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Understanding the Corporate Restructuring Side of FIRPTA by Joel G. Young, JD, LLM

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Posted on March 11, 2025 by Joel Young

With the complexity of the U.S. tax code, foreign persons may inadvertently trigger a withholding tax on the sale or disposition of U.S. real estate even when they are party to an otherwise tax-free reorganization. It is important for foreign individuals to understand the nuances of the Foreign Investment in Real Property Act (FIRPTA) and the ways in which they may avoid FIRPTA withholding tax on these and other types of transactions.

The U.S. generally taxes foreign companies and individuals only on their U.S.-source income, which generally falls into two categories: fixed or determinable annual or periodical income (FDAP income), which consists of 1) passive income, like dividends, interests, rents and royalties, and 2) effectively connected income (ECI) that is generated by the conduct of a U.S. trade or business. For the most part, sales of capital assets that are not effectively connected with a U.S. trade or business do not generate U.S. source income and, therefore, are not subject to U.S. tax. Prior to 1980 and the enactment of FIRPTA, this exemption from U.S. tax also applied to sales of U.S. real property held for investment by foreign persons.

FIRPTA leveled the playing field between U.S. and foreign investors in U.S. real estate by treating the gain on any U.S. real estate sold by a foreign person as ECI subject to taxation. Consequently, FIRPTA now provides that the sale, exchange or other “disposition” of a U.S. real property interest (USRPI) by a foreign person is subject to tax in the U.S. as well as a 15 percent withholding tax on the sale proceeds (or fair market value in a non-sale transfer). A USRPI is generally real property located in the U.S., but it also includes a United States Real Property Holding Corporation (USRPHC), which is any domestic corporation where the fair market value of its USRPIs equals or exceeds 50 percent of the fair market value of all the corporation’s assets.  In addition, any interest in a partnership in which 50 percent or more of the value of the gross assets consist of USRPIs and 90 percent or more of the value of the gross assets consist of USRPIs plus any cash or cash equivalents shall be treated as entirely a USRPI.

The most widely known application of FIRPTA is on sales of U.S. real estate by foreign persons. However, given that FIRPTA withholding tax can be applied to any “disposition” of a USRPI, FIRPTA can be implicated in surprising ways.

A “disposition” is generally defined as any transfer of property, including transfers that are not generally subject to taxation. These tax-free transfers are referred to as non-recognition transactions that can include contributions of property to corporations, partnerships or trusts; certain distributions from corporations, partnerships or trusts; some parent-subsidiary liquidations; and tax-free reorganizations, like mergers and spin-offs.

FIRPTA overrides these non-recognition transactions in situations where a USRPI, including a USRPHC or partnership interest treated like a USRPI, are transferred by a foreign person as part of the reorganization. Absent an exception, these transactions can be subject to tax, including the 15 percent withholding tax assessed on the total value of the USRPI transferred. Therefore, FIRPTA can be inadvertently triggered where you have a foreign person as a party to what would otherwise be a tax-free reorganization. However, there are a few limited exceptions that will allow the transfer of a USRPI in a nonrecognition transaction to avoid FIRPTA tax.

For example, a nonrecognition provision will apply to a transfer by a foreign person of a USRPI to the extent that it is exchanged for another USRPI that would subsequently be taxable in the hands of the transferor. The transferor must also comply with certain procedural requirements, including filing statements with the IRS within 20 calendar days of the transaction, describing how the transaction satisfies both the general and FIRPTA requirements for non-recognition.

This USRPI-for-USPRI exception can also apply to the transfer of a USRPI to a corporation in exchange for corporate stock provided that the corporation qualifies as a USRPHC immediately after the exchange, and corporate mergers or other tax-free reorganizations provided that the foreign transferor receives shares of a USPRHC in exchange for a USRPI or USRPHC as a result of the reorganization.

In certain circumstances, USRPIs and USRPHCs can be transferred to foreign corporations, even though foreign corporations do not expressly meet the definition of USRPHCs because they are not domestic corporations. There are two primary ways this can be accomplished. First, the transfer of a USRPI to a foreign corporation may qualify for the USRPI-for-USPRI exception by making a special election to treat the foreign corporation like a domestic corporation for FIRPTA purposes only. The primary requirement of this 897(i) election is that the foreign corporation be entitled to non-discriminatory treatment under a U.S. treaty.  This is generally satisfied if the foreign corporation is a resident of a country with which the U.S. has a tax treaty. Secondly, a foreign corporation can contribute shares of a USRPHC to a foreign subsidiary corporation provided that certain ownership thresholds and holding periods are satisfied. Under either of these exceptions, strict procedural requirements, including special filings with the IRS, must be met.

Due to the narrow scope of the FIRPTA nonrecognition exceptions and the strict procedural requirements that need to be met to avoid FIRPTA tax, a tax advisor knowledgeable on the topic should be consulted whenever restructuring ownership of U.S. real estate assets, whether held directly or through a partnership or corporation, to avoid unnecessary tax withholding.

About the Author: Joel G. Young, JD, LLM, is an associate director of Tax Services with Berkowitz Pollack Brant, where he provides tax, income and estate tax planning and compliance services for high-net-worth families and closely held businesses with international operations. He can be reached at the firm’s Boca Raton, Fla., office at (561) 361-2000 or info@bpbcpa.com.