U.S. Real Estate Purchasing Tax Considerations for Foreign Investors
For a non-U.S. person investment in U.S. real estate has to be carefully structured in order to create the most beneficial tax situation. Income during the ownership period , tax when selling the property and even gift-and estate taxes when transferring the property to an heir by gift or inheritance will be impacted by the original structure. Fragment of The Federal Real Estate and Partnerships Tax Conference made in The NYU School Of Professional Studies.
The purpose and intent behind the purchase is of great significance.
- Is the property meant for personal use, and by whom?
- Is it an investment, if so, will it generate rental income?
- Is it an investment for future resell, and if so, potentially how long will it be held?
- Is it meant to be transferred to heirs one day?
Possible approaches open for a non-resident alien (NRA):
- Ownership in personal capacity
- Ownership through a U.S. Corporation
- Ownership through a foreign corporation (FC) usually located in a neutral jurisdiction
- Ownership through a U.S. corporation that is owned by the FC and/or combined with a trust
The last option is often the most tax-efficient option. Since the changes in the U.S. tax laws U.S. corporate tax rates were lowered to 21%, this is the most beneficial option, but it is probably the most complex structure to adapt and precaution requires that proper independent legal advice be sought before such a purchase, taking the location in the United States of the property as well as the NRA’s domicile, into consideration.
Advantages and Disadvantages of the Potential Ownership Methods
Purchasing in personal capacity is a straight-forward option. In order to attain personal limited liability this can be done by adopting a LLC owned by the NRA. A single member LLC is considered to be the same as personal capacity for tax purposes, unless the contrary election is made by checking IRS form 8832.
The main disadvantage of this option falls in the field of U.S. estate and gift tax exposure. Real estate owned by a NRA is exposed to estate tax, and this will include any shares owned in the U.S. too. Even the exclusion from estate tax of bequests to a spouse is excluded for NRA spouses unless the property is passed through a qualified domestic trust, which will be exposed to estate tax in any case, when the surviving spouse dies.
The NRA will also have only a very small exemption from estate tax. Assets with a value that exceed $60,000 will be taxed at a rate of 40%. What is more, several states add additional estate taxes which make the burden on heirs even more strenuous.
Relief can sometimes be sought from tax treaties, but of the only fifteen such treaties, relief is minimal and none cover U.S. real estate at the time of death. If the NRA is survived by a U.S. citizen spouse, unlimited marital deductions can be made, but this is usually not applicable.
If the property has non-recourse debt against it, in will reduce the U.S. taxable estate otherwise the deduction will be limited to the ratio between US assets and worldwide assets, which meant that the NRA will be required to reveal worldwide assets, something wholly undesirable.
Gift tax is also problematic. If the NRA wanted to transfer the property during his lifetime as a gift, a U.S. tax rate of 40% will apply with no allowable exclusions other than the allowable exclusion of $14,000 per annum per recipient. No U.S. gift tax applies to gifts of stock, even if it’s stock of a U.S. company that owns only U.S. real estate.
So, albeit simple to structure the personal acquisition of real estate in the U.S. even the advantage it would have held on capital gain upon sale was diminished when new regulations lowered the rate for corporations to 21% which almost equals the 20% rate individuals pay.
Withholding tax will be applied to the sale of the property by the NRA and by a foreign corporation. FIRPTA, the Foreign Investment in Real Property Tax requires buyers to withhold 15% of the proceeds of the sale to remit to the tax authorities (there are some limited exceptions).
Afterward, the NRA has to file a tax return to report the actual gain or loss on the transaction, and claim a refund or pay additional tax if they overpaid – BUT – this return can only be filed after the end of the year.
If the withholding exceeds the actual value of the gain/loss, the buyer or seller can petition the IRS for relief on or before the Closing Date to reduce the tax withheld, or even to release the obligation to withhold completely if sold at a loss. This will suspend the obligation to remit or withhold will be suspended until the IRS can determine the actual tax due. If the IRS makes such a determination, whatever needs to be withheld has to be paid to the IRS within 20-days.
Buying for Income Generation
Income derived from a personally owned property will be taxed in the hands of a NRA in one of two ways:
- The tenant must withhold a flat rate of 30% of all rent paid with zero offsetting of any deductions.
- A graduated tax rate on income that is net of allowable deductions. Net income taxation occurs when the ownership of real estate becomes a business or trade in U.S. terms (ETB), which does not happen with ownership of a single parcel of real estate net leased to a single tenant, although a contrary election can be made in terms of code §871(d).
- If the investor is ETB then depreciation can be claimed but prior tax benefits will be taxed as ordinary income upon the sale while the same capital gains tax as above will apply.
- The 30% withholding will as a rule result in a higher tax exposure
- It is hence advisable that the investor should elect to be taxable on a net basis and that she hence files annual U.S. income tax returns with the IRS.
- If the investor elects thus, he has to supply the tenant with IRS form W-8ECI to insure that the tenant is informed not to withhold the 30% tax
- Since personal ownership excludes any liability protection, a rented out property can place the NRA under significant risk. After death expensive and time consuming probate proceedings to determine ownership, pay taxes and transfer title will also encumber the asset.
- To protect the owner, a single member Delaware LLC can be formed to own the real estate, in order to provide the owner with personal liability protection.
- This will however not shield the NRA against tax liabilities, only personal liability unless the investor elects to make a tax election to treat the LLC as tax transparent.
Through a Foreign Corporation
The main advantage among many, from owning real estate through a FC is the protection it offers against U.S. estate tax. Logically, while the real estate is a U.S. tax asset, the shares in a foreign corporation are not, and the FC can be gifted by the NRA without incurring gift tax, but, when the FC decides to sell the property the original cost basis of the property will be used to determine the gains or losses to the FC.
Other non-tax advantages are:
- The property is in the name of the FC, not the individual
- Limited liability. Any claims against the property owner can only be liquidated against the property itself, not the NRA.
It is important not to mix any more assets with the FC that holds the real estate. If any shareholder or officer of the FC wants to use the property for any personal reasons, the corporation might be required to charge rent to the individual. The problem with this is that it can create taxable income for the property user without any corresponding tax deduction.
Since the 2017 tax act, when the property is sold all gains will be taxed at a flat corporate rate of 21% plus applicable state tax. Additional branch profit tax may also be applicable, which will be discussed below. If the FC is considered to be doing business in the U.S. it will have to file a U.S. tax return irrespective whether a profit or loss was made. State and local taxes dependent on location will also be required.
Through a U.S. Corporation
Ownership by a FC might not be the most suitable form of ownership, but neither is a U.S. Corporation as the direct owner. The U.S. corporation as sole owner will not provide estate tax protection but it would be exposed to the new 21% corporate tax rate on income and gains.
U.S. Corporation Owned by a Foreign Corporation
For the NRA the best protection might be attained when combining the benefits of a FC and U.S. corporation together
Estate tax is not applicable to FC ownership, as mentioned above, but probate will apply, however, only in the jurisdiction where the FC shares are registered. This adds privacy for the owner, since no obligation exists for the FC to disclose its NRA owner/s. Upon the sale of the property only a flat corporate tax rate of 21% will apply. If the sale of the real estate is a liquidation event for the U.S. Corporation then the proceeds can be distributed to the FC without further tax.
For Income Protection
When a U.S. corporation receives rental income, it is taxed at the U.S. corporate tax rate of 21% at the entity level. When dividends are paid by the U.S. corporation to the FC then dependent upon further treaty reductions, a 30% withholding will apply, BUT as long as no dividends are paid to the FC no further tax will apply and it may in the end be avoided altogether by making a tax-free liquidating distribution. The U.S. corporation will have to file U.S. tax returns.
Purchasing Through a Trust
Clearly a corporate structure is not an estate plan in itself. Dealing with the estate of a resident of one country with assets in another can be a tenuous process that can expose those involved to heir-ship challenges and more. A trust can be useful in combination with any of the above to avoid probate and asset distribution to beneficiaries in a pre-determined and orderly manner.
For NRAs who live in a civil jurisdiction a trust might not be recognized as a legal structure. Alternate wealth transfer entities like stiftungs or foundations that are not specifically addressed in U.S. tax laws should be analyzed to classify it as corporations or trusts. When adding U.S. assets into trusts or its equivalent, the funding should follow specific steps to avoid a direct contribution that might cause the U.S. assets to be included in the estate of the NRA.
Real Estate Investment is a great alternative to create wealth if coupled with tax planning. As a real estate investor, you need to put in place the most effective company structure, usually a LLC and maximize the use of options available to reduce your tax bill, such as depreciation and amortization.
Creating a tax plan for your real estate venture is the best strategy to maximize tax shelters. This will save you time to dedicate to your real estate business and the painful experience of a large tax bill. Between, gift tax, capital gain tax, estate tax and income tax, a plan that helps you anticipate and put in place the actions to benefit from the tax code proactively using deductions available:
- Interest Expense
- Fixer Uppers vs Rental Property Investment
- Self-Directed IRA vs Solo IRA
- 1031 Exchange
- Gift Tax
- Capital Gain Tax
- Estate Tax
There are many real estate strategies designed to help you reduce your tax bill. Many of them are very sofisticated and involve proper planning:
- Acquisitions and Dispositions of Partnership and LLC Interests
- Section 1031 Like Kind Exchanges (including forward, reverse, and exchanges involving tenant-in-common interests)
- Tax Deferred Installment Sales
- Conservation Easements and Charitable Trusts Tax Free
- Partnership Liquidations Spinoffs and Partnership Divisions
- Tax Deferral Techniques
- Capital Gains Tax Planning
- Asset Protection Planning for Real Estate
- Depreciation Recapture Minimization Planning Tax Free
- Partnership Exit Strategies
These considerations can make a big difference on your tax bill. Take away the worry and plan to enjoy the benefits and tax savings.
For the NRA investor the potential tax exposure is so significant it is often enough to avoid ownership of U.S. real estate in their personal name. Depending on the situation can however, make sense if the tax exposure can be limited (e.g. if the holding period is short enough to warrant taking the estate tax risk or if the property could be purchased by a younger family member. Life insurance can obviously assist in mitigating the risk. It all comes down to balancing estate tax exposure (by owning in personal capacity) vs. paying potentially higher taxes on income and gains if held by a corporation. The 2017 Tax Act’s dramatic reduction of federal corporate tax to 21% owning real estate through a corporation might now bring about only marginal extra tax, so the scales have tipped so that use of a U.S. corporation owning the real estate, which is owned by a foreign corporation owned by the NRA, may be the best option to choose.
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