Episode 303: Foreign Investment and Tax Considerations in the U.S

Foreign Investment and Tax Considerations in the U.S

The U.S. economy attracts more foreign investment than any other, as it is stable and largely trustworthy. In 2021 alone, foreign investors pumped nearly $5 trillion in inward investments, much of this dedicated to real estate development. Opening the economy to so much foreign investment brings certain risks with it, but the truth is that the vast majority of noncitizen investors are just wealthy people looking to further their own interests.

Optimizing those foreign interests in America comes with challenges. Many of them are legal or tax-related, so it’s standard operating procedure for foreign investors to work with domestic parties for investment purposes.

Here, we’ll address how this dynamic works and what steps can be taken to minimize a foreign investor’s U.S. tax liability.

A Foreign Investor and a Domestic Developer: An Ideal (Limited) Partnership

The first step for foreign investors is to connect with a U.S.-based partner to invest in. There are numerous brokerage services that can facilitate this connection and simplify the process for investors. There are, of course, brokerage fees attached to this.

A common tactic for foreign investors is to partner with a domestic developer – if we’re talking real estate investment. Whether it’s a piece of land, a hotel, a golf course or any other piece of commercial real estate, foreign investors frequently partner with U.S. real estate developers in need of a capital infusion. The U.S. partner executes the job on the ground while the foreign partner supplies cash.

Typically, the investor and developer form a limited partnership (LP) to manage this professional relationship. LPs are a favored choice for real estate development for a couple of reasons, including:

  • Limited liability for investors – In an LP arrangement, the domestic partner is considered the “general partner” while any foreign investors are considered “limited partners.” Limited partners are only liable up to the amount of their investment, so foreign investors have a liability shield that protects them.
  • Minimal commitment – Limited partners are not involved with the day-to-day operations tied to their investment. This responsibility falls on the general partner (the U.S. developer), so foreign investors can put their money to work without committing time.

Which Tax Structure Makes Sense for a Domestic Company Working with a Foreign Investor?

The foreign and domestic parties are usually tied together through an LP, but there’s still the matter of corporate tax structure.

When an LP is formed between a foreign investor and U.S.-based developer, the next step is usually to set up a domestic company that serves as the LP’s business instrument. In other words, a new corporation is formed to ensure tax and legal compliance, and to simplify the distribution process when it’s time to pay foreign investors.

In most cases, a C-corporation provides the desired tax structure for the new company. This company is formed in a state that has stable, corporation-friendly laws in place – Delaware, Nevada and Texas are three examples.

Why is a C-Corporation Tax Structure Preferred for Foreign Investment?

C-corporations are not pass-through entities. They are required to pay corporate taxes on top of capital gains, which are added to the company’s income. As such, they do not enjoy the same tax benefits as a pass-through organization. Further, loss and depreciation, which can offset corporate tax burdens, are usually not relevant during the initial years following the C-corp’s founding. With all this in play, what makes C-corps the optimal choice for foreign investors?

First, domestic developers often provide an increased rate of return to foreign investors to offset the increased tax burden.

Second, when leveraging a C-corp tax structure, certain withholding and reporting requirements are not triggered until distributions are paid out to investors. This simplifies tax planning and usually gives foreign investors additional flexibility in managing their investment instruments. Further, C-corporations have a long, well-established legal history that makes it easier for non-U.S. parties to invest in. In fact, foreign investors may not own stock or assets in some corporations, including S-corps. Tax laws prohibit it.

As such, C-corps provide an ideal mix of accessibility and planning advantages that foreign investors can fully leverage.

Why Foreign Investors are Better Served with a U.S.-Based Attorney and Accounting Expert

Unsurprisingly, tax laws and accounting procedures are complex where foreign investors are concerned. If not properly planned and reported, foreign investors may be on the hook for a deep tax cut or may be barred from investing altogether. Given the complexity involved, it’s necessary for investors to hire an attorney in their home country and a U.S.-based attorney. Ideally, this attorney has accounting expertise and experience working with real estate investors.

There are a few important advantages to working with a U.S. attorney, including:

  • Helping resolve any language or cultural barriers – There’s a great deal of paperwork associated with managing a foreign investment, and this can pose a language barrier that leads to costly mistakes. Cultural issues can also be in play, as the investor’s expectations may not align with what the developer is experiencing on the ground.

A U.S. attorney can smooth these issues over and work directly with the investor’s home attorney to ensure all parties are moving in the same direction.

  • Establishing a clear accounting trail for security law purposes – The U.S. has standing economic sanctions against a handful of nations, including Russia, Iran and others. Investment flowing from these countries is barred under U.S. securities law, so it may be necessary to create a clear accounting trail for certain investors. This is done to confirm that a particular investor is indeed allowed to seed a project with capital.
  • Helping avoid, or mitigate, double taxation – Double taxation is a widespread concern among foreign investors, as both the U.S. and the investor’s home country will both attempt to take a bite out of any distributions.

A U.S. attorney specialized in accounting practices will be aware of any tax provisions, such as tax treaties, that can be used to avoid or reduce the impact of double taxation, ensuring foreign investors are able to secure more of their distributions.

  • Planning around FIRPTA for taxation purposes – FIRPTA is a federal tax law created specifically for foreign real estate investments. Under FIRPTA, there are certain withholding and taxation requirements that property investments must follow if they are tied to a foreign investor.

For example, when a real estate property connected to foreign investment is sold, a certain portion (10 to 15 percent, depending on the sale price) must be withheld for tax purposes. There are exceptions to some of these taxation and withholding requirements, and an attorney knowledgeable in FIRPTA law can leverage them for foreign investors.

There are Major Complications Involved with Foreign Real Estate Investment, But They Can Be Managed with the Right Legal and Accounting Team in Place

Trillions in foreign investment are dumped into the U.S. every year, much of it allocated to real estate development. America’s excellent reputation as a safe investment haven means this trend isn’t going anywhere.

If you’re a non-U.S. investor looking to take advantage of this trend, a proven way to optimize your investment is to have experienced advisors and experts facilitating the process. This includes working with a U.S. attorney and accounting team that knows the ins and outs of U.S. tax law.

The Real Estate Blender of Investment and Bankrupcy

Straight from the files of a Houston real estate attorney focusing on bankruptcy, and investment, we want to share an interesting personal story about a recent undertaking that blended all three of these areas. Our hope in sharing this story is that it will shed some light on the process for others aspiring to have similar endeavors. The process is not without risk, but if done right, the payoff can be big.

Finding the Property

Late last year, we were contacted by a bankruptcy lawyer who was representing a bank trying to foreclose on a specific piece of property where the borrower was in default. The borrower had gone through several bankruptcy tactics and was now delaying foreclosure. Our acquaintance was about to have the stay lifted so they could foreclose on behalf of her small out of town bank. The bank had asked the attorney to find someone who would buy the note and just take over the foreclosure and repossession process for the property.

Getting the Property

In the end, there was an arrangement put in place for a company we owned to buy the note from the bank and take over the bankruptcy process. Although the process was complicated and at times drawn out, we got the automatic stay in bankruptcy which then prevents foreclosures from occurring while someone is in bankruptcy. The automatic stay prevents foreclosures until such a time as the judge allows it. We went through the process, got the judge to approve it, and then received the right to foreclose.

Although the debtor did try to do several things to stop the foreclosure, they were unable to do so. We then got the order to lift the stay and then posted the property for foreclosure. We then conducted a foreclosure sale, where as the holder of the note, we were allowed to credit bids. This enabled us to bid up to the amount of the debt including:

  • Unpaid interest
  • Attorney’s fees
  • Related costs

By that time, with the attorney’s fees, because of the bankruptcy and interest running at a default rate, the balance owed was enough that nobody else bid and we were able to bid and eventually became owners of the property.

Property Evictions

As new owners of the property, we had to go through the process of evicting the occupant. The next step was to hire eviction counsel, file the papers and serve them on the property. By having a process server tape the papers to the wall and also send letters to the debtor and the property, it then triggered a thirty-day clock where the occupant had thirty days to leave the property. Fortunately, the occupant called us on the thirtieth day and said they were turning over the property.

Had the occupants not turned over the property within the thirty-day time period, we would have had to go to court and either have them evicted or get a judgement saying the occupant had no right to be on the property. Then, if necessary, a constable would have gone out to the property and physically removed the occupant. Luckily it did not come to that.

Renovating and Selling the Property for Profit

The property was not horrible, but it was definitely not clean either, so we spent several days hauling out trash and then began painting and cleaning and getting ready to put in new floors so the property could go on the market soon.

The project became a family affair as my wife is a real estate agent and helped take on many of the responsibilities of improving the property and staging it in a way that makes it more marketable.

The property is now awaiting a few final touches and inspections before it goes on the market. The endeavor has been a mixture of bankruptcy, real estate law, real estate investment, and real estate marketing. It is an adventure that we are glad we signed on for because although we have helped with legalities of situations like this before, going through it personally has given us a firsthand perspective that will only add to us successfully representing similar cases in the future.