Can FIRPTA Be Avoided With Financial Instruments?

Foreign investors are looking to invest in U.S. real estate due to uncertainty in the stock markets. However, they face tax obstacles under the Foreign Investment in Real Property Tax Act (FIRPTA). This law requires foreign investors to pay taxes on any gains from selling U.S. real estate. Some investors are using financial instruments to avoid these taxes, but it’s unclear if this strategy is legal. A total return equity swap is a contract where two parties agree to make payments to each other based on the value and dividends of a stock. An investor might use a swap to make a bet on a stock’s performance without actually buying it, or to get rid of the risk of owning a stock without selling it. For example, a foreign investor who can’t buy a certain stock directly might enter into a swap with a bank. The bank would pay the investor any dividends or increases in the stock’s value, and the investor would pay the bank any decreases in value. The bank would then buy the stock to cover its own risks. The IRS is trying to decide if a certain rule applies to an investor who invested in a swap. They could argue that the investor’s position in the swap is like owning property in the US, or that the investor should be seen as owning the actual US company’s stock. A long position in an equity swap may or may not be considered a US real property interest for tax purposes. The rules are unclear and the IRS has not provided guidance on this issue. Some argue that the rules were not intended to include long positions in equity swaps, but rather were meant for other types of investments. The lack of clear guidance from the IRS leaves this issue open for interpretation. The IRS may argue that investors in a long position in an equity swap should be treated as the owners of the underlying asset, and therefore subject to certain tax rules. However, this argument is unlikely to hold up because the investor in a swap actually receives 100% of the appreciation in the underlying asset, and therefore is not “sharing” the appreciation with anyone else. Additionally, the long position in a swap does not confer the same rights and concerns as direct ownership of the underlying asset. Therefore, it is generally agreed that investors in a long position in an equity swap should not be treated as the owners of the underlying asset for tax purposes. If you do a swap with someone for stocks that aren’t traded much, the IRS might think that they’re just holding the stocks for you. But, there are cases where the IRS didn’t treat the person doing the swap as the owner of the stocks, even if they were obligated to share in the profits or losses. The rules for swaps with non-actively traded stocks also say that they can be treated as a swap, so it’s unlikely the IRS would treat you as the owner of the stocks in this situation. Code §1260 was enacted to prevent taxpayers from using derivatives to manipulate the character and timing of income. It recharacterizes long-term capital gains from derivative contracts into ordinary income and imposes an interest charge. However, it does not affect the tax ownership of property. Even if the IRS argues that Code §897 should apply to a long position in a swap with respect to the stock of a USRPHC, a non-U.S. investor will only be taxed when such position is “disposed” of, which can include a broad range of transactions. An equity swap can result in a disposal (or sale) when it ends, depending on the types of payments involved. There are three types of payments in an equity swap: periodic, nonperiodic, and termination. The only type that is likely to result in a disposal for tax purposes is a termination payment. This is because the tax law treats the termination of a right or obligation as a sale of a capital asset. So, when a termination payment is made or received in an equity swap, it is considered a disposal for tax purposes. The IRS doesn’t consider receiving regular or one-time payments as getting rid of or giving away a capital asset. Even though courts may have a broader interpretation of the term “disposition,” the regulations don’t indicate that receiving final payments on a swap should result in a tax disposition. An example in the regulations shows that a foreign lender receiving regular payments from a domestic borrower does not trigger a tax disposition. However, selling the debt obligation would result in taxable gain. Foreign investors are investing in U.S. real estate, and using equity swaps to avoid certain taxes. These swaps involve contracts that allow the investors to share in the profits of the real estate without actually owning it. The tax rules around these kinds of investments are complicated, and there is ongoing debate about how they should be treated for tax purposes. As long as the investments are structured as equity swaps and not sold before they mature, they may not be subject to certain tax laws. As the real estate market grows, more foreign investors may choose to invest this way to avoid taxes. Jeffrey L. Rubinger is a lawyer in Florida who specializes in tax law. He is a member of the Tax Section and is admitted to practice law in both Florida and New York. He is also a certified public accountant.

Source: https://www.floridabar.org/the-florida-bar-journal/can-firpta-be-avoided-with-financial-instruments/