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Disposition of a Closed-End U.S. Real Estate Fund Investment
May 30, 2012
Julie Armstrong, CPA
In the third and final part of this series, we discuss the ramifications of disposing of an investment in a U.S. real estate fund. Part 1, Investing in a Closed-End Real Estate Fund, discussed the initial investment in U.S. real estate, while Part 2, Annual Income Tax Return Requirements for Nonresident Aliens Invested in U.S. Closed-End Real Estate Funds discusses the annual filing requirements associated with your investment. While the same general principals apply to any disposition of any U.S. real estate, we will focus on the disposition of investment held via a partnership interest. The foregoing discussion is a very simple overview. There are many intricacies in the tax law that should be considered and followed. Wilson LLP is experienced in this area and will be happy to help the casual or seasoned investor through the process.
Tracking Basis of the Investment
Basis is an important concept as it is the amount used to calculate the gain or loss upon a disposition. Basis begins with the initial investment amount – the amount you paid for the partnership interest. If you acquired your interest by inheritance, your basis begins with the fair market value of the interest at the date of death of whom you inherited it from, or if acquired by gift, the “carryover basis” (their basis in the interest at the time of the gift) of the person who gifted the interest to you. This is an oversimplification of the law for inheritance and gift, but is provided to give a general and simple overview.
Any additional contributions to the partnership will increase your basis and any distributions from the partnership will decrease the basis. In addition, the income allocation reported on the annual Schedule K-1 of the investment will increase your basis. Likewise any loss allocation on the Schedule K-1 will decrease your basis. All of the information needed to track basis after the initial acquisition can be found on the annual Schedule K-1. Accordingly, it is important to retain the Schedule K-1 distributed to you from the partnership each year as well as any documents pertaining to your initial investment.
Passive Income and Loss
Income or loss from a partnership investing in U.S. real estate to a partner is usually always deemed to be passive for U.S. tax purposes. This means that while the net rental income is subject to the normal U.S. marginal tax rates, any net rental losses can only offset passive income that the investor has from this partnership interest or another partnership interest in which they are a partner. Any passive losses that are unable to be used in the current year may be carried forward indefinitely to future years where there is income.
Once a partnership interest is completely disposed, then the losses are no longer passive and can be taken in full in the year of complete disposition. Once this occurs, if there is no passive income to offset, the loss is converted to a net operating loss (NOL). NOL’s can be carried back two years or carried forward twenty years. An election in the year of the NOL may be made to forgo the carryback and use the carryforward period only.
Disposition of Investment by Sale in a Secondary Market
If you sell your interest to an unrelated party, you will report gain or loss on the investment on your individual tax return in the year of the sale. The gain or loss is calculated by subtracting your basis from the sales proceeds (net of any commissions paid). A gain may be reduced by any current year passive losses or passive loss carryforwards from this investment or any other investment held by the investor. A majority of the gain is treated as a capital gain, currently taxed at a maximum rate of 15%, however, a portion of the gain may be taxed at a maximum rate of 25%.
If the seller of the interest is a nonresident alien, the purchaser of the interest is required to withhold 10% of the sales proceeds and remit to the IRS on behalf of the seller. The law provides for a reduction in the withholding if the seller provides information to the purchaser that substantiates that the withholding is greater than the tax liability. However this article is intended as a basic overview and will not go into the detail of how that law works. The seller will receive a Form 8288-A which will report the amount of the withholding. The amount of the withholding will be reported on the nonresident’s individual tax return as a payment towards any tax liability reported on the return. The Form 8288-A should be attached to the seller’s individual return in the year of sale in order to claim the withholding payment. If the withholding is greater than the seller’s tax liability, the remainder will be refunded to the seller by the IRS upon filing of the tax return. If the withholding is less than the seller’s tax liability, the seller will be required to pay the additional tax with the filing of the return.
Disposition of Underlying Real Estate by the Partnership
Frequently, an investor holds onto their partnership interest until the partnership sells all or a portion of the real estate it owns. If this is the case, the gain or loss on the sale is calculated at the partnership level and allocated to the partners on the Schedule K-1.
Due to the depreciation rules formulated by the IRS, the gain could be subject to several different tax rates. A portion may be considered ordinary and taxed using the marginal rates with the highest current rate being 35%. A portion could also be classified as a recapture of depreciation previously deducted and taxed at a maximum rate of 25%. Any remaining gain would be considered capital gain and taxed at a maximum rate of 15%.
If partnerships have partners who are nonresident aliens or foreign entities, they are required to withhold on behalf of these foreign partners. They must withhold 35% on all income of foreign corporations and 35% on ordinary income, 25% on depreciation recapture, and 15% on capital gain income for individuals. This withholding is reported on Form 8805 and usually distributed to the partner when the Schedule K-1 is distributed. The partner reports the withholding from the Form 8805 as a payment on their individual return. As with the Form 8288-A discussed above, the form should be attached to the individual’s return and is treated as any other payment of tax. If the payment is greater than their liability, then the excess is refunded. If the payment is less than their liability, the balance of the tax will have to be paid by the individual.
Disposition by Gift or Due to Death
An investor may want to gift their interest to another. If this is the case, there is no gain or loss associated with the act of a gift for income tax purposes. However, there could be gift tax consequences. Gifts by foreign investors are treated differently than gifts by U.S. investors and the gift tax laws and any applicable tax treaties should be considered before making a gift of a partnership interest.
An investor who dies while owning an investment in U.S. real estate is subject to the U.S. estate tax. The rules are complex and not discussed in depth here. The amount of the estate tax is subject to how large the estate is and to whom the property is bequeathed. There is a separate estate tax return (Form 706NA) for a nonresident alien.