This article is produced by Withers real estate planning think tank, a group focused on innovative thinking and practical applications for our clients investing in US real estate, and follows an article by the group published September 24, 2020, about the IRS tax compliance campaign targeting non-U.S. owners of U.S. real estate. Click here to view the previous article.
With the impact of rampant U.S. federal government stimulus spending to address the coronavirus pandemic and the continuing impact of tax cuts under the 2017 Tax Cuts and Jobs Act (TCJA), the country is awash in red ink. Regardless of the outcome of next month's presidential and congressional elections, expect efforts to staunch this red tide. The IRS is rapidly gearing up to play its part in collecting more tax revenues. The IRS has made a sea change in its auditing approach in the deployment of its manpower, shifting from more traditional taxpayer-focused audits to more targeted issue-based examinations, education and guidance, with a focus on issues that the IRS' improved analytic data suggest have greater risks of noncompliance. The tax man's spotlight has shifted solidly of late to target real estate investment transactions by foreigners.
Spearheading these developments has been the Large Business & International (LBI) Division of the IRS. LBI has issued notification of over 60 enforcement campaigns, many of which target international issues. Last month, we wrote about LBI's newly announced campaign to target tax reporting and compliance with respect to foreigners' dispositions of US real property interests (USRPIs) that are subject to the 1980 Foreign Investment in Real Property Tax Act (FIRPTA). Now, on October 5, LBI issued notice of a further enforcement campaign targeting tax compliance by foreign owners' rental income from USRPIs. A nonresident alien (NRA) and other non-US taxpayers who owns US rental property can be subject to a 30% withholding tax on the gross amount of rent unless an election is made to treat the income as effectively connected with US trade or business activities. The IRS concern seems to be that there is substantial noncompliance with the reporting of these US real estate rental activities, this required 30% withholding, and required tax filings and compliance with respect to rental activities of NRAs and other foreigners, such as, e.g., foreign corporations and foreign trusts.
The specific rental problems that this audit campaign targets is an area where we have seen substantial errors or omissions in reporting U.S. real property rental and development activities of foreigners. For example, tenants paying rent to foreign landlords or their US property managers are with some frequency failing to pay the required 30% withholding on the gross amount of rent paid. This failure to withhold by tenants frequently results due to tenants' inadequate diligence on their landlords' identity as domestic or foreign. Since the tenants are the withholding agents, they face potential personal liability for the 30% withholding tax where they fail to obtain proper documentation of the foreign landlords' possible exemption from such withholding. Further, absent proper planning for the structure of the foreigners' real property investments, those foreign owners may be facing that 30% withholding tax as a final tax, which in many circumstances may more than offset their entire net profit from their US real property rental activities.
LBI's new audit campaign on foreigners' rental activities should be capturing the attention of a variety of parties. For example, the tenants, whether businesses or residential tenants, should be engaging in robust due diligence on their landlords in order to identify possible foreign landlords. NRAs, foreign corporations and other foreigners invested directly or indirectly in US real property have potentially even more to lose from adopting non-optimal structures for these investments or failing to meet their tax reporting and compliance obligations with respect to their rental activities (and, additionally, with respect to their dispositions of USRPIs under last month's announced tax compliance on FIRPTA transactions).
These US tax matters for foreigners investments in US real estate involve legal issues that can be thorny and regularly require the analysis and input from counsel on the acquisition, operation and disposition of USRPIs and the attendant US tax reporting and compliance with respect to these activities. With proper guidance, foreign taxpayers can structure their holdings, dispositions and commercialization of U.S. real property investments and institute procedures for proper U.S. federal, as well as state, tax reporting and other associated compliance. Please contact the author of this alert or your regular contact at Withers to discuss these planning and compliance matters for investments in US real property or other cross-border U.S. tax planning considerations.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.