Build Your Holding Structure Before You Sign a Purchase ContractMay 25, 2018 - Phil HodgenFriday Edition
Hello from Singapore by way of Jakarta, and welcome to the Friday Edition. It’s all alt-country1 and international tax here, folks.
Build Your Holding Structure Before You Sign a Purchase Contract
For our literary purposes, you are a nonresident and noncitizen of the United States. You sign a contract to buy U.S. real estate, then think of tax planning and come to see me.
You decide on some kind of holding structure to own the real estate. Let us arbitrarily assume that your U.S. real estate purchase will be owned by a corporation, and you will be the sole shareholder of that corporation.2
Problem! The contract says you are the buyer, but you want your holding structure to be the owner. So you ask the seller whether you can assign the purchase contract to your new corporation.
The seller does not care — as long as the purchase price is paid, the identity of the buyer is of no concern to the seller. So the seller agrees, and the purchase contract is assigned. Now the buyer is the corporation, not you. You are off the hook for the purchase.
You put enough money in the corporation’s bank account to buy the property, and that’s exactly what happens. Now your corporation is the proud owner of U.S. real estate.
All is well, right?
It’s a Bad Thing
When a nonresident has a “disposition” of a “U.S. Real Property Interest”, that is a taxable event, and tax withholding is required.
A contract to acquire U.S. real estate is a “U.S. Real Property Interest”.3
Therefore, when you assigned the purchase contract to your new corporation, you had a “disposition” of a “U.S. Real Property Interest”.
Yes, I know. What you did is no different from reaching into your left pants pocket, pulling out your car keys, and putting the keys in your right pants pocket. It’s a total non-event in the real world.
Result of the Bad Thing
Yet in the tax world, it is a real event, with real consequences:
- You must file a U.S. income tax return to report the fact that you signed a purchase contract then assigned the contract to the corporation that you own.
- Your corporation must withhold tax (in real cash money) and pay it to the IRS. You will get a refund later (many, many months later).
The IRS Knows About This
The IRS knows about this, and published a little warning to real estate professionals about it. Fact Sheet 2005-16 says:
The IRS has become aware of instances in which foreign persons have acquired options or entered into contracts to purchase U.S. real property interests and sold the options or assigned the contracts before such instruments are exercised or executed and title to the underlying property is taken. Buyers of the options or contracts are failing to withhold and remit to the IRS the required 10 percent [now 15%]4 from the proceeds of the sale.
Why File a Tax Return?
Why must you file a U.S. income tax return? You did not make any capital gain, and you in fact collected no money when you assigned the purchase contract from yourself to your corporation.
You Are Engaged in Trade or Business
Section 897(a) tells us to treat a nonresident as engaged in trade or business in the United States when there is a disposition of U.S. real estate:
. . . [G]ain or loss of a nonresident alien individual or a foreign corporation from the disposition of a United States real property interest shall be taken into account . . . as if the taxpayer were engaged in a trade or business within the United States during the taxable year and as if such gain or loss were effectively connected with such trade or business.5
By assigning the purchase contract (a “disposition”) you are treated as being “engaged in trade or business in the United States”. That is a term of art, and it means something.
Return Filing Requirement
Nonresidents who are engaged in trade or business in the United States must file income tax returns — even if they make no money:
[A] nonresident alien individual who is engaged in a trade or business in the United States at any time during the taxable year is required to file a return on Form 1040NR even though (a) he has no income which is effectively connected with the conduct of a trade or business in the United States, (b) he has no income from sources within the United States, or (c) his income is exempt from income tax by reason of an income tax convention or any section of the Code.6
Tax Withholding Requirement
Your corporation is the “buyer” in the transaction. Tax law talks of the parties as “transferor” and “transferee”, if you want to think of it that way.
When someone acquired U.S. real estate from a nonresident, tax must be withheld — by the buyer (or “transferee”) and paid to the U.S. government. The amount of tax to be withheld is 15% of the “amount realized” by the nonresident who is transferring the purchase contract to the holding structure:
Except as otherwise provided in this section, in the case of any disposition of a United States real property interest (as defined in section 897(c)) by a foreign person, the transferee shall be required to deduct and withhold a tax equal to 15 percent of the amount realized on the disposition.7
This means that your corporation must figure out what the “amount realized” is, and send 15% of that amount to the Internal Revenue Service.
Example: Assign the Contract to a Corporation
Let’s put some numbers to your purchase, and see how it works.
You sign a contract to buy U.S. real property for $1,000,000. You gives a deposit of $100,000 when signing the contract, with the remaining purchase price of $900,000 to be paid on the closing date.
You then create a corporation.
You assign your right to purchase the real estate (meaning you assign the contract) to the new corporation, and the seller agrees.
After the assignment, the corporation is new buyer in the real estate transaction.
The corporation now sits in the following position:
- It has a binding contractual right to buy the real estate for $1,000,000; and
- It has a binding contractual obligation to pay the seller $1,000,000; and
- It owns your $100,000 cash deposit that you paid the seller when signing the purchase contract.
What is your “amount realized” for the purpose of computing the tax that the new corporation must withhold and pay over to the IRS?
The “amount realized” is what you get in return for what you transferred away. Here is how the government defines “amount realized”:
The amount realized by the transferor for the transfer of a U.S. real property interest is the sum of:
(i) The cash paid, or to be paid.
(ii) The fair market value of other property transferred, or to be transferred, and
(iii) The outstanding amount of any liability assumed by the transferee or to which the U.S. real property interest is subject immediately before and after the transfer.8
Cash [Reg. §1.1445-1(g)(5)(i)]
In my example, you receive no cash back from your corporation in return for assigning the purchase contract (and ownership of the $100,000 cash deposit).
Amount realized: zero.
Other Property [Reg. §1.1445-1(g)(5)(ii)]
When you assign the purchase contract to your new corporation, you are transferring ownership of the $100,000 cash deposit.
This is a capital contribution, for which you receive corporate stock in return. That is “other property”.
The value of that stock is the value of the property transferred to the corporation:
|Corporate stock received||$100,000|
Relief from Liability [Reg. §1.1445-1(g)(5)(iii)]
In addition to the cash deposit, you transferred a second asset to the corporation: the right to buy a $1,000,000 piece of real estate.
This right, however, comes with an obligation to pay $1,000,000 to the seller of the real estate, so the value of the contractual asset is zero.
But the effect of this transfer (the corporation is the buyer and must pay the purchase price, and you are off the hook for paying the puchase price) is that the corporation has assumed a liability of $1,000,000 that used to be yours.
You have an “amount realized” of $1,000,000. But since the seller already has $100,000 of cash as the deposit, the “amount realized” by you is $900,000:
|Relieved of obligation to pay purchase price||$1,000,000|
|Less cash already paid to seller||-$100,000|
Total Amount Realized
The total amount realized — when the nonresident assigns the purchase contract to the corporation that will purchase and own the U.S. real estate — is $1,000,000.
|Corporate stock received||$100,000|
|Relief from liability||$900,000|
Since the nonresident has an “amount realized” of $1,000,000, we have two results:
- The nonresident (who signed a purchase contract and then assigned it to the holding structure he created) must file a U.S. income tax return; and
- The holding structure (a corporation in my example) must withhold $150,000 (15% of the $1,000,000 “amount realized”) and pay this in cash to the IRS.
How Do You Make Bad Things Go Away?
How do you make bad things go away? Here are some ways to handle this problem:
- Cancel the purchase contract,
- the seller returns the deposit to you,
- The corporation signs a new purchase contract with the seller,
- The corporation makes the deposit and pays the purchase price.
This requires cooperation from the seller. It is the safest method. When you cancel the purchase price, you have not made a disposition of a U.S. Real Property Interest. This means that the whole cascade of tax problems (tax returns for you, withholding for the corporation) will not occur.
Do the Withholding, File a Tax Return
- Assign the purchase contract to the corporation,
- The corporation withholds 15% of the amount realized,
- You file a tax return and claim a refund of the purchase price.
Really? Who does this?
- Answer: people who have a lot of cash liquidity and can affort to put 15% of the purchase price into the U.S. Treasury for several months while waiting for a tax refund.
- Answer: transactions where a hyper-aware third party exists. Real estate brokers, title companies, escrow companies, and other professionals can be treated as “withholding agents” and therefore personally on the hook for the withholding tax. They may insist on withholding in order to protect themselves.
Don’t Do the Withholding, File a Tax Return
- Assign the purchase contract to your corporation,
- DON’T do the tax withholding,
- File a tax return to report the assignment of the contract and zero tax liability.
Then the holding structure (as withholding agent) is on the hook for interest only9 on the amount of the tax withholding that should have been done–but wasn’t. Maybe the IRS will catch this, maybe they will not.
No Withholding, No Tax Return
- Ignore the whole problem and hope it doesn’t blow up in your face.
This works well if you do not have real estate professionals in the transaction (title companies, escrow companies, real estate agents) who could potentially be “withholding agents” and thereby be on the hook for the tax withholding that should have been done but was not.
In the real world, people ignore the whole problem and it never blows up in anyone’s face. It’s a no harm, no foul situation. I’m not saying that’s the right thing to do. I’m just saying that is what happens.
Which means that now is the perfect time for a disclaimer.
Nothing here is legal advice. Go hire someone to give you good advice. My frank opinion is that the “start over” strategy is best, but you can’t always rely on cooperation from the seller.
- When it’s not lo-fi house. ↩
- This is is not tax advice. In fact, it might be a Very Bad Idea. But let’s go with it, for literary purposes. ↩
- Treas. Reg. §1.897-1(d)(2)(ii)(B). ↩
- Now 15% for sales after February 16, 2016; see IRC §1445(a). The legislation changing the withholding tax rate is at 2015 PATH Act, Pub. L. No. 114-113, Div. Q, §324(a). ↩
- IRC §897(a)(1). ↩
- Reg. §1.6012-1(b)(1)(i). Notice 2005-77 allows nonresidents working in the United States (employment is a “trade or business”) with low wage income to avoid filing U.S. income tax returns. This exception does not apply to “engaged in trade or business” status resulting from a disposition of U.S. real estate. ↩
- IRC §1445(a). ↩
- Reg. §1.1445-1(g)(5). ↩
- In the case of withholding tax failures, interest is payable, no matter what. Regs. §1.1445-1(e)(3)(ii). If you file a tax return and prove that your actual tax liability is zero, then the withholding agent — your corporation, or any professional involved in the transaction — is not personally liable for the withholding tax or penalties. Regs. §1.1445-1(e)(3)(i). ↩