How U.S. Investors Can Make A Sound Tax Plan for Offshore Real Estate
It is of major importance to select the right entity to own real estate. A non-U.S. partnership / disregarded entity might incur income losses through flow through but foreign tax credits can lower or eliminate U.S. tax. Fragment of The Federal Real Estate and Partnerships Tax Conference made in The NYU School Of Professional Studies.
Non-U.S. corporations can attain tax deferrals subject to controlled foreign corporation (CFC). Subpart F income triggers income inclusion. A Passive Foreign Investment Company (PFIC) might be subject to an interest charge for a tax deferral and ordinary tax on income on sale.
Check the box rules apply. The choice of an entity is an elective system, except for per se corporations (Sociedades Anónimas, etc.). If the default classification is not preferred then file Form 8832 for different treatment, but this has to be timely, however, a retroactive effect of 75-days is allowed.
Similarly, the selection of the right shareholder is also critical. In terms of the 2017 Tax Act, in the U.S. territorial system dividends are not subject to U.S. tax but this applies only if it is paid to a U.S. C Corporation shareholder. GILTI tax on a U.S. shareholder of foreign corporations that are profitable, apply at a rate of 37% on U.S. individual shareholders. U.S. C Corp shareholders gets preferential treatment with only a 10.5% – 0% tax rate. A C Corporation has a 21% tax rate.
Offshore RE investment is subject to foreign taxes that have to be determined individually. Taxes of 37% or 20% LTCG might apply with tax credits that are lower than in the U.S. Investment structure is dependent on the determination of foreign taxes. CFC planning can include having employees do work to avoid the same, but the new GILTI tax imposed are imposed on shareholders at a rate of 37%. Dividends paid to U.S. individuals are fully taxable. Foreign taxes must be determined.
CFC planning can point at employees doing work to avoid it, but the new GILTI tax imposed on C corporations are between 10.5% and 80% FTC, but zero if foreign tax are equal to or above 13.125%. However, dividends paid to the U.S. Corp are untaxable. Dividends paid by a U.S. Corp to U.S. individuals are taxed at a 20% rate & 3.8% NIIT. The effective tax rate might however be much lower than this.
Before Planning Begins
Venture characteristics and objectives must be ascertained before planning begins:
- Income & cash distributions
- Decision making and management
- Liability and debt protection
- What is the best structure from the federal, state and local income/taxation point of view?
- Are the contracts enforceable in state’s that qualify?
- Family enterprise and succession plans
Income tax perspectives
- Profits/investment activities minimized or deferred
- Tax losses/investment losses used to offset income
- Assets be transferred into and out of the entity
Business (non-tax) perspective
- Liabilities? Limited to the assets of the business & protect owners personally
- Efficient management structuring
- Flexible future transfer ability of ownership
US RE Investment
The Tax Act makes use of U.S. Blocker Corporations more beneficial. The lower (21%) corporate Tax Rate reduces U.S. tax and it reduces the need for a related party debt & the interest paid to the related party. The portfolio interest exemption still stands, but earnings stripping rules have been replaced by broader limits applicable to all U.S. corporations.
Residence of Individuals
- Green Card Test
- S. resident as soon as present in the U.S. with a green card
- S. residency only terminates when green card is formally surrendered
- Substantial presence test (“183-days rule)
- Based on 3 years presence in the U.S.
- 31 Days minimum
- Foreign closer connection exception
- Exempt individuals
- First year residence election
- Spousal residency election
- Beware leaving the U.S.
- Individuals: Exit tax for U.S. citizens renouncing and for long term green card holders surrendering green cards or claiming foreign residency under a treaty (first $690,000 exempt)
- Full value is deemed distributed as part of the exit. There is no threshold exemption. Gains are generally recognized on conversion of a U.S. trust to a foreign trust. In the case of corporations, inverting can result in the foreign parent as a U.S. corporation (i.e. inversion is nullified).
Taxation of Foreign Persons
Inbound: Key Issues to Consider
Money flowing into the U.S. must consider the following:
- Legal entity form: corporation vs. partnership vs. disregarded entity
- Business Income: Corporations pay 21% + 30% BPT while individuals pay a 37% regular rate or 20% LTCG rate
- Capitalization considerations:
- Debt vs. equity: deductibility of interest vs. the non-deductibility of dividends
- Tax-free repayment of debt vs. ordering rules of Code 301
- Traditional Common Law factors & §385 regulations
- Withholding taxes.
- Passive income, dividends might be of interest, maybe rent
- Withholding will be 30%, or reduced tax by treaty or portfolio investment exemption
- Exit tax liabilities are incurred upon sale of investment, FIRPTA concerns
Overview: Income Taxation of Nonresident Aliens and Foreign Corporations
- Active: Income that is effectively connected with a U.S. business (ECI)
- On a “net” basis at regular rates
- Foreign Corp. subject to a BPT at 30% or lower treaty rate
- Passive: Income fixed, determinable, annual or periodical (FDAP) from U.S. sources
- Taxed on a gross basis at 30% or lower at treaty rate
- Includes interest dividends, rents and royalties
- Exemptions exist for portfolio interests (described below) and for sovereign investors
- Net income election
- Capital gains are generally not FDAP
- FIRPTA: Gains from disposition of U.S. real property interests treated as ECI.
Estate and Gift Taxation of NRAs
- Only U.S. Situs Assets subject to tax
- Intangibles are exempt from gift tax
- Stocks of U.S. Corporation
- Probably a partnership interest
- If the IRS does not concede, arguments for aggregate approach might be made
- Rev. Rule 91-32
- S. Situs Assets Include
- Real property located inside the U.S.
- Shares in a U.S. Corporation
- Tangible personal property located in the U.S.
- Certain debt obligations of U.S. issuers
- Intangible property used in the U.S.
- In domestic context, value is reduced by NR debt.
- States can impose estate and gift taxes too
Using Debt To Lower the Tax of a Corporate Structure
- Interest deductions reduces corporate tax base.
- There is a new limit on interest deduction but can use ADR system to avoid it.
- Repayment of principal allows repatriation to shareholder on tax-free basis
- Desirable to avoid or reduce WHT if possible.
- Portfolio interest exemption
- Need to ensure debt respected for tax purposes, e.g.,
- Interest rate cannot be excessive
- Cannot be thinly capitalized
- Reasonable term
Portfolio Interest Exemption (FOR NON-ECI)
- Interest must be fixed. No kicker is allowed.
- Lender may not be a 10%shareholder or borrower;
- For corporate borrower based on voting power
- For partnership borrower, based on capital or profits interest
- Limitation N/A to trusts
- Lender may not be a bank making a loan in ordinary course of a CFC related to borrower
- Must certify foreign status
Issues For US Withholding Agents
- Is the item FDAP?
- Is the item US source?
- Is the payment a withholdable payment?
- Is the payee an FFI?
- Is the payee an NFFE and if so, is it excepted? Active? Passive?
- Are the payees exempt beneficial owners?
- What type of documentation is required?
- Usually this will be Form W-8 fully filled out
- S. agents cannot eliminate FACTA withholding
- without obtaining form W-8 and
- FACTA: by corroborating that G.I.I.N. on the form is correct on IRS webpage.
- Must be file form 1042-S. Foreign person’s income is subject to withholding which includes:
- Payments subject to chapter 3 & chapter 4 withholding & tax withheld
- Applicable exemption if no FACTA withholding
- Recipient’s foreign TIN & date of birth
Form W-8 Choices
|Form W-8BEN||Foreign Individual|
|Form W-8BEN-E||Foreign business entity such as a corporation|
|Form W-8IMY||Foreign business entity that IRS treats as a partnership or disregarded entity|
|Form W-8EXP||Foreign government or tax exempt entity|
FIRPTA: Foreign Investment In US Real Estate
- Foreign persons taxed on gain from disposition of United States real property interest (USRPI) as ECI.
- As a rule the same tax rates as applicable to U.S. persons
- BPT may also apply
- Look-through rules for partnerships
- Must file tax return
- Buyer required to withhold 15% of the amount realized from the foreign seller
- Arbitrary and may exceed tax due
- Includes the assumption of debt (complicated if purchase partnership interest).
- May request withholding certificate from IRS
US Real Property Interest
The above generally includes:
- Land, buildings and improvements
- Any interest other than solely as a creditor, in real property. This does not necessarily include debt secured by real property. Is there a kicker?
- Any interest other than just as a creditor in any U.S. corporation that is or during 5-year or shorter look back period was a U.S. real property holding corporation (USRPHC).
- Corporation is a USRPHC if USRPIs represents 50% or more of total of USRPIs, plus foreign real property, plus assets used in a trade or business
- Not all assets enter the denominator
- Stock of former USRPHC is not a USRPI if the corporation has sold all USRPIs and/or recognized all gain
- Like-kind exchanges (§ 1031); US and non-U.S. cannot be like kind
- Certain REIT stock publically traded. If the taxpayer do not own and have not owned during the applicable look-back period, interest of greater than 10%. On publically traded non-REIT stock a 5% rate applies.
- Interests in domestically controlled REIT & other REIT exceptions
- Stock owned by foreign governments
Foreign Pension Plan Exception
- Qualified foreign pension funds (QFPF) which are:
- Organized or were created under the law of a foreign country
- That were established to provide retirement or pension benefits to beneficiaries who are currently or were, employees
- Does not have a single beneficiary with a right to more than 5% of assets or income
- Is subject to government regulations and provide annual information reporting about its beneficiaries to the relevant tax authorities
- Under local law, contributions to the QFPF which would otherwise be subject to tax under local law are deductible or excluded from the gross income of such entity or taxed at a reduced rate, or
- Taxation of any investment income of the QFPF is deferred or tax at a reduced rate.
- Applies to ANY USPRI held directly by the QFPF or indirectly through one or more partnerships. It also applies to wholly owned QFPF subsidiaries.
- It does not protect against non-FIRPTA ECI or withholding taxes. Gain from the sale of real estate is exempt but real income is not. Gain from sale of the USRPHC is exempt but not withholding tax on dividends.
Sale of Partnership Interest
In terms of section 897 (g) notice 88-72 , sales of interest in a partnership owing USRPI triggers ECI, however, unless the 50/90 test is met, no 1445 withholding. In terms of temp. reg. sec. 1.897-7T (a) if more than 50% of the partnership assets are USRPI and more than 90% of the partnership assets are USRPI, cash and cash equivalents, entire partnership interest classified as USRPI for section 1445 purposes but not section 897 purposes. If so the withhold on entire amount is realized or apply for withholding certificate.
Care has to be taken to understand the investor’s characteristics, type and location. So too, with the investment characteristics and objectives. For what use or purpose is the investment being made?
- Is it for personal use, development or purely as investment?
- What types of income is generated from the real estate?
- Interest, dividends, capital gains, services; others?
- The anticipated timing and method the exist might take on
- Is there any donative intent?
- Is confidentiality paramount?
- Is the investor willing to file personal returns?
The choice of the entity has to be carefully considered. Will it be wholly-owned, a joint venture or will passive investment vehicles be used (e.g. REITS)? Withholding and compliance have to be investigated, and so too exit and gift taxes and foreign considerations.
Structure One: Direct Individual By Foreign Individual
- Must file personal return
- Rental Income
- Gross rental income taxable at 30%
- Net rental income taxable at up to 37%
- Long term capital gains
- LTCG taxable at 20%
- FIRPTA withholding at 15% of amount realized unless reduced by withholding certificates
- Gift or Estate Tax
- Applies at 40%
- Taxpayer may purchase term insurance to ameliorate risk
- May use NR debt to reduce value
Structure Two: Investment By Foreign Individual Through Domestic Partnership
- Rental Income
- Same as direct investment in Structure 1 except there will be no withholding on rent by the lessee and partnership withholding on ECI rent required under section 1446.
- Long Term Capital Gains
- Same as direct investment in structure one above, except there are no FIRPTA withholding imposed on the sale of the property sale by the partnership, but the partnership must be withheld on gain under section 1446.
- Gift/Estate Tax
- Tax-free gifts should be possible pursuant to intangible exception.
- iThere is no clear authority as to whether estate tax would apply.
Structure Three: Investment By Foreign Individual Through A Foreign Partnership
- Rental Income: same as with domestic partnership except lessee should withhold on non ECI rent
- Long term capital gains are also the same as above, except the purchaser must withhold on sale of property by the partnership, absent a withholding certificate.
- Gift/Estate Tax will also be dealt with in the same way, but there will be a slightly better argument available for the avoidance of estate tax.
Structure Four Trust Alternative
- The settlor transfers cash to FT, then the trustee buys the property. The settlor may not have any rights to use the trust property, nor any dominion nor control over the trust. This is often a deal breaker for investors.
- If properly executed, no gift taxes come into play when the trust is funded and no estate taxes when the settlor dies.
- The income tax consequences are the same as for individual investors above, e.g. LTCG rates apply
- A domestic trust can also be used, but 3.8% NII tax applies.
Structure Five: Investment By Foreign Individual Through Foreign Corporation
For The Individual
- No income tax are levied on distributions or dividends or §301(c)(3) amounts
- No U.S. estate tax
For the Corporation
- Gross rental income will be taxable at 30% via withholding by the lessee
- Net rental income will be taxable at a 21% tax rate. Branch Profit Tax (BPT) applies at 30% or lower in terms of treaty rates
- Gains from sales are taxable at 21% with FIRPTA withholding on sale of property by FC.
Structure Six: Investment By Foreign Individual Through a Domestic Corporation
For the Individual
- Income tax: withholding tax on distributions of dividends or § 301(c)(3) amounts but not on liquidation amounts.
- Estate tax: S. estate tax is applicable.
For the Corporation
- Net rental income is taxable at a 21% rate, while dividend withholding taxes applies at 30% or lower in terms of treaty.
- Gain from Sale: Gain is taxable at 21% but no withholding tax on liquidating distributions after sell all assets in taxable transactions.
Structure Seven: Investment by Foreign Individual Through Foreign and Domestic Corporation
For The Foreign Individual
- Has no consequences for the individual
For The Foreign Corporation
- The dividends for the same are taxable at 30% or lower treaty rate. Needs a withholding certificate for §301(c)(2) distributions and 301(c)(3) distributions taxable.
- Liquidating distributions from a US Corporation may be tax-free per cleansing exception
- Sale of stock of the US Corporation generally subject to regular corporate tax at 21% rate.
For U.S. Corporation
- Both rental income and gains are taxable at 21% rate.
Structure Eight: Multiple Properties Consolidation Priority
- Foreign individuals own a foreign corporation that owns a U.S. Corporation that owns properties 1; 2 and 3 etc. in the U.S.
- Profits and losses may be offset.
- However, when property one is sold at a profit, it becomes difficult for the U.S. Corporation to repatriate the proceeds without dividend WHT, until treaty allows for ZWD.
Structure Nine: Multiple Properties. Distribution of Sale Proceeds Priority
- Foreign individual owns a foreign corporation that owns U.S. [properties 1; 2; 3 etc.
- Profits and losses may not be offset.
- When US property 1 sells all property at a substantial gain, it can liquidate tax-free per cleansing exception.
- HOWEVER, CONSIDER A MERGER!
Structure Ten: Portfolio Interest Partnership Lender
- Foreign partners own a foreign partnership, but none of the partners have more than 10% share in the FP.
- The Foreign Partnership owns a foreign corporation
- The foreign corporation owns a U.S. Corporation
- The U.S. Corporation owns real property in U.S. with a loan supplied by the Foreign Partnership
- The U.S. Corp pays interest to the Foreign Partnership
Structure Eleven: Portfolio Interest Split Vote/Value Structure
- Foreign individual owns 100% of a Foreign Corporation, FC1
- FC1 provides a loan to a US Corporation (US Corp) that is owned 95% by value and 0% by vote, by the same FC1.
- The US Corp. buys real property with the loan, and pays portfolio interest to FC1.
- Another shareholder owns 100% of Foreign Company, FC2.
- FC2 owns 5% of the real property by value and 100% by vote ( the 10% shareholder test based on voting power.)
Reits As an Alternative Investment Option
- Ordinary Dividends (§§ 1441 & 1442)
- FDAP income subject to 30% withholding tax or lower treaty rate
- Capital Gains Dividend (§ 897(h) (1):
- Relating to the sale of real estate, it is taxable under FIRPTA. REIT withholds 35% tax and shareholder must file a tax return.
- Publicly traded REIT Rule
- Applicable to foreign persons that own 10% or less of stock for at least one year
- This will be treated like an ordinary dividend subject to 30% withholding tax or lower treaty rate
- The benefit this will provide is that less tax than general is payable. No requirements to file tax returns and no branch profit tax on foreign corporate shareholders.
Reits – Sale of Reit Stocks
All gains are taxable under FIRPTA, except publicly traded REIT. There is no tax on shareholder owning less than 10% or less, since not USRPHC in terms of §897(c)(3). Another exception falls on domestically controlled REIT. It is considered domestically controlled if 50% or more of the REIT is owned by U.S. persons during the last 5 years, or if less, the time the REIT has been in existence. No tax since not USRPI in terms of §897(h) (2). PATH Act Exception: REIT stock whether public or private, held by certain publicly traded entities and collective vehicles.
Reits Tax Treaties
The 2006 U.S. Model Treaty provides for:
- A 5% dividend rate does not apply to REIT dividends
- A 15% rate on REIT ordinary dividends applies if:
- The beneficial owner is an individual or pension fund, in either case holding not more than 10% interest in REIT
- Dividends is paid with respect to publicly traded class of stock and beneficial owner holds an interest of not more than 5% of any class of REIT’s stock
- Or, if the beneficial owner holds an interest of not more than 10% in the REIT and the REIT diversified
- A REIT shall be considered diversified in terms of the 2006 Model Treaty if the value of no single interest in real property exceeds 10% of its total interests in real property. Foreclosure property is not considered an interest in real property. According to the 2006 U.S. model technical explanation, distribution of gains attributable to the alienation of a U.S. real property “interest” from a REIT will not be a dividend but rather will be taxable as gain from real property.
- FIRPTA Withholding is regulated in this context by Treas. Reg. §1.1445-8
- Accordingly 35% withholding of capital gain dividends or, if larger, largest amount that could have been designated as capital gain dividends. Catch-up withholding for designations or prior distribution as capital gain dividends.
- IRC § 1445(e) (3) a 10% withholding tax on non-dividend distributions by USRPHCs. As mentioned before, if a distribution from a REIT is from gain on the disposition of a USRPI under §897(h)(1) the distributing entity must generally withhold 35% under 1445(e)(6).
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