Buying Real Estate Before Setting Up a Holding Structure

This discussion is inspired by a question I got from Marissa M., so thank you for that. :-) Her question was not what I discuss here, but it reminded me of a problem that pops up again and again.

Summary

Here's what happens.

A nonresident signs a contract to buy U.S. real estate which is a "United States real property interest."

The nonresident gets tax advice about holding structures.

Rather than complete the purchase and take title as an individual, the nonresident creates a holding structure and assigns the contract rights to that newly created holding structure, which then completes the purchase.

That assignment of rights under the purchase contract is a "disposition" of a "United States real property interest" which announces the arrival of two footguns:

• A Form 1040NR filing requirement for the nonresident who assigned the contract to the holding structure; and
• A FIRPTA withholding requirement for the holding structure.

Both of these are routinely ignored in the real world. :-) But the technical requirements exist.

The basic rule of taxation of real estate dispositions

Section 897(a) is where you find the rule. Gain or loss is taxed when there is a:

• "disposition" of a
• "United States real property interest" by a
• "nonresident alien or foreign corporation."

It's actually weirder than that. Section 897(a) says to treat the gain or loss on that disposition "as if" it is income effectively connected with the conduct of a U.S. trade or business by that nonresident alien or foreign corporation transferor. More on that "as if" stuff below.

"U.S. real property interest" is more than just dirt and buildings

A United States real property interest (I'm going to abbreviate it as USRPI) is more than just the dirt and buildings on it. Oh, that's included. But there's so much more. A "United States real property interest" is:

• An "interest in real property". IRC Section 897(c)(1)(A)(i).
• An "interest other than solely as a creditor" in a United States real property holding company. IRC Section 897(c)(1)(A)(i). A United States real property holding company is a domestic corporation that owns a lot of real estate (balance sheet test). IRC Section 897(c)(2).

"Interest in real property" includes a purchase contract

A nonresident visits the United States and falls under the spell of a real estate agent. The next thing you know, there is a contract for purchase of a beautiful house or condominium, with the nonresident as buyer.

That contract to purchase is an "interest in real property." Reg. Section 1.897-1(d)(2)(ii)(B) says:

So if the nonresident (as buyer) and the current owner (as seller) have a signed contract that either party could take to court and enforce -- the buyer is the owner of an interest in real property. The real property happens to be in the United States, so it's a USRPI.

Oops, I want to use a holding structure

In my world, people sign the contract to purchase U.S. real estate and make an earnest money deposit. Then they come to me for holding structure advice. We talk about estate tax, and then set up a structure of some kind to protect the nonresident buyer from U.S. estate tax.

Prior to closing, the individual (who is the named buyer) assigns his right to buy the property (and the obligation to pay the purchase price) to the new holding structure. The seller consents.

This is a "disposition" of a "USRPI" by a "nonresident alien"

Stop right there. We have a FIRPTA transaction defined by IRC Section 897(a), and there is FIRPTA withholding required by IRC Section 1445(a).

The contract right to purchase real estate is an interest in real estate. It's a USRPI. You're a nonresident alien. You disposed of the USRPI when you assigned all of your rights and obligations under the contract to your new holding structure.

The assignment of the purchase contract is a transaction that fits squarely into IRC Section 897(a)(1). Read the statute. You be the judge:

But there's no gain or loss!

"So what?" you say. There is zero gain or loss on the transaction. No income, no problem.

Not exactly. Two problems arise:

• The individual who assigned the contract to the holding structure has a Form 1040NR filing requirement, even with zero gross income.
• The holding structure that acquired the contract to buy the real estate has a FIRPTA withholding requirement, even though it is paying nothing.

Income tax return filing requirement

Read it and weep. Reg. Section 1.6012-1(b)(1)(i) says:

Get it? The mere fact of being engaged in a U.S. trade or business triggers a Form 1040NR filing requirement for a nonresident alien. This is true even if there is zero income. Cold comfort: the last sentence of that Regulation makes the return preparation a tiny bit easier. But there is still a filing requirement.

Does IRC Section 897(a)(1) make the taxpayer "engaged in business"?

IRC Section 897(a)(1) continues the well-trodden path of defining tax obligations with "let's pretend" language. Usually, Congress uses the $5 word "deemed" but in Section 897(a) Congress deigns to use peasant language and says "as if." Gain from disposition of a USRPI is treated

IRC Section 897(a)(1), flushleft text at the bottom.

Is the nonresident taxpayer considered to be engaged in a trade or business in the United States? Or is this a clumsy way to say that Congress intends to characterize the gain from disposition of USRPIs in a way that makes the gain taxable and the "as if" only applies to the income and not the individual?

• Does Section 897(a)(1) just characterize gain and loss from disposition of U.S. real property interests as taxable effectively connected income, while attributing nothing more to the taxpayer?
• Or does Section 897(a) characterize gain and loss from disposition of U.S. real property interest by attributing "engaged in business" status to the nonresident alien AND specifically connecting the disposition gain to that activity?

I think you have to choose the latter. The definition of effectively connected income demands that there is a business activity in the United States from which the income is derived.

Therefore, I think you must treat the nonresident taxpayer as "engaged in a U.S. trade or business" for the year of disposition of a USRIP, and only for the purpose of that real estate transaction.

If you're "engaged in business" you must file a tax return

Merely being engaged in a U.S. trade or business is enough to trigger a Form 1040NR filing requirement. Maybe it's an abbreviated filing requirement, but it exists. Reg. Section 1.6012-1(b)(1)(i) says so. And look at the Instructions for Form 1040NR:

There is no financial downside for failing to file. There is no tax due, and there can't be any penalties for late filing or late payment. Penalties are a given percentage of tax due, and in my example there cannot be any tax due. See IRC Section 6651(a).

The filing requirement is useless and dumb.

FIRPTA withholding

The other problem is FIRPTA withholding.

Anytime there is a transaction to which IRC Section 897(a) applies, there is an obligation on the part of the buyer to withhold 15% and remit it to the IRS. IRC Section 1445(a) says:

Note that withholding is calculated on "amount realized", not the amount of gain.

If you signed a contract to buy a house for $1 million and you assign that contract to a corporation that you own, you have a "disposition" of an "interest in United States real property." You haven't paid the $1 million yet, but you have promised to pay the $1 million and in return get your name on a grant deed to show that you own the house.

What is your "amount realized" for purposes of FIRPTA withholding? It's $1 million. That is the amount of your contractual liability to the seller. Reg. Section 1.1445-1(g)(5)(iii) says that "amount realized" includes:

The contract to purchase real estate imposes a $1 million contractual liability. ("You pay me $1 million, I give you the house.") By assigning the contract to your holding structure, you no longer have a $1 million contractual liability. The assignee -- your holding structure -- holds the contractual liability. And of course the holding structure will pay off that liability and acquire title to the house.

Thus, merely by assigning that contract to your holding structure you have incurred a FIRPTA withholding requirement.

What really happens

In the real world the nonresident individual buyer is simply going to assign the purchase contract.

The nonresident is not going to file a Form 1040NR to report the status of "as if" status of being engaged in a U.S. trade or business.

The holding structure that receives the assigned purchase contract is not going to remit FIRPTA withholding money to the IRS.

The holding structure is going to complete the purchase and everyone is going to carry on peacefully.