Investing in a Closed-End U.S. Real Estate Fund

Mary Ann Rosenberg, CPA

With strong performance in 2011, closed-end real estate funds still offer an attractive way for the foreign investor to invest in U.S. real estate.  Foreign investors considering investing in a closed-end fund have a complex set of rules to learn and several steps to follow to ensure they are properly complying with U.S. tax law.   In this article , the first of a three-part series, we hope to provide a helpful guideline for the foreign investor, with a general overview of what a closed-end fund is, a summary of  U.S. tax law, and a list of the steps that the investor needs to take to comply with U.S. tax law.

A common form of the closed-end real estate fund is the limited partnership, and for purposes of this article, we will assume the closed-end fund is structured as a limited partnership.

What is a closed-end fund?

A closed-end fund is an investment often used as a vehicle to invest in U.S. real estate.  Closed-end funds can increase yield by using leverage, which increases risk as well.  Closed-end funds offer a fixed number of units to investors.  These units can be sold, usually on a secondary market.   For tax purposes, closed-end funds are often structured as limited partnerships.  The partner is not taxed on any distributions from the partnership; rather he is taxed on his proportionate share of income and loss, which is reported to him on a Schedule K-1.  The partner’s investment in the partnership is maintained via a capital account, which serves to track the partner’s net investment in the partnership.  Contributions by the partner to the partnership increase his capital account; distributions reduce it.  Similarly, the partner’s share of income from the partnership will increase his capital account, while losses reduce it.

How is a foreign investor in a closed-end fund taxed in the U.S.?

It is important to have a basic understanding of how U.S. tax law applies to foreign individuals.  The residency status of the foreign individual must first be determined.  A foreign individual who does not have a green card and does not meet a substantial presence test is considered a nonresident alien for U.S. tax purposes.  An individual does not meet the substantial presence test if he is present in the U.S. for less than 31 days during the current tax year, and 183 days during the 3 year period ending with the current tax year (using a specially weighted formula to calculate the 183 days). For purposes of this article, we will address the issues facing the nonresident alien investor.  (See IRS Publication 519, U.S. Tax Guide for Nonresident Aliens, for more details on the substantial presence test).

Nonresident aliens are taxed on U.S. sourced income.  This income is divided into two categories:

  1. Income that is effectively connected with a U.S. trade or business
  2. Income that is not effectively connected with a U.S. trade or business

Generally, effectively connected income is allowed to be offset by deductions, and is taxed at the graduated rates applying to U.S. citizens and residents.  Income that is not effectively connected (i.e., interest, dividends) is taxed at a flat 30% or a lower treaty rate. 

How are earnings from a limited partnership taxed?

If a nonresident alien is a partner in a partnership that is engaged in a U.S. trade or business, then he is considered to be engaged in a trade or business, and thus will have effectively connected income.  He is subject to U.S. tax on his share of this effectively connected income from the partnership, which is reported to him on Schedule K-1.  To ensure collection of tax, the IRS requires partnerships to generally withhold income tax at 35% on this effectively connected income.  By filing an individual U.S. tax return (Form 1040NR) and utilizing a personal exemption and certain itemized deductions, the taxpayer can often obtain a refund of some, if not all of this withholding. 

What does the foreign investor need to do for U.S. tax purposes?

  1. Obtain an ITIN

The IRS requires foreign persons to use an ITIN as their unique identification number on Federal tax returns.  An ITIN is a nine-digit tax processing number for certain resident and nonresident aliens and their spouses and dependents.  The ITIN is available only to individuals who have a valid U.S. filing requirement or are filing to claim a refund of over-withheld tax and who are not eligible for a social security number.  In many cases, the closed-end real estate fund will help you complete the forms necessary to obtain an ITIN via one of the following two methods:

          Form W-7:

To apply for an ITIN, the individual completes Form W-7 (Application for IRS Individual Taxpayer Identification Number) and attaches it to the initial U.S. tax return.  Also required are original, notarized or certified documents that establish proof of identity and foreign status.  (Refer to the instructions for Form W-7 listing the acceptable documents).  The return, Form W-7 and these documents are then filed with the IRS in Austin, Texas.

Acceptance Agent Agreement:

Another way to apply for an ITIN is to use an acceptance agent.  Acceptance agents (AAs) are persons who have entered into formal agreements with the IRS that permit them to assist applicants in obtaining ITINs.  Certifying acceptance agents (CAAs) are individuals or entities who assume a greater responsibility and are authorized to verify the applicant's claim of identity and foreign status through a review of the appropriate documents, as well as verifying the authenticity, accuracy and completeness of the supporting documentation.  They can submit a Form W-7 on behalf of an individual, and can receive the ITINs directly from the IRS.  Typically, large closed-end real estate funds operate as certifying acceptance agents.

  1. File Form 1040NR – U.S. Nonresident Alien Income Tax Return

As discussed earlier, a nonresident alien invested in a limited partnership will receive a Schedule K-1 reporting to him his share of the partnership’s taxable income.  This income must be reported on Form 1040NR, U.S. Nonresident Alien Income Tax Return.  Part II of this article discusses in more detail the steps necessary to file Form 1040NR.