The Mexican Federal Constitution restricts the ownership of real property located within 100 kilometers of Mexico’s border or within 50 kilometers of its coastline to Mexican citizens. These areas are known as the “restricted zone.” Foreign investment from non-Mexican citizens is desirable in the restricted zone because the Baja Peninsula and beach front properties are the most attractive real property locations. Since Mexican Laws prohibit a non-Mexican citizen from owning real property in the restricted zone, the acquisition of real property in the restricted zone is accomplished through a fideicomiso.

A fideicomiso is a civil law contractual arrangement under which the trustee and the beneficiary are both bound by the terms of the fideicomiso agreement. Fideicoiso agreements are regulated by Mexican commercial and banking statutes. Generally, the real property in the trust is owned by the trustee, usually a Mexican bank, to satisfy the prohibitions against foreign ownership of real property in the restricted zone. The beneficiary, usually a non-Mexican citizen, has a beneficial interest in the fideicomiso property. Due to the HIRE Act, U.S. beneficiaries of fideicomisos that hold real property may be subject to phantom U.S. taxation.

The HIRE Act amended Internal Revenue Code Section 643(i) so that any “uncompensated use” of trust property would be considered a distribution to the U.S. owner. The distribution is equal to the fair market value of the use of such trust property, whether the trust property is used by the beneficiary or a related person of the beneficiary. Thus, the U.S. beneficiary of a fidiecomiso may be considered to receive a distribution under the HIRE act for any uncompensated use of real property held in the fideicomiso.

For example, Mr. and Mrs. Jones acquire a beneficial interest in a fideicomiso that holds a beach house in Cabo San Lucas and the trustee is a Mexican bank. The Jones family vacations for a week at the beach house. The HIRE Act may treat the uncompensated use of the beach house as a distribution to Mr. and Mrs. Jones. The distribution would be equal to the fair market value of the use of a similar beach house in Cabo San Lucas for a week.

The HIRE act may treat the uncompensated use of fideicomiso property as a distribution if a fideicomiso is classified as a foreign trust for U.S. federal tax purposes and if the U.S. beneficiary is required to comply with the U.S. foreign trust reporting requirements. Whether a fideicomiso is classified as a foreign trust under U.S. tax law or whether the beneficiary is required to comply with the U.S. foreign trust reporting requirements is unsettled law.

In general, the “U.S. foreign trust reporting requirements” require the U.S. beneficiary of a foreign trust to report an annual accounting on Internal Revenue Service (“IRS”) Form 3520-A. Additionally, transfers of property to a foreign trust and distributions from the foreign trust must be reported on IRS Form 3520. Failure to satisfy the U.S. foreign trust reporting requirements subjects the taxpayer to a penalty of up to 35 percent of the unreported amount. Thus, the consequences could be severe if the beneficiary of a fideicomiso fails to comply with the foreign trust reporting requirements. For example, if a U.S. investor pays $100,000 for a beneficial interest in a fideicomiso that holds a vacation home in Cancun and does not report the transaction, the theoretical penalty could be $35,000.

The IRS has been largely silent on whether a fideicomiso is a foreign trust or whether the beneficiary must comply with the U.S. foreign trust reporting requirements. In a recent advisory opinion, however, the IRS responded to a request regarding the reporting obligations with respect to fideicomisos that own Mexican real property on behalf of U.S. persons. The IRS refrained from making any specific conclusions as to whether a fideicomiso is a foreign trust or whether the beneficiary must comply with the U.S. foreign trust reporting requirements.

However, the IRS’s response did not stop there. The advisory opinion outlined the statutory definition of a foreign trust and the U.S. foreign trust reporting requirements and then advised, “Any U.S. person who transfers property to or has an interest in a Mexican fideicomiso that is classified as a foreign trust must comply with section 6048 (i.e. the U.S. foreign trust reporting requirements).” According to the advisory opinion, if a fideicomiso is classified as a foreign trust then the U.S beneficiary must comply with the U.S. foreign trust reporting requirements. The uncompensated use of fideicomiso property by a U.S. beneficiary would likely be treated as a distribution under the HIRE act and could result in U.S. phantom income taxation on this deemed distribution if the fideicomiso is classified as a foreign trust under U.S. tax law.

The advisory opinion does not expressly resolve the issues of whether a fideicomiso is a foreign trust, whether the beneficiary must comply with the U.S. foreign trust reporting requirements or whether uncompensated use of fideicomiso property results in a distribution under the HIRE act. While still unsettled law, it appears that the IRS is leaning towards classifying a fideicomiso as a foreign trust and requiring the beneficiary to comply with the U.S. foreign trust reporting requirements. Since there is currently no precedent providing guidance on these issues, this advisory opinion should be a warning to any U.S. person who owns a beneficial interest in a fideicomiso. Given the uncertainty of the IRS’s position, U.S. persons with a beneficial interest in a fideicomiso may wish to review their exposure to IRS penalties as well as take protective measures, including a voluntary disclosure to the IRS.