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By: S.H. Spencer Compton, First American Title Insurance Company and Diane Schottenstein, Schottenstein Law
Today, many parts of the world are unsettled due to a variety of economic, political, and/ or environmental issues. Such unrest can lead to rapid inflation, which can devalue local currencies. Some nations restrict the amount of local currency a citizen may take out of their country. Where does international money consistently find a safe home? Foreign investors have historically viewed U.S. real estate as an attractive and stable investment.
ACCORDING TO THE NATIONAL ASSOCIATION OF REALTORS (NAR), between April 2016 and March 2017 foreign buyers and recent immigrants purchased $153 billion in U.S. residential property. This represented about 284,455 homes, an increase from 214,885 homes in the previous 12-month period, or 5% of all existing residential home sales in that 12-month period.1 Furthermore, international investors have purchased over $365 billion in U.S. commercial real estate since 2010, with the majority of capital flowing to the largest metropolitan regions. Manhattan alone represented nearly a fifth of all foreign investment in commercial real estate.2 In fact, NAR reported that 18% of its surveyed commercial real estate brokers closed transactions with international clients.3 Because so much U.S. real estate is bought and sold by foreign investors, it is ever more likely that you, as an attorney, will represent either a foreign purchaser or seller of U.S. real estate or a domestic client buying U.S. real estate from a foreign person. This article discusses issues you may encounter in such circumstances. At the outset, you need to understand your client’s expectations as to immigration and U.S. citizenship. Property ownership is not sufficient to entitle a person to reside in the United States and does not create a pathway to citizenship except pursuant to a specific program such as the EB-5 program. Once you understand your foreign client’s proposed transaction, you should walk the client through the steps necessary to consummate it, explain what the expectations of the parties to the transaction will be, and listen to the client’s expectations.
In the United States, local real estate laws and customs vary, sometimes greatly, from state to state. For example, some states levy a tax on mortgage recording, while others tax real property transfers but not transfers of the entity that owns the real property. In the United States, title insurance is commonplace, but in most foreign countries, it is rarely used.
Certain customs and practices can make for unpleasant surprises (which are devoutly to be avoided). For example, a foreign buyer (or any buyer) of a New York City condominium should be advised that there is a 1% mansion tax that a buyer must pay on residential conveyances over $1,000,000. Similarly, when the purchase is based on a floorplan in a glossy brochure that is marketing a building yet to be constructed, the buyer should expect to pay the seller’s New York State and New York City transfer taxes, as is customary in contracts for new construction in New York City. Because the buyer is now paying the seller’s tax obligation, that cost is deemed additional consideration and is added to the purchase price to reach the grossed-up purchase price upon which the buyer will pay the computed transfer taxes.
A buyer’s expectation for the availability of services and amenities on the move-in date should also be tempered. Contracts often provide for a closing as soon as a temporary certificate of occupancy is obtained (so that occupancy is legal), but despite the developer’s good faith efforts, certain construction may be ongoing, and full services, such as a health club or screening room, might not be available until a later date (which can be much later).
Certain complexities that might not arise with a U.S. party may slow down or complicate a transaction for a foreign party. If a transaction will be financed, for example, a foreign party may have more hoops to jump through in getting a mortgage than a domestic buyer might. There could be additional documentation requirements to prove creditworthiness and confirm international assets. Currency conversion issues can impact transaction timing due requirements of the U.S. banking system or the home country (or both). An international wire transfer will likely not move as quickly or smoothly as a domestic one.
Documents executed in a foreign country with a notarial attestation that are to be recorded in a U.S. jurisdiction must be authenticated. Many countries, including the United States, have joined a treaty called the “Hague Convention of 5 October 1961 Abolishing the Requirement of Legalisation for Foreign Public Documents.” This treaty reduces the authentication process to the issuance of a certificate called an apostille by an authority designated by the country where the document was issued. If your client plans to execute a document in a foreign country where attestation is required in the United States, the client must obtain an apostille, generally from a U.S. consulate or embassy. This process should be initiated well in advance of closing.
Note that it is generally more difficult to serve and sue a foreign person than a domestic one. For this reason, sellers sometimes require a larger down payment, rather than relying solely on their ability to take a foreign person to court. Likewise, any judgment obtained against a foreign person might be difficult to enforce if all or most of their assets are located abroad.
Nonetheless, many successful transactions today involve foreign persons and these complexities need not deter or derail a mutually satisfactory closing.
Although there are many cooperative apartments available in locales like New York City, a foreign purchaser should consider carefully before seeking to purchase one. It is generally accepted that a cooperative’s board of directors has the right to accept or reject a purchaser for any reason, or no reason, as long as it does not violate anti-discrimination laws. Cooperative boards can and do ask for detailed financial and social information that a foreign buyer may not want to produce. Compared to ownership of a condominium, cooperative ownership is more restrictive: limited or no subleasing permitted, occupancy and use requirements, etc. Although there is a board approval process for a condominium purchase, it is generally less rigorous than for a cooperative, and condominium boards rarely prohibit corporate or other types of ownerships often favored by foreign investors. Rather than a buyer approval right, a condominium board has merely a right of first refusal to purchase the unit. Where a board does not wish the transaction to go through, it can refuse to waive its first refusal right. The resulting cloud on title can (and often will) discourage a commercial lender from granting a mortgage. Such refusals to waive are rare, but not unheard of. Where a foreign buyer is determined to purchase a cooperative (and not a condominium), he or she might consider buying a sponsor cooperative unit, where board approval is not required.
Foreign Investors’ Tax and Structural Considerations
This article is not intended to give tax advice, and readers should encourage foreign buyers or sellers in real estate transactions to consult tax advisors. That said, a foreign person buying or selling U.S. property should be aware of several potential tax issues: there are income tax, gains tax, and state and local transfer tax, as well as estate tax issues to be concerned with. In addition to federal, state, and local tax considerations, deciding how to structure the transaction can be a multilayered and fact-specific process. Considerations include:
The size of the investment and whether it is for personal use or part of a business can also play roles in determining the best approach.
Should an individual or a U.S. or a foreign entity purchase the property? And, if an entity, what kind of entity? A common structure for holding U.S. property is a limited liability company, a pass-through tax entity that offers certain privacy and other benefits. However, as of 2017, Internal Revenue Service (IRS) regulations mandate that a single-member foreign-owned limited liability company comply with specific complex requirements established under Section 6038A of the Internal Revenue Code. These requirements can include designating a responsible party, complying with reporting requirements, and retaining permanent records regarding related-party transactions. Will this be acceptable to your client? There can be large penalties for noncompliance.
Income Tax Issues
Income tax consequences vary depending on the use of the property. If a property is for personal benefit, such as a vacation home that will not generate income, this analysis may not apply. However, where rental income will be generated, the IRS has two divergent approaches to taxing income of foreign persons. Under the first approach, when income can be effectively connected with the conduct of a U.S. trade or business, foreign persons are taxed on the amount of effectively connected income net of deductions allocable to such income, which may consist of such items as mortgage costs, taxes, insurance, and brokerage fees. The net is then taxed using the regular rate that applies to U.S. persons. Alternatively, income can be characterized as Fixed, Determinable, Annual, or Periodic (FDAP). Generally, income from U.S. sources that constitutes interest, dividends, rents, or royalties is FDAP income and is taxed at a flat rate of 30% of the gross income with no deductions. That said, where there is rental income, even if it is not considered effectively connected, the investor may be able to make a special election to have it taxed on a net basis. To further complicate the analysis, under certain circumstances where a foreign person is present in the United States over a specified period of time, that person might be deemed a U.S. resident for U.S. income tax purpose and consequently required to file a U.S. income tax return and pay taxes on their worldwide income. Your client should consult with an experienced tax advisor to identify and work through any such issues.
Taxes on Disposition
The question here is: what taxes will be due on the disposition of the property? When the estate of a deceased foreign person sells property that he or she owned as an individual, U.S. estate tax (if triggered) will apply to the fair market value of the property on the date of death, without adjustment for inflation and with limited credits. Additionally, there will be U.S. capital gains taxes on the gain.
FIRPTA Liability for U.S. Purchasers
The Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) creates a procedure for the payment of U.S. capital gains tax by a foreign seller.4 With some exceptions, 15% of the purchase price must be remitted to the IRS. Note that a buyer of real property from a foreign seller must be concerned with FIRPTA compliance because the buyer will be liable for the applicable gains taxes if the foreign seller fails to pay them.
At a typical closing, the buyer receives a seller’s affidavit certifying that the seller is not a foreign person, in which event there are no issues, unless the buyer has reason to doubt the certification. However, where the seller is a foreign person and cannot legitimately deliver a FIRPTA affidavit, the FIRPTA statute imposes secondary liability for the foreign seller’s unpaid capital gains taxes on the buyer. In this way, the law makes the buyer a party to a seller’s noncompliance, and the buyer must assure that there is proper compliance or will be left with an unwanted liability. Since the seller’s gains tax liability can be a large amount, the seller will often file for a determination that a lesser amount is due. Under this scenario, the seller files for a Notice of Determination and the 15% tax, rather than being paid to the IRS at the time of the closing, is held in escrow. Once the IRS determination letter is received, the escrow agent will remit the indicated tax amount to the IRS and refund any balance to the foreign seller. The buyer may want evidence that a Notice of Determination has been applied for as a condition to closing and withholding. Further, the buyer may want to know the foreign seller’s basis in the property in order to calculate the estimated liability amount. For example, if the foreign seller sold at a loss, the capital gains tax due will be less than the 15%, so the buyer’s transferee liability will be accordingly reduced.
There is no blanket prohibition on foreigners owning real estate in the United States. However, there are a number of U.S. reporting requirements and restrictions that may apply in certain circumstances.
BEA Reporting Requirements
In 1976, Congress passed the International Investment and Trade in Services Survey Act (Survey Act), requiring the Bureau of Economic Analysis (BEA) to regularly collect data on international capital flows and investments in the United States.5 However, in 2009, the BEA’s filing requirement for the acquisition of a direct or indirect interest in U.S. real estate by a foreign investor was discontinued for budgetary reasons. It wasn’t until 2014 that the BEA reinstated such mandatory reporting requirements. The BEA rules apply to a U.S. business investing in U.S. real estate if any foreign person has a 10% or more direct or indirect interest in that business. There are many rules and exceptions relating to the BEA reporting requirements, as well as a form to file for exemption from reporting.6
Agricultural Foreign Investment Disclosure Act of 1978
This Act mandates filing requirements in connection with the acquisition or transfer of any agricultural land to a foreign person.7 Hefty fines will be levied for a failure to report. The statute’s goal is to prevent purchaser anonymity for acquisitions of agricultural land in the United States.8
Foreign Asset Control Rules
The U.S. federal government imposes economic sanctions against, and prohibits certain transactions with, specified countries, entities, individuals, and organizations. The Office of Foreign Asset Control (OFAC) at the U.S. Department of Treasury oversees and enforces these sanctions. All U.S. persons as defined by OFAC must comply with these restrictions. According to applicable rules, the term “United States person” or “U.S. person” means “any United States citizen, permanent resident alien, entity organized under the laws of the United States or any jurisdiction within the United States (including foreign branches), or any person in the United States.”9
Patriot Act Compliance
The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (commonly known as the Patriot Act) was passed after September 11, 2001, primarily to deter and punish terrorist acts in the United States, and around the world, as well as to enhance law enforcement’s investigatory tools.10 No U.S. citizen or company may do business with any Specially Designated Global Terrorist, which is a designation authorized under U.S. Executive Order 13224 (among other executive orders), and C.F.R. Title 31, pts. 595, 596, and 597 (among other U.S. laws and regulations). People or entities are designated as Specially Designated Global Terrorists (SDGTs) under Executive Order 13224 by the U.S. Department of State or the U.S. Department of the Treasury.
The penalties for failure to comply with the Patriot Act are up to $500,000 for companies or up to $250,000 and/or 10 years’ imprisonment for individuals. Most purchase and sale agreements for real estate today contain representations to establish the parties’ compliance with the Patriot Act. Accordingly, it is critical to know the background of each counterparty all the way down to its individual constituents. Patriot Act issues can have a significant impact on a transaction and its ability to close, and Patriot Act representations should be thoroughly evaluated. Section 352 of the Patriot Act imposes requirements on every financial institution and all persons involved in real estate settlements and closings.11
The specifics of a transaction may trigger additional considerations that might not come into play in a real estate transaction without a foreign party.
Other Governmental Requirements
Other federal requirements may apply to specialized situations (such as antidumping, antitrust, traffic in arms, etc.) that probably would not apply to an everyday real estate transaction. There also may be local and/or state filing requirements that must be complied with.
If a foreign purchaser intends to own but not occupy their property, maintenance and management processes should be put in place.
From a foreigner’s perspective, diplomatic immunity is a good thing but, from a counterparty’s perspective, it is troubling. Many will hesitate to enter into a contract with someone who is not subject to the same rules as they are. There are a number of potential ways to address this concern: a deep-pocketed domestic guarantor, a designated U.S. agent for service of process, and/or a larger contract deposit than usual to be held in escrow in the event the foreign purchaser decides to default.
This article is intended to illuminate issues that may arise in real estate transactions involving foreign persons. Although each situation is unique and nuanced, an attorney who is sensitive to potential concerns can guide his or her client to a positive outcome.
S.H. Spencer Compton is a vice president and special counsel at First American Title Insurance Co., New York Division, and has served in the same capacity since 2001 when he joined the pre-merger First American Title Insurance Co. of New York as a vice president. He also oversees all New York 1031 exchange transactions for First American Exchange Co. Diane Schottenstein is an experienced attorney practicing law in New York City for over 30 years. Diane’s clients have included major national and international corporations and banks, not-for profit organizations, smaller businesses, and a broad range of individuals. Before embarking on solo practice, Diane had been associated with Cahill Gordon & Reindel LLP.
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RESEARCH PATH: Practice Notes
For a discussion of the tax considerations applicable to foreign investment in U.S. property, see
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RESEARCH PATH: Real Estate > Commercial Purchase and Sales > Tax Considerations > Practice Notes
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1. See 2017 Profile of International Activity In U.S. Residential Real Estate, National Association of Realtors (July 2017). 2. See Evan Gentry, Why Foreign Investors Love U.S. Commercial Real Estate and Why More Will Follow, Forbes Real Estate Council (May 30, 2018). 3. See Commercial Real Estate International Business Trends 2018, National Association of Realtors (June 2018). 4. See 26 U.S.C.S. § 1445; 26 U.S.C.S. § 897; 26 U.S.C.S. § 6039C. 5. See 22 U.S.C.S. §§ 3101–3108. 6. See the Bureau of Economic Analysis website at https://www.bea.gov, and A Guide to BEA’s Direct Investment Surveys, Bureau of Economic Analysis (2018), https://www.bea.gov/system/files/2018-04/a-guide-to-bea-direct-investment-surveys.pdf. 7. See 7 U.S.C.S. §§ 3501–3508. 8. See 7 C.F.R. § 781.1. 9. See 31 C.F.R. § 560.314. 10. See Pub. L. No. 107-56, 115 Stat. 272 (Oct. 26, 2001). 11. See 31 U.S.C.S. § 5318