate.  This primary obstacle facing non US investors who invest in US real property – the FIRPTA – should be repealed. The law has profound implications for non US investors in US real estate. FIRPTA’s discriminatory application (aimed solely at real estate) coupled with onerous reporting requirements impedes foreign investment in US real property, which in turn, has negative effects on the vitality of the US economy.

FIRPTA was enacted in 1980.  A senator from Michigan was concerned about farm land and wanted to protect “the American heartland” from foreign interests. The world has changed, but FIRPTA has not. Many of the rules that were written in the 1980s look outdated and unsuited to modern investment  practices because they were written with a particular paradigm in mind, that being a single foreign investor or a small group of foreign investor acquiring US real property.

Today, investments in US real property are being made in many different forms. They include REITs owned in part by foreign persons, private equity partnerships, and collective investment funds organized outside the US, making ultimate ownership difficult to determine.  

The United States generally has no jurisdiction to tax foreign persons on capital gains that are sourced within the US, unless those gains are “effectively connected with a US trade or business”.  The US taxation of international investors is governed by either the Internal Revenue Code or income tax treaties that the US has signed with other nations.

Non US investors in US real property are subject to fundamentally different US federal income tax rules than those that apply to their investments in US corporations or other capital assets.  Most notably, a foreign person’s gains attributable to the disposition of capital assets other than US real property interests are not subject to US tax. FIRPTA discriminates against the asset class of real property.

Credit availability in our market today is scarce creating a greater need for equity. Foreign investors and entities are a tremendous potential source of this greatly needed equity. Unfortunately, many foreign sources of equity investment have expressed little desire to make investments in US real estate when future gains will be taxed at marginal rates ranging from 35 to 50 percent, according to The Real Estate Roundtable.  These sources of potential investment are looking for positions as lenders with contingent interest debt instruments to minimize their incidence of taxation in the United States.  Property owners are reluctant to offer senior positions in the capital stack that could effectively diminish future upside in their investments.

The US tax system should not be a barrier in the competition for institutional investment in real estate.  As emerging economies grow, destinations for international institutional capital will grow and the US has to be competitive in this global market.

The US real estate market has benefitted immensely from having an open ecomony that allows for the free flow of capital and goods with foreign trade partners.  The continuation of policies such as FIRPTA will have negative effects on both real estate markets and the US economy. Foreign investors should be allowed to invest in US real property without any more disclosure other than that required of a US investor.  Similarly, tax law affecting foreign investment in US real property should not be any more burdensome to foreign investors in the US than those that apply to US investors.

Our market needs capital and if the foreign market wants to provide that capital, we should encourage that investment.

4 Responses to “It is Time to Modify FIRPTA”

  1. 1 Ken Dreifus - Dreifus Realty-Funding, LLC April 1, 2009 at 9:13 pm

    The proposal to change FIRPTA is coming from an interested party, and is misguided. I sympathize with Mr. Knakal’s desire to increase realty sales; however, there are ample ways for foreigners to compete in the real estate market in an equitable way. Were they to create a domestic entity, it would be taxed at domestic rates. Repealing FIRPTA would put U.S. investors at a disadvantage because they would be taxed on earnings or appreciation, while foreign nationals might potentially escape taxation, especially if the foreign investor did so under a pseudonym for whatever reason. The disadvantage cited by Mr. Knakal regarding different kinds of investments should be addressed so that real estate and paper investments are treated the same – which again increases fairness to everyone.

  2. 2 rknakal April 2, 2009 at 9:52 am

    Hi Ken, You know that I like and respect you very much but you will have to do a much better job of convincing me that my position on FIRPTA is “misguided”. Here is why:

    Yes, I am an interested party. It is rare to see someone take a passionate position about something without being self-interested. I love my profession and will do what I can to do what I believe will make it better for all involved.

    If a foreigner forms a domestic entity, they are no longer a foreigner. Your thesis suggests that every US investor pays all of their taxes without exception. You can’t believe that. Should withholding be taken on each and every sale? Moreover, sovereign wealth funds are not able to form domestic entities and are capable of providing billions in liquidity to our market.

    Additionally, “hiding” behind a pseudonym does not really work and could be done by a domestic investor with the same results as a foreigner.

    Since the enactment of FIRPTA, there have been several changes in the tax law that have eliminated the ability to avoid US tax on the disposition of US real property through the use of the pre-FIRPTA techniques. For example, the like-kind exchange rule was amended in 1989 to provide that US and foreign real property are not like-kind property.

    The discrimination against real estate is tangible and you seem to agree with that position. Foreign investors, who make passive investments in US investment assets, including particularly stocks and bonds, are generally exempt from US taxation under either the Internal Revenue Code or applicable tax treaties. A passive investment in real estate is the notable exception to this general rule, even if the investment is in the form of stock investments such as shares in a REIT. This disparity has greatly reduced the willingness of foreign persons to invest in US real estate.

    This law was established out of fear. Xenophobia is not a reason to harm our economy or our market. Last I checked, I have never seen a foreign investor pick up a building and ship it back to the old country. While Treasury has been exceptionally active in attempting to open up the credit markets, it takes time for its policies to become effective. New sources of capital will assist in stabilizing the markets over the next 2-3 years. The global investment community’s confidence in US markets has been badly shaken from the residential mortgage crisis. The US tax code should not be a barrier to the competition for institutional investment in real estate.

  3. 3 Ken Dreifus - Dreifus Realty-Funding, LLC April 2, 2009 at 10:18 am

    Bob – let’s clarify several points. Every real estate professional is an interested party to what’s happening, so I don’t want you to take my earlier remarks personally. I am confused, however, about several of your remarks.

    A. I am not aware of any restriction on a sovereign wealth
    fund creating a U.S. entity in order to be taxed at U.S. rates.

    B. You seem to be concerned that the withholding of tax on foreign investors as a deterrence to participating in the U.S. real estate market.It doesn’t seem to have hurt to date. The U.S. is still the center of the financial world, and paying taxes is a cost of doing business that really should be included in any investor’s computation of rate of return.The purpose of the existing IRS regulations is to insure that all investors pay their share of taxes on earnings and appreciation, rather than have it fall exclusively on U.S. persons. Were the withholding requirement lifted for foreign entities not having a U.S. vehicle, you and I both know that you could kiss those tax revenues good bye, regardless of whether the investor had registered in a personal name, an LLC, or a pseudonym. As a U.S. taxpayer, I am befuddled by your position that the current laws are unfair, especially if I’ve agreed with you that the regs should be amended to provide equal treatment of real and paper investments.

  4. 4 rknakal April 3, 2009 at 10:58 am

    Hi Ken, just two follow-up points. 1) I believe that foreign investment would be greater without FIRPTA as it is not just about paying the tax. It is more about the tremendous disclosure that is associated with the paperwork. Clearly, we do not want the “wrong” money but the market is thirsting for capital at the moment. 2) If you want to keep FIRPTA than have similar requirements for all types of financial assets so that real estate is not discriminated against. It appears you agree with that position.

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