In 1624 Peter Minuit bought the island of Manhattan for $24 in trinkets, thus establishing a precedent of foreign investment in U.S. real estate that is still going strong. Though the numbers may have changed -- today foreign investment accounts for $44 billion of investment in U.S. real estate -- the principle is still the same. Investors from foreign countries who are seeking consistent returns at lower risk, availability of property, political and economic stability, and market liquidity are looking at the U.S. real estate market. However, foreign investors may be unsure or unaware of the tax ramifications of investing in U.S. real property, including the provisions of any tax treaties that may override the general provisions of U.S. tax laws.

The structure of foreign investment in U.S. real estate can take many forms. A foreign individual can own a direct interest in U.S. real property, he/she can invest in a partnership or limited liability company that owns the real property, or the U.S. real estate can be held through a domestic or foreign corporation. The most commonly used structure for foreign real estate investors is a limited partnership or limited liability company.

A limited partnership or limited liability company has several advantages for all involved parties. For all practical purposes, this structure gives each individual the assurance of financial protection for all unrelated assets in the event of law suits or bankruptcy.

Foreign Investor Rule #1: A foreign partner must obtain an Individual Taxpayer Identification Number from the Internal Revenue Service. This number must be used on all tax forms and will assure the correct application of withholding taxes.

Income from foreign partners can be treated in one of two ways. Real estate investments by foreign investors can be held as portfolio investments and considered investment income described as fixed and determinable annual or periodic income. Included in this category are dividends, interest, gains, rents, and royalties unless specifically exempt under the Internal Revenue Code. This type of investment income is generally taxed at the flat rate of 30% on the gross revenues, without reduction for expenses.

However, when income allocated from the limited partnership is effectively connected with a trade or business within the U.S., the income is taxed to the nonresident alien partner at the graduated U.S. tax rates, on a net basis, after deducting all expenses and allowances. In order to take advantage of this strategy and be considered as actively engaged in a U.S. trade or business, the partner's level of involvement with the activity generally must be considerable, continuous and regular.

To alleviate the harsh tax treatment of rental income, foreign individuals can take advantage of the provisions of the Internal Revenue Code permitting foreign investors to make an election to treat investments in U.S. real property as trade or businesses. By making this election, the net income is taxed rather than the gross income, saving the taxpayer significant tax dollars. The election applies to all income from U.S. real property that is not already effectively connected with a U.S. trade or business and, once made, the election is effective for all subsequent years and can only be revoked with the consent of the IRS.

Foreign Investor Rule # 2: Save taxes by electing to treat U.S. property as effectively connected to a trade or business; attach the appropriate statement to a timely filled income tax return that reports income from U.S. real property.

The tax treatment for foreign investors becomes somewhat more complicated when we look at tax withholding, a frequently misunderstood but extremely important area. The payor of investment income to a foreign investor is required to withhold U.S. income tax at the rate of 30%, unless a reduced rate or exemption under a tax treaty applies.

When a limited partnership has effectively connected income allocable to a foreign partner, the partnership is required to withhold tax on that partner's distributive share of the net income. The amount of the withholding tax is calculated at the highest rate of U.S. tax to which each foreign partner is subject. For corporate partners the rate is 35%; for individual partners and other partnerships the rate is 39.6%. Since tax is withheld at the highest U.S. tax rate, most partners will be due a refund when filing their U.S. income tax return.