Cost Segregation for Foreign Investors (FIRPTA)

Foreign investors who own U.S. real estate are subject to U.S. tax on income from the property. Rental income is treated as effectively connected income (ECI), which is taxed at graduated rates with deductions allowed, including depreciation.

This is different from fixed, determinable, annual, or periodical (FDAP) income, which is subject to 30% withholding with no deductions. By treating rental income as ECI, foreign investors can claim depreciation deductions, which reduces taxable income and the amount of U.S. tax owed.

For cost segregation purposes, foreign investors calculate depreciation using the same methods as U.S. investors. The accelerated depreciation from cost segregation reduces ECI and can significantly reduce U.S. tax liability on rental income.

Effectively connected income from U.S. real estate includes rental income, gain on sale, and other income from the property. Foreign investors report ECI on Form 1040-NR and are taxed at the same graduated rates as U.S. residents.

Depreciation deductions are allowed when calculating ECI. Cost segregation accelerates depreciation, which increases deductions in earlier years and reduces taxable income. This can lower the foreign investor's U.S. tax liability and improve after-tax cash flow from the property.

Understanding how entity structure affects tax planning is critical when evaluating whether to hold U.S. real estate directly or through a partnership, LLC, or other entity.

Non resident cost segregation strategies focus on maximizing depreciation deductions to reduce taxable income during the holding period. By accelerating depreciation, foreign investors reduce the amount of ECI subject to U.S. tax, which improves cash flow and reduces the overall U.S. tax burden.

However, increased depreciation reduces basis, which increases the gain on sale. When the property is sold, the gain is subject to FIRPTA withholding, which is calculated on the gross sales price, not the net gain. This means the withholding amount may exceed the actual tax liability.

Foreign investors should model the net tax outcome over the entire holding period, including the FIRPTA withholding and the ability to file a return and claim a refund. In most cases, the benefit of reduced tax during the holding period outweighs the higher withholding on sale.

The Foreign Investment in Real Property Tax Act (FIRPTA) requires the buyer to withhold 15% of the gross sales price when purchasing U.S. real property from a foreign person. This withholding is remitted to the IRS and serves as a prepayment of the foreign seller's U.S. tax liability on the sale.

Cost segregation increases depreciation, which reduces basis and increases the gain on sale. This can increase the actual tax liability, but the FIRPTA withholding is based on the gross sales price, not the gain. If the withholding exceeds the actual tax liability, the foreign investor can file Form 1040-NR to report the sale and claim a refund.

For more on how firpta depreciation interacts with sale planning, review the disposition considerations section below.

When a foreign investor sells U.S. real property, depreciation recapture is calculated the same way as for U.S. investors. Personal property depreciation is subject to ordinary income recapture under Section 1245, and real property depreciation may be subject to unrecaptured Section 1250 gain at 25%.

Cost segregation increases the amount of personal property depreciation, which can increase the amount of ordinary income recapture on sale. However, the overall tax benefit during the holding period typically outweighs the recapture tax on sale.

Foreign investors should model the net tax outcome over the entire holding period, including the recapture tax and FIRPTA withholding, to determine whether cost segregation is beneficial for their investment.

Foreign investors with U.S. rental income must file Form 1040-NR to report effectively connected income and claim depreciation deductions. This return is due by June 15 of the year following the tax year if the investor has no U.S. office or place of business.

Cost segregation is reported on Form 4562 and attached to the Form 1040-NR. International investor depreciation deductions are claimed the same way as for U.S. investors, but the return is filed on a different form.

Foreign investors should work with a U.S. tax advisor who is familiar with non-resident filing requirements and can help navigate the intersection of depreciation, ECI, and FIRPTA withholding.

Foreign investors can hold U.S. real estate directly or through a partnership, LLC, corporation, or other entity. Each structure has different tax implications for depreciation, FIRPTA withholding, and U.S. tax filing requirements.

Partnerships and LLCs are common structures because they allow pass-through taxation and can provide flexibility in allocating depreciation deductions. Foreign investors who hold U.S. real estate through a partnership receive a Schedule K-1 showing their share of income and deductions, including cost segregation depreciation.

For more on how cost segregation works for properties held for many years, review the dedicated page, which discusses late cost segregation studies and catch-up depreciation strategies.

The United States has income tax treaties with many countries that may affect the taxation of rental income and gain on sale for foreign investors. However, most treaties do not provide relief from U.S. tax on rental income or gain from U.S. real property.

Foreign investors should consult with a tax advisor who is familiar with the applicable treaty to determine whether any treaty benefits are available. In most cases, rental income is taxed as effectively connected income and cost segregation depreciation is allowed regardless of treaty provisions.

Treaties may affect withholding rates on other types of income, such as interest or dividends, but generally do not affect the taxation of U.S. real property income or the availability of depreciation deductions.

Foreign investors and U.S. investors are taxed similarly on rental income, with both allowed to claim depreciation deductions. The primary differences are the filing requirements, the FIRPTA withholding on sale, and the absence of passive activity loss limitations for foreign investors.

U.S. investors are subject to passive activity rules, which limit the ability to use rental losses to offset ordinary income unless they qualify as real estate professionals. Foreign investors are not subject to these limitations because they are taxed on effectively connected income.

Both foreign and U.S. investors can benefit from foreign owned property cost segregation, but foreign investors must navigate FIRPTA withholding and non-resident filing requirements.