By now, most foreign investors that are investing in US real property or US infrastructure projects have likely encountered the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”). In general, FIRPTA was enacted to impose a tax on gains derived by foreign persons on the disposition of US real property interests (“USRPI”). Included in the definition of a USRPI is a US real property holding company (“USRPHC”), which is a corporation whose assets consist of more than 50% of USRPIs. However, the FIRPTA rules contain a little-known trap that applies to companies during their start-up phase. The problem is that when testing whether a company’s assets consist of 50% of USRPIs, a USRPI must be included in the USRPHC calculation regardless of whether it is used or held for use in a trade or business. On the other hand, a non-USRPI asset may be included in the USRPHC calculation as a Trade or Business Asset only if it is currently used or held for use in the active conduct of a trade or business. Thus, until a corporation commences operations, none of the non-USRPI assets can qualify as Trade or Business Assets. Although the regulations provide a 120-day start-up grace period during which a new corporation is not required to determine its USRPHC status, 120 days typically is not enough time for most businesses to commence operations. Therefore, as a practical matter, most corporations that acquire land or an office (or any other USRPI other than a fair market value lease) before commencing operations likely will be USRPHCs as of their first determination date. Additionally, once a corporation is treated as a USRPHC for any given year, it is treated as automatically treated as a USRPHC for the next 5 years.
For example, assume a new corporation is formed on June 1, 2022, to manufacture widgets. The corporation immediately acquires a factory (a USRPI) and purchases machinery, but it does not commence operations until March 1, 2023. On December 31, 2022, its first determination date, the corporation’s only assets are a $2 million factory and $30 million of machinery. For purposes of determining whether the corporation is a USRPHC, the value of the factory must be included in the calculation as a USRPI, but the value of the machinery may not be taken into account as a Trade or Business Asset because the corporation is not yet engaged in the active conduct of a trade or business. Accordingly, the USRPHC fraction will be 100% ($2 million / $2 million), making the corporation a USRPHC. Although the corporation will cease to be a USRPHC after it commences operations (assuming the same asset mix), the corporation will be treated as a USRPHC for at least five years.
This trap can cause many start-up businesses to be treated as a USRPHC for the first 5 years after operations even when they don’t necessarily expect to be treated as a USRPHC. Some businesses may be able to avoid this result, such as certain developers that are in the business of developing property, by claiming they have been in a trade or business of developing from the first moment they purchased assets.