The Cashless Real Estate Deal: Beware of Phantom Withholding on Foreign Partners’ Income

When the real estate market goes down, it can result in more transactions where people can’t pay their debts. This can lead to something called cancellation of indebtedness income (COD income). In Florida, the commercial real estate market has been hit hard by hurricanes, causing insurance rates to go up a lot. This means that people who borrowed money for their commercial real estate in Florida might not be able to pay it back. They might have to file for bankruptcy, give the property back to the lender, or face other legal proceedings, which could result in COD income. Also, if the property had foreign investors, the people in charge of the deal might be personally responsible for withholding taxes on the COD income from the foreign investors. This article talks about how all of this can affect taxes, and what the consequences might be under the law. The U.S. Supreme Court says that when it comes to taxes, you have to pay taxes on any money or property that you have control over and can use as your own. But if you borrow money and have to pay it back, that doesn’t count as income. However, if you don’t have to pay the money back, then you have to pay taxes on it. This usually happens years after you got the loan. So, it’s like getting money you have to pay taxes on, even though you didn’t actually receive any money. When a commercial real estate loan is paid off through a sale, transfer to the lender in bankruptcy, foreclosure, or deed in lieu, the tax consequences depend on whether the loan is nonrecourse or recourse. If it’s nonrecourse, the amount of the loan discharged is considered sales proceeds to the borrower. If it’s recourse, the borrower has taxable gain or loss from selling the property, as well as taxable income from the amount of the loan discharged. Whether it’s better for the borrower depends on their specific situation. When a person has a debt and it is forgiven or reduced, it’s usually considered taxable income. However, there are some specific situations where this forgiven debt is not counted as income, such as in bankruptcy, when a person is insolvent (their debts are more than their assets), or if the debt is related to a farm or real estate business. Also, if a person’s main home had debt forgiven, they may not have to count it as income. It’s important to remember that these rules have limits and if none of these situations apply, the forgiven debt will be counted as income for tax purposes. A partnership is not taxed as a business entity, but its partners are taxed individually on their share of the partnership’s income. If the partnership has cancellation of debt (COD) income, each partner must include their share of the COD income in their taxes, unless they qualify for an exception. In a partnership, different partners might have different tax results depending on their individual financial situations. For example, if a partnership has $3 million of COD income and partners A, B, and C are equal partners, and partner A is insolvent, partner B files for bankruptcy, and partner C is solvent, each partner will have to include $1 million of COD income in their taxes, but they might qualify for different exceptions to exclude that income. If you live in another country and earn money from the US, you only have to pay taxes on two types of income: 1) money you get from things like interest, dividends, and royalties, and 2) money you make from doing business in the US. Whether your income is from doing business in the US or not depends on a few different factors, and it can be kind of tricky to figure out. If you owe money to someone and they cancel the debt, you might still have to pay taxes on that money if it’s related to your business in the US. In a court case, a foreign-owned company had to pay taxes on cancelled debt because it was related to their business activities in the US. This is one of the few examples of how cancelled debt income is connected to doing business in the US. If a foreign person earns money in the US, the person or company paying them usually has to take out 30% of the money for taxes. If a partnership gives a foreign person money that’s connected to their business in the US, they have to take out money for taxes at the highest rate the foreign person would have to pay. If a foreign person sells US property, the buyer usually has to take out 15% for taxes. The law holds people in charge of a company personally responsible if the company doesn’t take out and give the right amount of taxes. These penalties can’t be erased in bankruptcy. If someone from another country owns a building in the US and can’t pay back a loan for the building, the lender might forgive a part of the debt. In this case, the lender does not have to withhold any money for taxes if the foreign owner doesn’t get anything else from the lender. This is true as long as the foreign owner follows all the rules. If the forgiven debt is considered income, the foreign owner might still have to pay taxes on it, depending on their specific situation. A Florida company that owns a commercial building with some foreign owners is giving the building to a U.S. lender instead of repaying a $70 million loan. The tax consequences for the company and its owners depend on whether the loan is guaranteed by the owners and whether the building is used for business. If the loan is guaranteed and the building is used for business, the company and its foreign owners will owe $7.14 million in taxes. If the loan is not guaranteed, the company and its foreign owners will owe $8.14 million in taxes. In scenario 3, if a foreign taxpayer is involved in a U.S. partnership that is not doing business in the U.S., and the partnership has debt that is forgiven, it could be considered taxable income. This could cause the partnership to owe a lot of money in taxes, even if they don’t have the cash to pay it. The person in charge of the partnership could also be held personally responsible for not paying the taxes, even if there was no cash to pay them with. This situation is not very clear and there is no clear guidance on what to do in this case. In a tough real estate market, foreign partners in a U.S. real estate venture may be on the hook for taxes. The Treasury Department and the IRS made exceptions for some taxes, but not for the one that applies to foreign partners. This could lead to big penalties for the person in charge of the real estate venture. It’s a complicated situation with serious consequences. When the real estate market is doing well, everyone benefits. But in a down market, legal obligations for foreign investors can cause problems. People setting up real estate partnerships should make sure that foreign investors invest through a separate U.S. entity to avoid these issues. If a partnership is struggling financially and has a foreign partner, steps should be taken to remove the foreign partner when certain income is recognized. It might also be helpful to change the partnership to a C corporation, but there are tax issues to consider. Dealing with these legal obligations in real estate deals is difficult, but it’s important to address them early on. This text contains references to various legal cases, tax codes, and regulations related to international taxation and cancellation of debt income. It also discusses withholding requirements for foreign taxpayers and partnerships. Some of the key points include the treatment of rental income as effectively connected income, the taxation of foreign taxpayers, and the withholding requirements for partnership interests with assets generating income in the U.S.

In simple terms, the text talks about different rules and regulations for how income and taxes are handled for people and businesses in different countries. It also discusses when money owed to someone is canceled, and how that affects taxes. Finally, it explains the rules for taking money out of a partnership if the partnership has income from the U.S. Bryan S. Appel and Mitchell W. Goldberg are attorneys at a law firm in Ft. Lauderdale. They specialize in tax law and focus on helping clients with their tax and wealth planning needs. They use technology to efficiently handle their cases. This information comes from the Tax Section, which is chaired by Shawn Wolf and edited by Charlotte A. Erdmann, Daniel W. Hudson, Angie Miller, and Abrahm Smith.

Source: https://www.floridabar.org/the-florida-bar-journal/the-cashless-real-estate-deal-beware-of-phantom-withholding-on-foreign-partners-income/