How Section 897 Capital Gain Rules Impact Your Real Estate Portfolio

Investing in United States real estate for foreign nationals has long been a potentially lucrative opportunity, but there are tax laws that must be taken into consideration. One of the most critical tax rules is Section 897 of the Internal Revenue Code (IRC). This section is part of the Foreign Investment in Real Property Tax Act (FIRPTA), which was passed in 1980 to address concerns about increasing foreign land ownership in the U.S. 

Nowadays, FIRPTA allows the U.S. to tax foreign persons on dispositions of U.S. real property interests. In this article, we’ll cover how Section 897 specifically applies to capital gains on U.S. real estate transactions. This information is essential for foreign investors looking to boost their portfolios with U.S. real estate property. 

Read on to learn how Section 897 capital gains are taxed, why they matter to real estate investors, and strategies to guarantee compliance. 

What Is Section 897?

Before FIRPTA was enacted, foreign investors could sell U.S. real estate without incurring U.S. capital gains taxes. However, to create tax equivalence between foreign and domestic investors, Congress passed FIRPTA, ensuring more foreign investors pay tax on real estate sales just like U.S. taxpayers do.

Section 897 specifically addresses the taxation of ordinary dividends and capital gains from United States real property interests (to be defined in the following section) owned by foreign individuals or entities. This article will specifically deal with the capital gains section of this code. 

Under this section, any gain or loss from a foreign person’s disposition of a U.S. real estate property interest is treated as income that is effectively connected with a U.S. trade or business. Essentially, this means foreign investors must file U.S. tax returns and are subject to capital gains tax on their real estate sales. 

What Are Section 897 Capital Gains?

Capital gains are the profit earned from selling an asset, like real estate. Under Section 897, capital gains from the sale of United States real property interests (USRPIs) are subject to U.S. taxation. 

A USRPI includes:

1. Direct interest in real property like land, buildings, and improvements located in the U.S. or U.S. territories. 
2. Shares in corporations that are U.S. real property holding corporations (USRPHCs). These are companies where 50% or more of their assets consist of U.S. real property interests. 

Note: There are several exclusions to the term “United States real property interest.” For example, USRPIs do not include any interest in a domestically controlled qualified investment entity or a short-term regulated investment company. A qualified foreign pension fund is not treated as a nonresident alien individual or a foreign corporation, either.

Section 897 distinguishes between capital gains and ordinary income (such income includes rental income and short-term gains). The treatment of capital gains depends on whether the investor qualifies for long-term capital gains tax rates or is taxed at ordinary income rates. 

Taxation of Section 897 Capital Gains

• Long-term gains (property held by individuals for more than a year) may qualify for preferential tax rates (15% or 20%). 
• Short-term gains (property held by individuals for less than a year) are taxed at ordinary income rates (up to 37%). 
• Foreign corporations are taxed at the corporate rate of 21%.
• FIRPTA requires withholding at 15% of the gross sale price when a foreign investor sells U.S. property (on sales above $1,000,000). 
• Other taxes may apply depending on whether profits are repatriated to a foreign country. 

How Section 897 Impacts Real Estate Investors

There are different tax implications for foreign investors versus domestic investors. 

Foreign investors

When a foreign individual or such foreign corporation sells U.S. real property, the gain is subject to U.S. federal income tax, usually at capital gains rates for individuals and corporate tax rates for entities. The sale of real estate stock may also be subject to Section 897 mandated taxings. 

Domestic investors

Buyers of U.S. real estate must typically withhold 15% of the gross sale price when purchasing from a foreign seller. This amount is then remitted (sent) to the IRS to cover potential tax liability.

Let’s build a scenario to illustrate these impacts. Imagine that a nonresident foreign investor owns a building in a U.S. city, originally purchased the property for $7 million, and sells it for $10 million.

• The $3 million gain ($10M vs. $7M) is treated as effectively connected income under Section 897.
• The buyer is required to withhold 15% of the sale price ($1.5M) and remit it to the IRS under FIRPTA.
• The foreign investor files a U.S. tax return to report the capital gain and claim any potential refund if the tax owed is less than the amount withheld.

Calculating Section 897 Capital Gains

Below is a step-by-step guide to help foreign investors subject to Section 897 calculate capital gains. It is recommended to use this guide alongside guidance from a tax professional specializing in international tax law.

1. Determine if the property is a USRPI
2. Determine the cost basis (purchase price) and amount realized (sale price)
3. Calculate the capital gain
   1. Capital Gain = Amount Realized − Adjusted Cost Basis
4. Apply the appropriate tax rates (mentioned above)
5. Determine applicable FIRPTA withholding and potentially file for a U.S. tax return

Strategies to Minimize Tax Liability

There are potential strategies you can use to minimize Section 897-related tax liability, including properly structuring transactions, leveraging tax treaties where applicable, and utilizing professional tax advisors or legal counsel. 

Foreign investors can structure their investments in ways that mitigate tax consequences, for example, by using like-kind exchanges (1031 exchanges) to defer capital gains tax by reinvesting proceeds into another U.S. property. 

Some countries have tax treaties with the U.S. that can reduce specific tax obligations. Check for existing treaties to figure out your potential benefits. 

Not including a tax professional in the calculation process would be a serious mistake for any investor. FIRPTA regulations can be very confusing, and accidental noncompliance may result in penalties. A professional’s insight will help avoid this scenario. 

Optimize Your Investments with Capital Gains

It’s vital for foreign investors to understand Section 897 capital gains. Reviewing the tax code yourself is one way to get started, but seeking professional tax advice will truly help you navigate complex regulations. 

To learn more about 1031 exchanges and other tax-deferred investment options, visit 1031 Crowdfunding today. Our platform offers expert guidance and resources to help you navigate alternative investments with confidence.

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