Using the Federal Tax Code to Combat Money Laundering in Real Estate

Posted on by Kevin Deutsch

Real estate transactions are an attractive vehicle for criminals looking to launder their money.1 Sanctioned foreign officials, organized crime syndicates, and even terror groups move money domestically and internationally through real estate transactions.2 The problem of money laundering in real estate (MLRE) has been prevalent in the United States for decades: the Mafia built Las Vegas with laundered money beginning in the 1930s,3 and wealthy cocaine dealers known as “Cocaine Cowboys” began purchasing numerous properties around Miami, Florida in the 1970s and 1980s to hide their money.4 MLRE has grown in popularity as a tactic of criminals in the aftermath of 9/11, which motivated governments around the world to scrutinize other financial transactions.5

MLRE can take many different forms and can be effectuated through different schemes, including all cash payments for properties, purchasing properties with shell companies, using expensive leases to mask payments for illicit activities, and even flipping houses and selling them for more than they are worth post-renovation.6 Real estate can be used to simply hold money or can be used to transfer money between criminals. When used for transfers, the cost of the property or cost of the lease is just a cost of the criminals’ transaction. Indeed, MLRE can cost 10 to 20 percent of what criminals hope to hide or transfer.7

At first glance, MLRE may seem like a boon for local economies. Logically, increased demand for real estate should drive up prices to the benefit of local property owners. However, MLRE is fraught with consequences. For one, it can contribute to real estate bubbles, such as Japan’s Yakuza-fueled real estate bubble in the 1980s.8 MLRE also drives up prices, forcing local buyers out of the market and into a lifetime of renting,9 which can ultimately diminish people’s savings and which contradicts the widespread notion that becoming a homeowner is part of the American Dream. MLRE can create over-construction, resulting in empty units,10 which can become unsafe while unattended or become the targets of squatters and arsonists.11 Properties used for MLRE also tend to skirt safety and environmental regulations.12 In some American real estate markets, MLRE is a major driving force of development and represents a significant share of transactions.13

Over the past forty years, Congress has passed several laws to combat money laundering by foreign criminals, laws which collectively require financial institutions to “Know Your Consumer.”14 One of these laws is the Bank Secrecy Act, 31 U.S.C. § 5311 (2001), which demands financial institutions keep records that are useful to law enforcement agencies investigating alleged money laundering.15 Notably, the law immunizes from potential civil liability financial institutions that unwittingly facilitate money laundering, but report suspicious behavior.16 These protections do not extend to real estate brokers,17 who in many cases prefer to look the other way rather than investigate potential criminal activity that they may be facilitating.18 Financial institutions are specifically required to know the name, date of birth, address, and passport number for foreigners,19 although money launderers have been known to provide false documentation in order to conceal their true identities.20

The regulation of foreign ownership of agricultural land is unique in that some states outright ban foreign ownership of land intended for farming.21 The Agricultural Foreign Investment Disclosure Act requires foreign buyers of agricultural land to make disclosures about their identities and about the use of the land.22 This statutory scheme, however, was created to monitor and limit the impact of foreign-owned agricultural land in the United States on American family farms and not to uncover criminal behavior.23

Recently, Congress has begun considering additional measures to curb the money laundering of foreign criminals and sanctioned foreign officials.24 In particular, Congress hopes to crack down on the practice of using shell companies to conceal the identities of criminals laundering their money through real estate transactions by requiring title insurers to note the “true, human owner of a company” buying property.25 Presently, the United States Treasury Department’s Financial Crimes Enforcement Network already requires this of title insurers in specific locales where MLRE is especially prevalent: Los Angeles, Miami, New York, San Diego, and San Francisco.26 This “geographic targeting order” is authorized by 31 U.S.C. § 532(a), 31 CFR § 1010.370, and Treasury Order 180-01.27 This program is limited in scope; it must be renewed every six months and is not nation-wide.28 On the surface, this program appears successful; in targeted markets, “all cash” purchases of property, which are especially likely to acts of money laundering, have fallen by as much as 95 percent.29

Nevertheless, expanding this program’s requirements nationwide and making them permanent is unlikely to effectively curb MLRE. One major hole in the program is that title insurance is not required under Florida law, leaving out a major market for MLRE.30 Another is that only transfers purchased with “all cash” are covered, but not if a buyer pays by wiring money, which is popular among money launderers.31 Wire transfers do not necessarily subject criminals to increased scrutiny, because they can use shell companies to buy properties.32 And additionally, the program does not cover trusts, loosely defines terms, and only applies to residential properties.33 Unless Congress plugs these loopholes, legislation will prove ineffective. Still, an easy workaround remains: criminals can use third parties to purchase property.34

A more effective means of curbing MLRE by foreigners would be to tax certain purchases of American real estate by non-US citizens without green cards; in other words, create an anti-MLRE tax. This tax would be paid by the foreigners purchasing American real estate, and the tax would be a percentage of a property’s sale price.

Naturally, which individuals would be subject to the tax would depend on a person’s immigration status. Optimally, an anti-MLRE tax would be limited to foreigners who are looking to enter the American real estate market, but who have not been through the vigorous vetting that comes with obtaining a green card and who are not necessarily looking to remain in the United States permanently. This is because it would be unfair to force an anti-MLRE tax upon those who have theoretically demonstrated their commitment to being law-abiding residents of the United States.

Certainly, foreign investment in American real estate is of immense value to the American economy. From 2010 through December 2017, foreign investors pumped over $365 billion into American commercial real estate,35 and these purchases are a crucial source of capital for development, redevelopment, and refinancing of property. Given the importance of foreign investment in the American real estate market, this tax would need to target real estate transactions that are favorites of money launderers. Imposing an anti-MLRE tax on all purchases by foreigners without permanent residency status or on foreign companies could have a substantial chilling effect on the American real estate market and on the American economy as foreign investors seek cheaper investments elsewhere, especially given the fact that 30 percent of transactions in markets targeted by FinCEN’s geographic targeting order were considered “suspicious.”36

Single-unit real estate purchases (i.e. the purchase of one apartment or one home or one lot) should be subject to an anti-MLRE tax when purchased by foreigners. Single-unit purchases of luxury properties are favorite vehicles for money launderers.37 Still, this tax should not only be applied to high-end properties. Criminals across the globe have also used low-end properties to launder their money.38 Targeting single-unit purchases would insulate foreign institutional investors looking to make major legitimate investments in the American market from the anti-MLRE tax. For example, a foreign investor looking to buy several lots in order to build a high-rise building would not be subject to an MLRE tax.

Of course, there are many foreigners also looking to make legitimate single-unit purchases of American real estate. The Hollywood Hills, for instance, might become a lonelier place if celebrities without US citizenship or permanent residency status couldn’t purchase homes without paying a high anti-MLRE tax. To insulate these legitimate single-unit purchases, an exemption to the anti-MLRE tax could be carved out for people who intend to use the home as their primary residence. This would leave foreign buyers of secondary homes or single-unit investment properties in the United States exposed to the anti-MLRE tax, a drawback to imposing an anti-MLRE tax.

A logical counter argument to imposing an anti-MLRE tax on single-unit purchases of American property is that criminals would begin purchasing more expensive, multi-unit properties such as hotels or other commercial real estate that would be exempt from the tax. This was the case in Japan, where the Yakuza became a major speculator in the Japanese real estate market.39 Certainly, this has occurred in the United States in the past, both through investments by the Yakuza in Hawaii40 and the Mafia in Las Vegas.41 However, this phenomenon is less common in the post-9/11 banking regulatory environment, where criminals feel more pressure to keep their money in cash.42 What is more, over the last several decades, American anti-racketeering laws have destroyed many of the criminal organizations that once had enough spending power to make massive investments in real estate.43 While the smaller cash reserves of criminal organizations may incentivize more MLRE, it also forces criminals and criminal organizations to make smaller purchases of real estate, because they lack the large savings required to make major real estate investments in large commercial properties or residential developments.44

Foreigners are already subject to special sales and income taxes on real estate transactions. The Foreign Investment in Real Property Tax Act of 1980 created significant taxes on income from the sale and leasing of American real estate owned by foreigners.45 15% of the value of the sale must be withheld for the federal government.46 The law, however, does not tax the purchase of American real estate by foreigners, only the sale by foreigners.47  Taxing the act of purchasing real estate would be a more effective tool for discouraging MLRE, because criminals would be guaranteed to pay the tax and moreover, would need to pay it up front. The tax payment would no longer be a far-off consideration that could more easily be overlooked, and it would be harder for criminals to recoup money lost to taxes by waiting for their property to grow in value. In addition, an anti-MLRE tax would subject foreign criminals to potential IRS scrutiny at the beginning of their money laundering rather than at the end of their money laundering; in other words, foreign criminals would have an enhanced risk of IRS scrutiny for a longer period of time. Finally, most taxes on transactions are collected by the seller; by forcing the purchaser to collect and pay an anti-MLRE tax, criminals would be subject to IRS scrutiny—unless they are comfortable committing tax evasion.

The anti-MLRE tax should also be high enough to make money laundering through real estate purchases economically inefficient. Surely, there is no “magic” rate at which all MLRE schemes would no longer be worthwhile for criminals, but the American 15 percent tax rate on income from real estate transactions is clearly insufficient by itself, given that MLRE remains a popular practice among foreign criminals, who often expect to lose 10 to 20 percent of what they intend to hide or transfer.48 Generally, “land transfer taxes” or taxes on the purchase of real estate or on income from the sale of real estate, substantially reduce land transfers.49 One study of a German land transfer tax found that a 1% increase in a land transfer tax results in 6 percent fewer sales in the long run.50

If that study is an accurate reflection of the relationship between land transfer taxes and the real estate market, then the “purchase” tax rate for non-exempt foreigners may not need to be more than a few percentage points of the value of the property, given the large chilling effect of land transfer taxes and the pre-existing 15 percent rate on real estate income that foreigners already pay at the end of transactions. It is possible that land-transfer taxes that are paid up-front discourage transfers more than sales taxes. This would be especially true if the United States were the only country with an anti-MLRE tax, as criminals would be incentivized to launder their money in countries where they would lose a smaller share. Of course, it may provide no overall good to the world if MLRE is pushed elsewhere, but at the very least MLRE and its negative consequences would be pushed out of the United States.

It may be necessary for different states to have different anti-MLRE tax rates. The real estate market in Omaha is certainly different from Manhattan, and what is right for New York may not be right for Nebraska. I suspect that a lower anti-MLRE tax rate would be needed in more expensive markets, where a lower rate still represents a very large loss of money for foreign criminals. For this reason, a better public policy could be anti-MLRE taxes set by states themselves, either through federal law that gives states the option to set a rate or through state laws.

Undoubtedly, there are many potential externalities to an anti-MLRE tax to consider. For one, revenue from the tax could fund efforts by law enforcement to combat money laundering. On the other hand, although the tax could be tailored in a way to except many legitimate single-unit foreign buyers, many legitimate foreign single-unit foreign buyers would be shut out of the market. Naturally, this would cool real estate prices in markets favored by foreign buyers, particularly in the Bay Area where tear-down homes can go for millions.51 This would hurt the bottom-line of current owners of real estate, but also enable more middle-income US residents to enter the market.

As a disclaimer, I think that land transfer taxes represent poor public policy in most cases. The substantial negative impact that land transfer taxes had on the German52 and Toronto53 real estate markets present cautionary tales and highlight why an anti-MLRE land transfer tax would need to be carefully tailored. It is important to remember that many Americans’ largest asset is a single-unit property—their home.54 Given the importance of houses for Americans’ finances, public policy that potentially drives down the value of homes should be rejected by legislators more often than not. Because of its potentially large impact on the American real estate market, an anti-MLRE tax on non-resident foreign buyers would need to be seriously scrutinized and tailored before being added to the tax code.

And finally, an anti-MLRE tax alone would not stop foreign criminals from using American real estate to launder their money. The need for criminals to launder their money incentivizes them to accept proportionally large losses of whatever money they stow away, and some may not be deterred by losing an even larger share. An anti-MLRE tax is just one potential solution that could be used in conjunction with numerous others.

  1. See Louise Shelley, Money Laundering into Real Estate Part II: Complex Illicit Operations, in Convergence: Illicit Networks and National Security in the Age of Globalization 131, 131(Michael Miklaucic & Jacqueline Brewer eds., 2013). ↩

  2. Id. ↩

  3. Id. at 138. ↩

  4. Gary McPherson, Floating on Sea of Funny Money: An Analysis of Money Laundering through Miami Real Estate and the Federal Government’s Attempt to Stop It, 26 U. Miami Bus. L. Rev. 159, 167-68 (2017). ↩

  5. Shelley, supra, at 132. ↩

  6. Ahmed Taimour, Money Laundering Schemes in Real Estate, Corporate Compliance Insights (Feb. 17, 2016), https://www.corporatecomplianceinsights.com/money-laundering-schemes-in-real-estate/. ↩

  7. Shelley, supra, at 136. ↩

  8. Id. at 135. ↩

  9. Id. ↩

  10. Id. ↩

  11. Croner-i, Managing health and safety in vacant premises, https://app.croneri.co.uk/feature-articles/managing-health-and-safety-vacant-premises-0 (last visited Oct. 12, 2018). ↩

  12. Shelley, supra, at 135. ↩

  13. See, e.g. McPherson, supra, at 161. ↩

  14. Andrew J. Weiner & Frederick L. Klein, Foreign Investment in U.S. Real Estate – Now More than Ever, 33 Prac. Real Est. Law 40, 56 (2017). ↩

  15. Id. ↩

  16. 31 U.S.C. § 5318(g)(3)(A) (2014); Nat’l Ass’n of Realtors, Anti-Money Laundering Guidelines for Real Estate Professionals, https://www.nar.realtor/articles/anti-money-laundering-guidelines-for-real-estate-professionals (last visited Oct. 13, 2018). ↩

  17. Nat’l Ass’n of Realtors, supra. ↩

  18. See McPherson, supra, at 161. ↩

  19. Weiner, supra, at 57. ↩

  20. Shelley, supra, at 140. ↩

  21. Weiner, supra at 59. ↩

  22. Id. ↩

  23. United States Department of Agriculture, Farm Services Agency, Agricultural Foreign Investment Disclosure Act (AFIDA), https://www.fsa.usda.gov/programs-and-services/economic-and-policy-analysis/afida/index (last visited Oct. 13, 2018). ↩

  24. Samuel Rubenfeld, Senators Seek Probe of Money Laundering in Real-Estate Market, Wall Street Journal (Oct. 3, 2018, https://www.wsj.com/articles/senators-seek-probe-of-money-laundering-in-real-estate-market-1538599514) [hereinafter Senators Seek Probe]; Samuel Rubenfeld, Russia Sanctions Bill Also Targets Real Estate Deals, Wall Street Journal (Aug. 3, 2018, https://www.wsj.com/articles/russia-sanctions-bill-also-targets-real-estate-deals-1533296706?mod=article_inline) [hereinafter Russia Sanctions]. ↩

  25. Matthew D. Lee, FinCEN Quietly Extends Real Estate Geographic Targeting Orders for Another Six Months, Fox Rothschild: Tax Controversy and Financial Crimes Report (Arp. 25, 2018), https://taxcontroversy.foxrothschild.com/2018/04/fincen-quietly-extends-real-estate-geographic-targeting-orders-another-six-months/. ↩

  26. Russia Sanctions. ↩

  27. McPherson, supra, at 174. ↩

  28. Id. ↩

  29. Senators Seek Probe. ↩

  30. McPherson, supra, at 177. ↩

  31. Id. ↩

  32. Id. at 178-79. ↩

  33. Id. at 179-80. ↩

  34. Id. ↩

  35. Michael Wolfson, Foreign Investment in U.S. Commercial Real Estate, Newmark Knight Frank: Real Insight (Dec. 2017), http://www.ngkf.com/home/research/real-insight/foreign-investment-in-us-commercial-real-estate.aspx. ↩

  36. Robert Frank, Government expands crackdown on money laundering in real estate, CNBC (Aug. 24, 2017), https://www.cnbc.com/2017/08/24/a-third-of-luxe-real-estate-deals-involve-suspicious-activity.html. ↩

  37. See United States Department of the Treasury, Financial Crimes Enforcement Network, FIN-2017-A003, Advisory to Financial Institutions and Real Estate Firms and Professionals (2017), https://www.fincen.gov/sites/default/files/advisory/2017-08-22/Risk%20in%20Real%20Estate%20Advisory_FINAL%20508%20Tuesday%20%28002%29.pdf. ↩

  38. Shelley, supra, at 135-36. ↩

  39. See Shelly, supra, at 131. ↩

  40. A key distinction is that the Yakuza are embedded in Japanese banking in ways that American organized crime is not. Shelley, supra, at 140. ↩

  41. Id. at 137-38. ↩

  42. Id. at 140; see, e.g., 31 U.S.C. § 5311 (2001). ↩

  43. Selwyn Raab, A Battered and Ailing Mafia Is Losing Its Grip on America, New York Times (Oct. 22, 1990), https://www.nytimes.com/1990/10/22/us/a-battered-and-ailing-mafia-is-losing-its-grip-on-america.html. ↩

  44. Id. ↩

  45. Weiner, supra, at 43. ↩

  46. FIRPTA Withholding, Internal Revenue Serv., https://www.irs.gov/individuals/international-taxpayers/firpta-withholding (last visited Oct. 12, 2018). ↩

  47. Id. ↩

  48. Shelley, supra, at 136. ↩

  49. See Carolin Fritzsche & Lars Vandrei, The German Real Estate Transfer Tax: Evidence for Single-Family Home Transactions (Ifo Institute, Working Paper, No. 232, 2016), http://hdl.handle.net/10419/149554; Ben Dachis et al., The effects of land transfer taxes on real estate markets: evidence from a natural experiment in Toronto, 12 J. of Econ. Geography 327 (2012), https://academic.oup.com/joeg/article/12/2/327/959608. ↩

  50. Fritzsche, supra, at 2. ↩

  51. Marisa Kendall, Condemned house sells for $1.2 million in Fremont, San Jose Mercury News (Arp. 16, 2018), https://www.mercurynews.com/2018/04/16/condemned-house-sells-for-1-2-million-fremont/; see also Shelley, supra, at 135 (“MLRE can increase prices, making it impossible for local individuals to buy real estate.”). ↩

  52. See Fritzsche, supra. ↩

  53. See Dachis, supra. ↩

  54. See Pew Research Center, Wealth Gaps Rise To Record Highs Between Whites, Blacks, Hispanics, Chapter 5: Which Assets are Most Important? (Jul. 26, 2011), http://www.pewsocialtrends.org/2011/07/26/chapter-5-which-assets-are-most-important/. ↩

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