Depending upon how foreign real estate is owned and/or controlled, a number of different tax reporting regimes may be implicated. Each of these has its own corresponding penalties and generally applies to United States persons – U.S. citizens or those residing in the U.S. A selection of these provisions and the attendant potential penalties are summarized below:
Real Estate Owned by Foreign Corporation (Form 5471). If a U.S. person (or persons) owns real property through a majority interest in a foreign corporation, a Form 5471 (Information Return With Respect to Certain Foreign Corporations) may be required to be filed. The Form 5471 is a complicated information return and failure to properly and timely file this form can result in an automatic $10,000/person penalty. I.R.C. § 6038(b)(1). In addition, up to $50,000 in additional penalties can apply if the return is not filed after being notified by the Internal Revenue Service. I.R.C. § 6038(b)(2). The failure to file a Form 5471 can also suspend the statute of limitations indefinitely. I.R.C. § 6501(c)(8). To the extent that the corporation is making distributions to its owners (e.g., from rental income received), this income may be subject to other civil tax penalties. See Rental Income Associated with Real Estate.
Real Estate Owned by Foreign Partnership/LLC (Form 8865). If a U.S. person (or persons) owns real property through a majority interest in a foreign partnership, a Form 8865 (Return of U.S. Persons With Respect to Certain Foreign Partnerships) may be required to be filed. Like the Form 5471, failure to properly and timely file this form can result in an automatic $10,000/person penalty. I.R.C. § 6038(b)(1). In addition, up to $50,000 in additional penalties can apply if the return is not filed after being notified by the Internal Revenue Service. I.R.C. § 6038(b)(2). Similar to foreign corporations, failure to file a Form 8865 can suspend the statute of limitations indefinitely.
Real Estate Owned by Foreign Trust (Form 3520). If a U.S. person owns foreign real estate through a foreign trust, a Form 3520 (Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts) may be required to be filed. The penalties associated with failing to file a Form 3520 are generally similar to those for a Form 5471 or Form 8865 (e.g., $10,000 automatic assessment and up to $60,000 after notification of non-filing); however, penalties may also be calculated based upon a percentage of the assets held by the trust, if that would increase the penalty. I.R.C. § 6677(a)(2). That penalty can be as high as 35% of the gross value of the property transferred to the foreign trust. Failure to file a Form 3520 may also suspend the running of the statute of limitations on assessment with respect to those related to the trust.
Transfers of Real Estate by Gift from Foreign Persons (Form 3520). Aside from holding real estate through a foreign entity, U.S. persons may have to report gifts of foreign real property or monetary gifts from foreign persons used to purchase real property on a Form 3520. The threshold requirement to complete the Form 3520 is $100,000 in gifts from a foreign person (or set of related foreign persons) in a calendar year. (A lesser threshold exists for certain gifts from foreign entities.) The penalty for failing to provide this information is 5% of the value of the gift per month late, up to 25%. I.R.C. § 6039F(c)(1)(B).
Foreign Account Associated with Foreign Real Estate (FinCEN Form 114). Aside from the reporting of the entity owning and/or controlling the real estate and penalties potentially associated with that element, many owners of foreign real estate will also own or have access to a foreign bank account to receive or make payments. This accounts may be subject to required reporting as well. A FinCEN Form 114, also referred to as a foreign bank account report or FBAR, is required to be filed when a U.S. person owns or controls foreign bank accounts that contained more than $10,000, in the aggregate, at any point in the year. While these are merely information reports and do not have any bearing on one’s tax returns, the penalties can be severe. Willful failure to file an FBAR can result in a penalty of up to $100,000 or 50% of the maximum value of the account, per account per year. Non-willful failure to file can result in a penalty of up to $10,000 per account per year.
Real Estate Considered a Foreign Financial Asset (Form 8938). Even if the real estate is not held within an entity, it could be considered to be a foreign financial asset in certain circumstances (e.g., if it is investment property or income-producing property). If that is the case, a Form 8938 (Statement of Specified Foreign Financial Assets) may be required to be filed. Failure to file this form can result in a penalty of up to $10,000/person. In addition, up to $50,000 in additional penalties can apply if the return is not filed after being notified by the Internal Revenue Service. As with other forms, failure to file a Form 8938 when required can indefinitely suspend the statute of limitations on assessment. Moreover, even if real estate is reported on a Form 5471, Form 8865, or Form 3520, it may also be required to be reported on a Form 8938.
Rental Income Associated with Real Estate. While the other provisions outlined above carry significant penalties, they relate to the reporting of assets and not necessarily the associated income. Aside from information reporting penalties, if income is associated with foreign real estate, civil tax penalties can be assessed in addition to any tax that might be due. In instances where a tax return is timely filed but income goes unreported, these penalties can range from 20% for accuracy-related or negligence penalties (I.R.C. § 6662) to 75% for fraud-related penalties (I.R.C. § 6663). Moreover, if no tax return is filed for the years where foreign real estate income is generated, failure to file and failure to pay penalties can amount to 47.5% of the unreported tax. I.R.C. § 6651(a)(1) and I.R.C. § 6651(a)(2). When tax returns are not filed or when tax returns underreport tax that is due, the statute of limitations can be suspended or extended. I.R.C. § 6501.
The maximum penalties associated with noncompliance related to foreign assets are extremely high. In certain circumstances, criminal penalties may apply. See, e.g., I.R.C. § 7201 (tax evasion), I.R.C. § 7203 (failure to file), I.R.C. § 7206 (fraud and false statements), 31 U.S.C. § 5322 (willful failure to file an FBAR). However, there are a number of different programs and compliance initiatives, such as the Streamlined Filing Compliance Procedures, Delinquent International Information Return Submission Procedures, and Delinquent FBAR Submission Procedures, that may be used to mitigate these penalties. These procedures have many requirements and can be technical in nature and, therefore, professional guidance may be required. Penalties may also be reduced under applicable mitigation procedures, administrative abatement authority, and for statutory defenses to these penalties (e.g., reasonable cause); however, these processes frequently require a detailed legal analysis.
As the stakes are high, those with unreported foreign assets or those contemplating a compliance strategy should consult with a tax professional. Even minor mistakes may result in significant financial and non-financial consequences. Rosenberg Martin Greenberg has experience in all aspects of federal and state tax laws, including developments and required compliance for offshore assets and bank accounts. Our skilled tax advisors have represented countless businesses and individuals through the complex web of technical procedures and administrative options available to minimize their exposure to civil and criminal liability. For a free consultation, please contact Brandon N. Mourges at firstname.lastname@example.org or 410.951.1149.