Real estate has always been touted as a surefire way to invest to make a profit. But what happens when that real estate investment doesn’t work out? You sell! The sale may be easy, but taxwise there are some factors that you need to consider before putting that property on the market with the biggest factor being whether you’re a domestic investor or foreign investor. Why does this matter? Let’s see.
Q: Many investors come together and organize themselves are partnerships. How are real estate sales by domestic partnership investors treated in the U.S.?
A: The normal capital gains/losses rules apply in this situation. The profit from the sale is taxed at the current capital gains rate, which is dependent on how long the seller has held the asset. We’ll assume that you held it for more than a year before you decided to sell, so the long-term rates are either 0%, 15%, or 20% depending on your taxable income and your individual filing status (because partnerships act a pass-through entity). An additional 3.8% tax is added if your modified adjusted gross income exceeds $200,000 unmarried/head of household or $250,000 for married filers. And don’t forget about those state capital gains taxes. They can vary from 0% to 13.3%. This maxes the total capital tax gain out to 37.1!
Q: What happens if I have foreign investors?
A: Section 897 of the IRS code provides guidance on how to handle these situations. These real estate investments are what the IRS calls U.S. real property interests (USRPIs) and the foreign partner is considered a nonresident alien (NRA) in the USRPI. Gains or losses from the sale of a USRPI by a NRA are treated as gains or losses effectively connected with a trade or business within the United States. Rules mandate tax withholdings by the NRA on the sale; however, the withholding amount is dependent on if the NRS has a domestic partner or 100% foreign owned. If the foreign partner has a domestic partner in the partnership, 21% of the foreign partners gain must be withheld for the IRS. If the partnership is owned by NRA, 15% of the total gain must be withheld for the IRS. Again, you have to include state taxes here, which maxes out the total withholding at 34.3% a NRA in a domestic partnership or 28.3% for 100% foreign owned partnership.
Q: As a U.S. citizen looking to invest in real estate, is it better for me to choose a domestic or foreign partner?
No matter if you have a domestic or foreign partner, the sale of real estate triggers withholdings. To reduce or to eliminate withholdings, take into consideration—
- Your personal withholding rate– If you plan to stay below the 20% individual tax bracket, a 100% domestic partnership will always yield a lower withholding than partnering with a foreign partner.
- The primary domicile – If you’re using the real estate for company operations and the majority of your business is done overseas, consider making the primary domicile in the foreign partner’s country or another country that has more favorable real estate sale tax laws.
- The NRA’s partnership basis – Increase the NRA’s basis to be larger than the amount withheld for the NRA partner’s share of the gain on the disposition of USRPI to avoid a capital gain withholding. You can accomplish this through additional contributions to the NRA basis, the partnership increasing liabilities, or a combo of both.