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

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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.

By Harold "Hap" May, P.C. on July 21, 2023   /   Blog, Real Estate, The Legal Play Podcast   /   Leave a comment