The IRS ruled that a type of investment called a total return swap, which is tied to U.S. real estate, does not count as U.S. real property for tax purposes. This is good news for foreign investors using this type of investment to invest in U.S. real estate. Total return swaps are contracts where two parties agree to make payments to each other based on how an asset’s value and performance change. Investors can use these swaps to mimic owning the asset without actually buying it, or to get rid of the risk of owning the asset without selling it. A foreign investor believes that ABC, Inc., stock will go up in value, so they make a deal with a bank. The bank will pay the investor any money the stock makes (like dividends or if the stock goes up in value) and the investor will pay the bank if the stock loses money. This deal is called a total return swap. For tax reasons, the investor doesn’t want to invest directly in the stock, so they make this deal with the bank instead. This way, they won’t have to pay as much in taxes. Foreign individuals are subject to U.S. federal income tax on certain types of income they earn in the U.S. This includes things like interest, dividends, rents, and income from a U.S. business. When foreign individuals sell U.S. real estate, they have to pay a special tax called FIRPTA, which treats the profit from the sale as if it’s U.S. business income, subject to U.S. income tax. The buyer of the property also has to withhold and send 10% of the purchase price to the IRS. This is different from how foreign individuals are normally taxed on profits from selling things in the U.S. A USRPI, or U.S. Real Property Interest, is when a person or company has a stake in real estate in the U.S. This can include owning property directly or having shares in a corporation that mainly deals with U.S. real estate. A recent ruling looked at whether a type of financial contract, called a total return swap, counts as a USRPI. In the ruling, a foreign company made a deal with a U.S. company to swap returns based on a real estate index. The ruling said that, in this case, the financial contract does not count as a USRPI. The index measures the rise and fall of property values in a big city or area in the US. It looks at things like sales prices and appraisals to figure this out. Based on the index, FC can make money if property values go up, but lose money if they go down. The IRS says that because the index covers a lot of different properties, it doesn’t count as owning a piece of any specific property. So, FC doesn’t have to pay taxes on the money they make from the index. The ruling is important because it says that a certain type of financial agreement, called a swap, doesn’t count as owning U.S. real estate for tax purposes. This is because the agreement is based on a wide-ranging index that includes many different areas, not just specific properties. But there are still some questions about what exactly counts as owning a “material” amount of real estate. Overall, the ruling is significant because it sets a precedent for how these types of financial agreements are treated for taxes. The ruling doesn’t clearly say whether a foreign investor can use a total return swap tied to something other than a real estate index to avoid being taxed on U.S. real estate. Foreign taxpayers need to be careful with two types of REITs for U.S. tax purposes. If a REIT is domestically controlled, then a foreign investor won’t have to pay U.S. tax on any gains from selling the REIT shares. But they will have to pay tax on any distributions from the REIT that are from gains on U.S. real estate. It seems like it’s better for a foreign investor to use a total return swap to get exposure to a domestically controlled REIT instead of buying the shares directly, because they won’t have to pay U.S. tax on any swap payments tied to the REIT’s distributions. If a foreign investor owns a long position in a swap tied to the value and performance of shares in a U.S. real estate investment trust (REIT), it may not be considered a U.S. real property interest. The IRS would only be able to tax the foreign investor if the swap caused them to be treated as the actual owner of the REIT shares. This may be difficult for the IRS to prove.
For publicly traded REITs, foreign investors who own less than five percent of the stock won’t be taxed. But if they own more than five percent, they will be subject to U.S. federal income tax on any gains from selling the REIT shares and on any distributions from the REIT. If a foreign person owns more than 5% of a publicly traded real estate investment trust (REIT), they could face higher taxes on their investment. However, using a financial agreement called a swap could potentially lower their tax obligations. The rules on whether this swap would be subject to U.S. real property tax are still unclear. Another complicated issue is whether the end of the swap agreement would be seen as selling the property, which could trigger more taxes. This would depend on the specific terms of the swap agreement. A termination payment is a payment made to end or transfer some or all of the remaining rights and obligations of a party under a swap contract. This kind of payment is likely to be considered a sale of a capital asset, which means it could give rise to a disposition for tax purposes under section 897.
However, the IRS doesn’t see periodic or nonperiodic payments as a “cancellation, lapse, expiration, or other termination” of a capital asset. They have ruled that receiving regular or one-time payments according to the terms of the contract doesn’t count as a sale under section 1234A.
In short, a termination payment from ending a swap could be considered a sale for tax purposes, but regular and one-time payments from the swap may not count as a sale according to the IRS. According to the §897 regulations, if a foreign corporation gives a loan to a domestic individual and receives regular payments plus a share of the property’s increase in value, it does not count as a disposition under §897. This means the foreign corporation won’t have to pay taxes on the final payments it receives. However, if the foreign corporation sells the debt obligation, it will have to pay taxes on the gain. The tax rules for foreign investors participating in U.S. real estate appreciation through financial instruments like total return swaps are complicated and unclear. A recent ruling may allow foreign investors to avoid certain taxes on these investments, which could lead to new opportunities for them to invest in U.S. real estate. However, it’s still a complex area and it’s unclear how things will develop in the future. Ocala, Florida is one of the 363 Metropolitan Statistical Areas in the United States. A court case called Britt v. Commissioner in 1939 decided that a reorganization happened when a corporation transferred over 90 percent of its assets to another corporation in exchange for stock and cash. There is an argument that owning shares in a Real Estate Investment Trust (REIT) is like owning the real estate itself. A domestically controlled REIT is one where less than 50 percent of the stock is held by foreign persons. The IRS has rules about how gains from REITs are taxed, and they recently clarified that liquidating distributions from a REIT are also subject to these rules. If a foreign investor has a swap agreement for REIT shares, it doesn’t give them the same rights as owning the shares directly. The tax code has specific rules about how gains from the sale of REIT shares are treated. The article discusses tax regulations and exemptions related to nonperiodic payments. It mentions specific rulings and regulations that can impact how these payments are taxed. The author, a tax expert, shares their expertise on the topic.
Source: https://www.floridabar.org/the-florida-bar-journal/irs-rules-total-return-swap-tied-to-real-estate-index-is-not-subject-to-firpta/
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