U.S. Individual’s Investment in Overseas Rental Property

Editor: Kevin F. Reilly, J.D., CPA

The regulations under Sec. 904, issued in July 2004, make clear that the subpart F provisions continue to apply to overseas investment in real property by individuals. Those regulations expand the definition of what are considered active rents for the purposes of determining the passive activity foreign tax credit limitation. However, in passing, the preamble to those regulations reaffirms the long-standing but often overlooked and misunderstood rules about what constitutes active rents for subpart F inclusion purposes (TD 9141). This item addresses the tax ramifications of a typical scenario in today’s hot Costa Rican real estate market, which likely is applicable to many practitioners.

Example: X and Y, a U.S. couple, in 2005 formed two Costa Rican SAs (sociedades anónimas, or corporations), A and B, which purchased two condominium units (each costing approximately $120,000), partly through cash contributions from X and Y and partly through mortgage financing obtained by A and B. X and Y intend to rent out the condo units and have little interest in visiting Costa Rica. The purchase is an investment, which will be managed by a local management company in Costa Rica. Costa Rica will impose tax on the income derived from the rental operation.

Individuals generally are taxable on the cash basis. Corporations that do not repatriate earnings to individuals generally do not trigger a second layer of tax at the individual level. However, these rules are potentially superseded in certain cases, such as foreign corporations that are predominantly U.S. owned (controlled foreign corporations, or CFCs).

In the example, X and Y are significant U.S. shareholders and hold 100% of both A and B. Thus, it is clear under Sec. 957 that A and B are CFCs. X and Y are therefore subject to the CFC rules for A and B.

The CFC rules create for the CFC’s owners a deemed inclusion of income for certain types of income, all called subpart F income. The issue here is to determine whether the Costa Rican CFCs (A and B) have subpart F in-come. Under the CFC rules in the context of foreign rental operations, rents are generally subpart F income, with certain exceptions. Thus, unless an exception applies, X and Y would need to report A and B’s rental activity on a current basis.

Exceptions

The only possibly relevant exceptions in a typical individual ownership scenario are either (1) rents in an active trade or (2) rents earned in a “high tax” foreign country. Rents are considered derived from an active trade when they are derived from real property for which the CFC regularly performs active and substantial management and operational functions during the lease period (Regs. Sec. 1.954-2(c)). Typically, taxpayers and many practitioners seem to believe that this includes a situation in which a taxpayer hires a management company to manage the property, as opposed to just letting it be or calling from overseas to check on things. However, this is not the case. The example of inactive, and hence subpart F, rents is set forth in the regulations and includes instances in which the CFC engages an unrelated real estate management firm to lease the real property, manage the buildings, and pay over the net rents (Regs. Sec. 1.954-2(c)(3), Example (3)). This is what X and Y plan; accordingly, they will have a subpart F income inclusion if no other exception is met.

The regulations also include an example of active rents (Regs. Sec. 1.954-2(c)(3), Example (4)). The CFC hires its own employees to manage the operation. Typically, these employees would need to occupy a rented office space for their management operation.

There are obviously other scenarios between these extremes of not handling anything and handling everything about the properties; however, from a careful review of the few relevant rulings on point, a certain conclusion begins to emerge. To achieve active rents status, it appears that the CFC must retain some employees to handle at least some aspects of the rental activity’s management and operations (e.g., maintenance, marketing, etc.). For the purposes of this example, X and Y fail to qualify under this exception, because a management company will manage their Costa Rican rentals for them, so the only alternative is the high-taxed-income exception.

The rationale for the high-taxed-income exception is simply that a taxpayer would not attempt to defer income from U.S. tax by subjecting it to a higher tax in another country. The high-taxed-income exception applies when the income is subject to at least 90% of the highest U.S. corporate rate (Sec. 954(b)(4)). In numerical terms today, the income would need to be subject to at least a 31.5% effective tax rate (90% × 35%). Costa Rican tax rates graduate to a top rate of 30%, depending on the level and location of the income. Since 30%, though high, is less than the needed threshold of 31.5%, this exception does not apply to X and Y’s Costa Rican rentals. Since no exceptions apply, the U.S. owners will have a deemed inclusion of income on their U.S. tax returns to the extent of the net rental income of A and B.

Note: This deemed income inclusion is limited to a CFC’s earnings and profits (E&P) (Sec. 952(c)(1)(A)). E&P are computed according to U.S. ac-counting and tax principles and may therefore not be identical to the amount on the books kept locally for Costa Rican accounting purposes. It is also important to note that if there are deficits from the operation, they are not included on X and Y’s return; however, they may offset a future year’s current-year E&P, with the result that the income inclusion could be limited in such a year (Sec. 952(c)(1)(B)).

Treatment of Costa Rican Tax

From a U.S. tax point of view, the income tax imposed by Costa Rica on A’s and B’s rental earnings belongs to the corporations and does not automatically flow to the owners. Therefore, the tax would not be available as a foreign tax credit (but see “Elective Treatment,” below). This is akin to the U.S. treatment of U.S. corporations that pay tax on their income, on which the shareholders pay another tax when they receive their dividends. Given this, a taxpayer may wish to simply have the corporations remit the earnings that the taxpayer is being taxed on anyway. In such a case, the taxpayer needs to be aware of any withholding taxes that the foreign country might impose on the remittance.

Costa Rica imposes a dividend withholding at source of 15%. Although, generally speaking, foreign withholding tax at source (such as in the case of dividends) is available for a foreign tax credit in the U.S. (generally limited to the ratio of foreign source income to gross income multiplied by the U.S. tax due (Sec. 904)), this will not be true in the case of Costa Rica. Rather, under Regs. Sec. 1.903-1(b)(2), dividend distributions actually made, to the extent a tax at source would be imposed, would not be available in the case of Costa Rican withholding because the IRS has ruled (in Rev. Rul. 2003-8) that the Costa Rican tax at source is a “soak-up tax” (i.e., Costa Rica imposes it only if credit for it is given in the foreign country —in this case, the United States).

Practice tip: It is imperative when investing in soak-up countries that the investment corporation file an application with the foreign country’s tax authorities to request and obtain an exemption from the country’s withholding at source. Otherwise, foreign withholding on the distributions back to the United States will be subject to a noncreditable foreign withholding tax. This is an important planning point that practitioners should discuss with their clients.

Sec. 904(d) was amended by the American Jobs Creation Act of 2004, P.L. 108-357 (AJCA), to expand the definition of active rents for foreign tax credit limitation purposes. The amendment allows rents to be regarded as active (and thus not passive) if any related taxpayer (as defined) has active rents; assume this does not apply to X and Y. Finally, note that for 2007 onward (per the AJCA), the foreign tax credit limitation baskets in Sec. 904(d)(1) are reduced to only two: passive and general.

Elective Treatment

The use of corporations for real estate investment precludes the availability of a foreign tax credit for the foreign taxes imposed in the foreign country on the local rental activity of the corporations. However, Regs. Sec. 1.962-2 affords one avenue of relief to an individual taxpayer, allowing the individual to make an election to tax in the United States the subpart F inclusion at corporate tax rates and to receive a foreign tax credit for the underlying corporate tax that the CFC itself paid—in this case, the Costa Rican income tax paid by A and B. This could be beneficial for an individual, depending on his or her total U.S. tax picture, because U.S. corporate tax rates start at 15% (for the first $50,000 of income). This works only if the foreign country tax is regarded as an “income tax” in the U.S. tax-rules sense. Practitioners should get involved in making this determination.

Caution: Any amount actually distributed subsequent to this inclusion “pickup,” to the extent that the CFC’s E&P exceed the U.S. taxes paid on the previous inclusion pickup, must be included in income (Sec. 962(d)).The effect is to water down the benefit of the U.S. credit previously allowed to roughly equal the benefit of a deduction, the actual benefit of which would depend on the taxpayer’s marginal tax bracket and the length of time between the inclusion pickup and the actual distribution.

If the election is not made, the inclusion is treated under the regular CFC rules. It would be taxed at the individual rates, and a subsequent distribution of it would be wholly excluded from U.S. tax.

There are additional reporting re-quirements for U.S. owners of CFCs. Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations, must be filed. Generally speaking, taxpayer investors like X and Y would fall into Category 4 (see the Form 5471 instructions), which basically requires the reporting of much additional information about the CFC. Each CFC failure to file is subject to a $10,000 penalty, plus a reduction of any relevant foreign tax credit.

Under the election noted above, the taxpayer would need to use Form 1118, Foreign Tax Credit—Corporations. The taxpayer may also have an interest in a foreign account, to be disclosed on Treasury form TD F 90-22.1, Report of Foreign Bank and Financial Accounts.