FIRPTA Structure Series #1: Introduction, Single Tier Structures, and Impossibility

December 22, 2023 in Nonresident Investment in U.S. Real Estate

This is the beginning of a new series. It’s a “nonresident investor in U.S. real estate” series. I’m going to analyze a simple (!) client question:

“I am a nonresident of the United States. I am going to buy a condominium for my child to live in while she goes to school. What’s the best way for me to do this to minimize my U.S. tax?”

This translates to “who holds recorded title to the real estate? And that, in tax lawyer language, means “What holding structure should I tell my client to use?”

The Single-Level Holding Structure Choices

Here are (almost) all the holding structure choices available to a nonresident who wants to buy and hold U.S. real estate.

Direct Ownership

  1. The nonresident owns the real estate in his or her own name.

Disregarded Entity

  1. A domestic LLC holds title to the real estate, the nonresident individual is the sole member of the LLC, and no check-the-box election is made.
  2. A foreign company holds title to the real estate; a nonresident individual is the sole owner of the business entity, and a check-the-box election is made to reclassify the foreign company as a disregarded entity.

Corporation

  1. A corporation formed in one of the 50 States or District of Columbia owns the real estate, and a nonresident individual owns all of the stock of the domestic corporation.
  2. A corporation formed in one of the 50 States or District of Columbia owns the real estate, an S corporation election is made, and a nonresident individual owns all of the stock of the domestic corporation. (Hold onto your horses, you “Yeahbut!” people).
  3. A corporation formed outside the 50 States or District of Columbia owns the real estate, and a nonresident individual owns all of the stock of the foreign corporation.

Partnership

  1. A domestic partnership owns the real estate, and a nonresident individual is a partner in the domestic partnership.
  2. A foreign partnership owns the real estate, and a nonresident individual is a partner in the foreign partnership.

Trusts

  1. A domestic revocable trust owns the real estate and a nonresident individual holds the power of revocation.
  2. A foreign revocable trust owns the real estate and a nonresident individual holds the power of revocation.
  3. A domestic irrevocable trust owns the real estate; it is funded by a nonresident alien, who may or may not be a beneficiary of the trust.
  4. A foreign irrevocable trust owns the real estate; it is funded by a nonresident alien, who may or may not be a beneficiary of the trust.

Other

  1. A REIT owns the real estate.
  2. Can you think of any other possible entity type?

Multi-Level Structures

There are two types of holding structures: those that have one entity between the owner and the asset, and those which have multiple levels of entities between the owner and the asset.

A simple corporate structure is what I call a single-level structure. A parent/subsidiary structure is an example of a multi-level structure.

I am going to address multi-level structures in a future episode of this series. I will use the single-level structures to explain tax results, so you can see how (and if!) added complexity brings you added tax benefits.

How to Pick a Holding Structure

So many choices! How do you decide? There’s a method: drain the ocean and throw away the fish you don’t want. What you have left is dinner.

The analysis follows this sequence:

  • Start. List all of the possible structure choices.
  • Filter 1. Remove the prohibited (a legal question) choices.
  • Filter 2. Remove the legally impossible choices.
  • Filter 3. Remove the impractical (a real world question) choices.
  • Filter 4. Remove the choices that have unacceptable estate tax results.
  • Filter 5. Remove the choices that have unacceptable income tax results.
  • Filter 6. Remove the choices that have unacceptable tax withholding results.
  • End. Choose among the remaining structure options.

List All of the Options

As a preview of the conclusion of this episode in the “choose a holding structure” series, here is a table showing all of the single-entity holding structure choices available. I will show you the first three filters in this episode. Next time, I will address the estate tax analysis (Filter 4).

Filter 1: Explicitly Prohibited

A domestic corporation that has elected to be taxed under Subchapter S cannot be used. A nonresident alien may not be a shareholder of an S corporation.

(But do not be discouraged! When we look at multi-level holding structures we will discover that in fact a nonresident alien can use an S corporation to own U.S. real estate. This is an interesting strategy option for people renouncing U.S. citizenship or where you are fixing badly-designed existing holding structures).

Filter 2: Logically Impossible

It is impossible for a nonresident alien to own U.S. real property in a domestic revocable trust.

A domestic trust is one that passes the “court test” (a U.S. court has jurisdiction over trust administration) and the “control test” (all substantial decisions are made by United States persons).

If a nonresident alien creates a revocable trust and holds the power to revoke it, that power to revoke is substantial, and it is held by someone who is not a United States person. Therefore, the court fails the “court test” and is classified as a foreign trust.

Therefore, we cross the “domestic revocable trust” off the list, because even though in theory it’s a thing, it can never in fact exist as long as the power to revoke is held by a nonresident alien.

Filter 3: Wildly Impractical

The final item we cross off the list is the REIT idea. Among other things, an entity–to be classified as a REIT–must have at least 100 beneficial owners. This is buying a bulldozer for your potted plants.

At the end of these knockout punches, we have quickly and cheaply eliminated three ideas, using generic tax laws. We have not examined specific and technical estate, gift, or income tax rules to determine the performance of the different structures. That’s next.

Result: from 13 choices to 10 remaining

We have reduced the number of choices from 13 to 10 without looking at the tax performance of any particular structure. 

Next episode: estate tax

In the next exciting episode, we will whittle the number of single-level entity holding structure choices down from ten to three, based on estate tax performance of the structures. Future episodes will examine the income tax performance of those remaining three structures and FIRPTA withholding on sale. 

After that . . .

I will then look at multi-level holding structures. Perhaps some of the unacceptable single-level holding structures can redeem themselves when we add a layer.

Hint hint. Does your nonresident investor want to use an S corporation? 

As noted above, nonresidents cannot be shareholders of S corporations. But what if . . . a trust owns S corporation stock and a nonresident is a beneficiary of that trust? Hint hint Electing Small Business Trust hint hint Tax Cuts and Jobs Act amendment to IRC §1361(c)(2)(B)(v).

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