How The Tax Reform Is Good For U.S. Foreign Real Estate Investment

How The Tax Reform Is Good For U.S. Foreign Real Estate Investment

The Tax Cuts and Jobs Act (TCJA) that was enacted in December has changed the way foreign investors structure their investments and plan for taxes.  Before the enactment, there was a lower individual and trust tax rate in place.

The TCJA has given a huge benefit to foreign investors by dropping the corporate tax rate from 35% to 21%.  This change applies to all U.S. corporations and it doesn’t matter if the owners are foreign or domestic.  This has opened up a fantastic opportunity for foreign investors to restructure the way their U.S. properties are held to get in some cases up to 16% lower tax rates which will help minimize tax burdens and maximize profits.  Many owners are changing from a trust or direct ownership structure to a corporate one tax-free before they are completing the sale in question.  It makes more sense now to set things up in a corporate ownership structure instead of a pass through structure which has traditionally been the preferred route even though there was significant cost and complexity to set up the pass through structure. 

There are several reasons why a corporate ownership structure now makes more sense:

  • Lower corporate tax rates due to TCJA. Foreign individuals or trust owners are taxed at 37% for development gains.  When structured as a corporation the top tax rate will be 21%.
  • Individual and trusts are still charged 20% capital games for nonresidents.
  • There is a new $10,000 cap on federal deductions for state taxes which can hurt a foreign owners tax return but the state taxes are still deductible on a corporations federal tax return which can make a huge difference for foreign owners who own property in high-tax states.
  • S. corporation set up costs are minimal compared to complex pass through partnership or trust structures.
  • Corporations have fewer ongoing costs and fewer tax filings when you figure that they won’t have to also file an individual tax return.
  • Using a U.S. corporation for property ownership can eliminate complicated disclosure requirements for foreign investors. The foreign owner or trust will also not have to apply for a U.S. tax identification number (TIN), but traditional pass through structures still require the foreign owner to obtain a TIN.
  • One of the HUGE benefits to using a U.S. corporation structure is that you can avoid the 10% withholding that is required when a foreign owner sells a U.S. property in traditional structures. Owners are better able maximize their profits and the buyer doesn’t have to be hassled with withholding and reporting to the IRS.
  • Gifting exemptions are better for a U.S. corporation structure. Gifting stock in a corporation can eliminate the gift tax where as there is only a $15,000 exemption for a foreign owners gift of tangible property in the U.S. Intangible property is generally exempt.  Stock in a corporation is considered intangible property.
  • Foreign owners of property in the U.S. that move their property into a U.S. corporation will significantly simplify the estate planning process. In some cases exposure to the estate tax can be avoided all together when property planned and structured.  Estate taxes can range from 18-40% for properties over $60,000 in value.  Putting the property in a U.S. corporation can save a lot in planning headaches and money paid in estate tax.
  • There are long standing statutes that will allow a foreign person to transfer their property into a U.S. corporation tax-free even if there are substantial gains on the property. If the property is sold and the corporation is liquidated in the same year, the proceeds can be distributed without having to worry about dividend withholding taxes or second level branch profits.

Putting foreign owned interests in U.S. properties in a U.S. corporation instead of an LLC or partnership will absolutely lower the tax rate and simplify the filing procedures for the owners.  There are many reasons it makes a lot of sense to make this change now instead of holding out for further changes.  U.S. corporations will pay a 21% tax rate, which has been dropped from 35% and has created a massive opportunity for foreign investors to maximize profits and simplify the process.  Obviously this will be dependent on individual circumstances and this structure may not be right for everyone.  Check with an experienced tax adviser to figure out what structure will ultimately be right for the situation at hand because these tax codes can be challenging to navigate if you aren’t sure what you are doing.  Professionals are educated, knowledgeable and helpful in walking through the differing variations of dealing with inevitable taxes for both U.S. and foreign investors. 

Tax Consequences of Investing in Foreign Real Estate

Foreign Real Estate Tax

After the tax tax reform, foreign real estate taxes are not deductible as an itemized deduction. Nevertheless, some taxpayers living in a foreign residence and earning wages abroad may be able to claim an exclusion from gross income under the housing exclusion if such taxes paid come from a residential property in a foreign country that they live in permanently. Considering the foreign real estate taxes paid as reasonable expenses attributable to the residential housing, they are includible on form 2555, Foreign Earned Income.

Ownership

Holding the foreign property at your personal name will make it easy to report on your personal return same as domestic properties are reported. If you decide holding the foreign property on a foreign company, this will trigger an additional layer of reporting to your personal return: form 5471, Information Return of U.S. Persons With respect To Certain Foreign Corporations, which requires reporting income, expenses, assets, liabilities and equity. It is in itself a second report for each 10% or more foreign company owned abroad.

Company Structure

If you decide to form a company in the foreign jurisdiction, the structure could vary from an LTD. type, similar to an LLC, to a Corporation type. But this structure works for the foreign jurisdiction only. For tax purposes in the U.S., the company is treated as a corporation and its profit will create something call subpart F income similar to the pass-thru concept of LLC and S corporations, where owners of 10% or more of a foreign company will report profits on their personal return, regardless if company’s foreign profit were distributed or not and taxed at regular individual income tax rates.

Reporting

Investing on foreign real estate will involve opening a bank account in the foreign country and if the balance of the account is over $10K at any time, it will trigger FBAR reporting to the U.S. Treasury. If the balance of the account is over $50K, you will be subject to FATCA adding a layer of reporting to your personal tax return. Penalties for not reporting these items go from $10K up to prison if non-reporting involves tax fraud.

Controlled Foreign Company (CFC)

If you control 50% or more of the voting power of the foreign company and own 10% or more of the stock, your controlled company is under the CFC rules that result in subpart F income. This section of the tax code is created to avoid you benefit from deferral of the tax on the profits of the foreign company. Accordingly, you have to report profits of your foreign company if they are non-taxable on the foreign country, which typically happen in the offshore regimes.

Click To Download Our Free Tax Guide: 10 Real Estate Tax Strategies For U.S. Investors

Considerations For Foreign Investors In U.S. Real Estate After Tax Reform

Did Tax Reform Impact Foreign Investment In U.S. Real Estate?

Background

  • The US economy is growing, and interest rates are low. Strong underlying fundamentals support predictable cash-flow and property appreciation.
  • It is no surprise then that US real estate remains very popular with foreign investors.
  • The Tax Cuts and Jobs Act (TCJA) has changed the tax landscape. The TCJA did not make the life of foreign investors in US real estate any easier. Instead, it made it more critical for foreign investors to reassess their existing strategies and structures and to make these changes under the guidance of experienced tax practitioners.
  • It remains tough for foreign investors to navigate US tax laws, and compliance is not easy.
  • Challenges include potential tax liabilities that rely on very complicated rules based on the residency of property owners, the legal structure of property ownership, and the nature of the income the property generates.
  • Foreign investors run the risk of missing out on valuable tax planning opportunities for their investments in US real estate.

In Terms Of U.S. Law

The legal immigration status of foreign persons can differ from their tax residency status. When foreign persons are deemed to be resident aliens (RAs), they have the same obligations US citizens have to report and pay taxes on their worldwide income.

Nonresident aliens (NRAs) are required to pay US taxes only on their income from US sources.  What makes things more complicated is the fact that an investor’s residency status for US income tax purposes can differ from their domicile. Domicile is used to determine exposure to US gift and estate taxes.

The US tax system is complex, and therefore, no single structure will be optimal for all investors. Taxpayers require a personalized approach based on individual factual circumstances before developing an optimal organizational structure to reach specific investment objectives.

To maintain tax efficiency, foreign investors in US real estate must follow the “cat on the hot tin roof” scenario: investors must do substantial planning and due diligence when they enter the market and have to continually monitor the tax environment throughout the life of the investment.

It’s All About Objectives

Foreign investors must start with their objectives.  Why are you investing in US real estate?

  • Are you expanding your current business operations in the US
  • Are you starting a new venture in the US?
  • Do you want to earn rental income or property appreciation, or both?
  • Will the property be for personal use?
  • Do you need cash-flow immediately?
  • Do you plan to reinvest your earnings in future investments?

It would help if you answered these questions before selecting an appropriate structure for your investments. During the planning stage, the different categories of income that are subject to taxation should be reviewed, including:

  • Rental income from leasing US property
  • Gains from the disposition or sale of US property
  • Dividend income paid by a holding company to its shareholders

Also, consider gift and estate tax consequences for ownership of US real property carefully.

Direct Ownership

NRAs who acquire US property in their names for their personal use.

  • Will have no US income tax filing responsibilities until they sell the property.
    • Then, realized capital gains are subject to US taxes up to 37-percent (if you sell the property one year or less after the acquisition) or up to 20-percent, if not.
    • A 15-percent withholding tax on the gross sales price is applicable under the US Foreign Investment in Real Property Tax Act (FIRPTA)
      • It is applied against the investor’s ultimate US tax liability. It is not an additional tax. It is a mechanism to ensure compliance with their ultimate tax liabilities.
    • Property held by an NRA who passes away is subject to a 40-percent US estate tax based on the value of the property at the time of death minus $60,000.
      • In some cases, depending on the decedent’s domicile, an NRA can minimize their exposure to US estate tax if a treaty exists between his home country and the US.
    • Both RA and NRA foreign investors who generate rental income have the annual obligation to report and pay US income tax on it, and even if there is no net income earned after expenses and depreciation deductions, they must file a US tax return to avoid peril.

In tax terms, the disadvantage of direct foreign ownership of US real estate is your exposure to US estate tax.  In juridical terms, the disadvantage is the lack of ownership protection provided by direct ownership, especially if the property is leased.

Ownership Through A Trust

A trust structure will provide foreign investors with similar tax consequences as the direct ownership option.  If the trust meets specific requirements, it can protect from estate tax exposure, which can make a trust tax-efficient in terms of income and estate tax.

A trust structure is complex, more so than other structures.  The trust’s ability to provide beneficial income and estate tax results overshadow the complexity disadvantage.

Ownership Through An LLC

  • The IRS classifies an LLC with one member as a partnership.
  • For tax purposes, a partnership is a pass-through entity that does not pay any taxes.
  • A pass-through entity passes all its income to its members who are then subject to taxes on their share of the LLCs earnings.
  • As a result,  a US real estate investment through an LLC by an NRA has the same income tax consequences as the direct ownership and trust options.
  • If the LLC’s partners or members are corporations, the tax consequences will be different.
  • It remains unclear whether an investment in US real estate via an LLC or a combination of other US and foreign pass-through entities provides US estate tax protection.

Ownership Through A Foreign Or U.S. Corporation

The TCJA completely changed the ramifications of ownership of US real estate through a corporate structure. The reduced corporate rate is now 21-percent, which creates much less of a tradeoff.  Foreign investors should determine whether a corporate structure for US property holding may be advantageous for them.

Before the enactment of the law, ownership of US real estate through a corporate structure required a tradeoff.  Investors could yield the benefits of US estate tax protection, BUT THEN they would incur exposure to high US income tax rates (35% PLUS state taxes) on all earnings and gains and another layer of US income tax on non-liquidating distributions.

Check Our Tax Planning for U.S. Real Estate Investors To Start Your Tax Strategy

5 Things Foreign Investors Need to Know about Selling Real Estate in the U.S.

If you are a non-U.S. investor and want to sell property in the States, there are some important things you need to know in order to run the process smoothly and make a good profit. Here’s a short guide to the tax considerations and structuring you need to pay attention to.

  1. Apply for Individual Tax Payer Identification (ITIN) 

As a foreigner, you are not required to have individual taxpayer identification number (ITIN) to sell or exchange property in the United States. You must be aware, though, that the IRS will require specific information from you in order to lift the withholding upon the sale, resulting from the Foreign Investment in Real Property Tax Act or FIRPTA rules (15% on sales price). You will need to provide:

  • Name and address on the withholding tax return
  • Taxpayer identification number (ITIN)
  • Application for withholding certificate
  • Notice of nonrecognition and some related documents

It would be beneficial for you to obtain ITIN, even though you are not legally required to speed up the process of getting a tax refund if the withholding is higher than the income tax.

  1. Apply for a withholding certificate

You don’t necessarily have to pay 15% of the sales price as withholding tax. The alternative is to apply for withholding certificate from the IRS. You will need to prove that the maximum tax on the gains from the sale is lower than 15% of the selling price. If successful, the withholding tax may be decreased or eliminated. The time frame is 90 days from the application receipt.

  1. FIRPTA applies to all foreign owner transactions

If you are selling U.S. real estate through a foreign-owned single-member LLC or another form of disregarded entity the transaction will still be a subject to 15% withholding. Even foreign-owned corporations are treated like a foreign person, so they also have to comply with the FIRPTA rules. This does not apply to U.S. corporations and LLCs, but in some cases, withholding may be required for U.S. partnerships.

  1. Buyer is responsible for the withholding

Foreign sellers are not responsible for the withholding on the sale. This is for the buyer to do.

  1. Apply for reorganization exemption if you qualify

If, as a foreign seller, you are transferring a property to a U.S. business entity, there’s a chance you qualify for an exemption from the withholding. The requirements for reorganization exemption can be found in the Treasury Regulation 1.897-6T of the IRC or you could use the expertise of a CPA to clear any doubts and confusion.

Readers should note that this article is only intended to convey general information on these issues and that FAS CPA & Consultants (FAS) in no way intended for the contents of this article to be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services.  This article cannot serve as a substitute for such professional services or advice.  Any decision or action that may affect the reader’s business should not rely solely on the contents of this article, but should rather be consulted on with a qualified professional adviser. FAS shall not be responsible for any loss sustained by any person who relies on this presentation.  This article is subject to change at any time and for any reason.

Contact us for more info about tax strategies for Real Estate Investments. 

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Fulton Abraham Sánchez, CPA I am Certified Public Accountant, specialized in Tax Planning & Offshore Strategies for Real Estate, Hedge/Equity Funds, Fintech, Crypto, Expats, IRS Debt Resolution. You can email me fa@fascpaconsultants.com and follow us on Facebook : FAS CPA & Consultants.

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