Revenue Ruling 2008-31: IRS Rules That A Swap Interest in A Broad-Based U.S. Real Estate Index Is Not a U.S. Real Property Interest Under FIRPTA


On June 12, 2008, the Internal Revenue Service (“IRS”) published Revenue Ruling 2008-31, I.R.B. 2008-26 (the “Ruling”), holding that an interest in a notional principal contract that references data from an index derived from a geographically and numerically broad range of U.S. real estate values does not constitute a United States real property interest (“USRPI”) for purposes of the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”). As described below, the effect of the

Ruling is to exempt income derived by foreign persons in respect of notional principal contracts on broad-based U.S. real property indices from U.S. federal income tax. The guidance has already been hailed by some as a measure beneficial to foreign investors who wish to gain exposure to the U.S. real property market.

In general, U.S. source income of a foreign investor is taxed under one of two regimes under the Internal Revenue Code (the “Code”): either (i) the income (including income derived from the disposition of a USRPI) is subject to tax at full graduated rates (in the manner in which a U.S. person generally is taxed) as net income “effectively connected” with the conduct of a U.S. trade or

business, or (ii) if U.S. source and not effectively connected, the income is (absent an exemption under the Code or a treaty) subject to a flat 30% tax as “fixed or determinable annual or periodical” (“FDAP”) income. Income derived in respect of a swap is generally sourced to the

residence of the payee. Under these rules, a foreign investor’s income from a notional principal contract that is not a USRPI is generally treated as foreign source income not subject to United States federal income tax.

Under Code Section 897 (added by FIRPTA), a foreign person’s gain or loss from the disposition of a USRPI is treated as effectively connected with a U.S. trade or business.

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