This article went to publication prior to the passage of the Foreign Account Tax Compliance Act (“FATCA”) whose provisions are found in the Hiring Incentives to Restore Employment (HIRE) Act which President Obama signed on March 18, 2010. Several of FATCA’s provisions could impact a taxpayer’s disclosure and reporting requirements and are not reflected in this article.
Headlines declare that the U.S. dollar is cheaper than ever and foreign investors can buy U.S. real estate at bargain prices. America is now on sale and for sale. The result is an increase in foreign investment in U.S. real property. Although the sale of the Empire State Building to a Japanese corporation attracted much attention, subsequent large purchases have also occurred. Additionally, foreign individuals are also purchasing second homes, vacation properties, and other residential properties in the U.S. So, what perils await them? Tax traps loom, both income tax during the period of ownership and upon disposition of the property, as well as estate tax on the death of the owner.
So what should the foreign investor be aware of before signing on the purchase contract? Firstly, much depends on the foreigner’s country of residence. A treaty may exist which will improve the investor’s situation, vis a vis the U.S. tax, both income and estate tax. Secondly, the type of property (personal use versus income producing) will affect the tax paid. Thirdly, the intentions of the investor are important, such as if the investor intends to hold it long term or short term; or whether he or she intends to pass the property on to a spouse or children and the nationalities and residencies of those heirs. Fourthly, what is the complexity tolerance of the investor? The complexity of setting up
multi-tiered structures to minimize tax may be worth considering, but may be too cumbersome for the investor to maintain.
For purposes of this article, a “foreigner” is defined as a non-U.S. citizen, non-resident alien, and non-domiciliary of the U.S. In other words, a non-resident alien who spends generally no more than 4 months a year in the U.S. In structuring the foreigner’s investment in U.S. real property, one of the most significant landmines to avoid is the U.S. death tax. While most investors do not anticipate dying while owning U.S. real property, two sure things are death and taxes, so one must plan ahead for both. While the federal estate tax has been repealed for calendar year 2010, absent further legislative changes, it will return with a vengeance on January 1, 2011. This article addresses tax considerations when the U.S. federal estate tax returns and not the anomaly year of 2010. When a foreigner dies owning U.S. real property, his estate faces heavy taxes. Few realize that a foreign investor in U.S. real property is subject to U.S. federal estate tax at a Federal rate of up to 55% (2011) (often with an additional state estate tax) and with only a $60,000 exemption on the full fair market value of the property unreduced by any recourse mortgage loan. Thus, on a $1 million investment, if the foreigner dies, the federal estate tax will be approximately $500,000 (plus state estate tax depending on where the real property is located). Many states have repealed their estate tax, but some states continue to tax.
An estate tax treaty may increase the $60,000 explicable exclusion amount; however, there are only 16 current estate tax treaties with the U.S. So, if the foreign investor is not from Australia, Austria, Canada, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Japan, The Netherlands, Norway, Republic of South Africa, Switzerland, or the United Kingdom, then the investor will be subject to the regular exclusion and rates.
So, what is the solution? One solution is to obtain a life insurance policy sufficient to pay the U.S. estate tax. Secondly, the investor could finance the purchase with non-recourse debt. In that instance, for determining the amount on which the U.S. federal estate tax is based, it will be on a net basis (i.e., fair market value less the non-recourse debt).1 Avoiding the U.S. estate tax may not be the main priority of the foreign investor. This article will examine the advantages and disadvantages of the following types of ownership structures: individual ownership, ownership through a foreign corporation, ownership through a domestic corporation, ownership through a partnership or limited liability company, and ownership through a trust. Each one may serve to accomplish some of the foreign investor’s goals. No one structure is perfect for one investor, let alone all investors.
Direct Individual Ownership
The advantages of direct ownership include its simplicity; there is no imputed rent issue for personal use, the owner will enjoy preferable capital gain tax rates, and the estate will receive a step up in basis upon the owner’s death. The disadvantages include exposure to the U.S. estate tax, but if the property is secured by a non-recourse mortgage, only the net amount will be includible in the estate. Further, if the foreign investor is from a treaty country or is survived by a U.S. citizen spouse, then the investor may find some relief from the estate tax burden.
Income Tax. During ownership, any rent is taxed at a 30% flat income tax (or lower treaty rate) unless the individual elects to be taxed on a net basis2 in which case individual ordinary income tax rates will apply. If the foreign individual sells U.S. real property which the investor has held long term, then long term capital gains tax rates will apply (currently 15% at the federal level)3, along with state income tax, and an additional 25% tax on recapture income when depreciated real property is sold at a gain4. With respect to deductions, the individual will not be able to deduct expenses unless he or she makes the Section 871 “net” election. If made, for personal use real property, the foreigner can only deduct qualified mortgage interest and real property taxes.
Imputed Rent. For personal use real property, the individual owner and his or her family members may use the property without the imputation of rental income.
Gift Tax. A gift of U.S. real property by a foreign individual is subject to U.S. gift tax with no offsetting applicable exclusion amount. The non resident alien is also eligible for the annual exclusion ($13,000 in 2010). In 2010 the gift tax rate is 35%; in 2011 the highest gift tax rate will be 55%.
Estate Tax. As mentioned above, there is no federal estate tax for a foreign individual dying in 2010. If a foreign individual dies after 2010 owning U.S. real property encumbered by a mortgage without recourse, then the full value of the mortgage will reduce the value of the U.S. property. If a foreign individual dies with U.S. real property encumbered by a mortgage with recourse (i.e., the estate is fully liable for the debt), then the full value of the property is includible in the estate, and the deduction is limited to a proportionate amount of the debt.5 The proportionate amount of the debt is the ratio of the value of the gross estate situated in the U.S. to the value of the gross estate situated in all countries. Consequently, for the nonresident alien decedent’s estate to get the benefit of any mortgage reduction, the executor must disclose on the Form 706NA, the entirety of the decedent’s estate.6 The foreign estate will have the benefit of only a $60,000 applicable exclusion amount and face federal estate tax rates of 55% for 2011, unless a treaty provides relief or the estate qualifies for the marital deduction which will apply only if the surviving spouse is a U.S. citizen or the asset is transferred to a qualified domestic trust (“QDOT”).
FIRPTA. Upon a sale, the foreign owner will be exposed to the Foreign Investment in Real Property Tax Act (“FIRPTA”).7 FIRPTA is a mechanism to ensure the collection of tax by imposing withholding on the buyer of such property equal to 10% of the amount realized, generally the sales price, absent a treaty exception.
Investment through a foreign corporation has the advantages of anonymity, limited liability for the shareholders, and avoidance of U.S. gift and estate tax. The disadvantages include exposure to the “branch profits tax” and the ”branch interest tax”.8 (unless reduced by treaty), ordinary corporate income tax rates, FIRPTA , imputed rent for personal use and no inside basis step up.
Income Tax and Branch Profits Tax. There is no withholding on dividends from the foreign corporation to the nonresident alien. Instead, the branch profits tax essentially imposes an additional 30% tax on a foreign corporation’s U.S. branch operations that are deemed repatriated from the U.S. Thus, a foreign corporation, that invests in U.S. real property, will have corporate tax on its earnings in the U.S. (15%-35%) and an additional 30% branch profits tax on those earnings that are repatriated to the foreign parent equating to an effective tax rate of 54%. One major exception from the branch profits tax is for a complete termination of the branch.9 To meet this exception, the taxpayer must satisfy several requirements, some of which are fairly harsh.10 Further, a treaty between the U.S. and the country of the foreign corporation’s incorporation may reduce or eliminate the branch profits tax.11 The U.S. also imposes a branch level interest tax which treats the U.S. branch of a foreign corporation as if it were a U.S. corporation; so, interest paid (or deemed paid) by the branch to foreign lenders is considered U.S. source income and subject to the FDAP regime and 30% withholding.12 If the property generates substantial income and a treaty does not apply, then ownership through a foreign corporation may not be desirable.
Imputed Rent. One disadvantage of owning personal use property through a corporation is that the corporation must charge fair market rent to a shareholder or officer of the corporation if such individual uses the corporate owned property for his or her personal, use or such rent will be imputed to the corporation and trigger income tax.
Gift Tax. A gift of shares in a foreign corporation by a foreign individual is not subject to U.S. gift tax.13 FIRPTA does not apply to gift transactions.
Estate Tax. Investment through a foreign corporation does have the advantage of shielding the investor from a U.S. estate tax exposure provided the foreign corporation is not used as a sham. While shares of a U.S. corporation have a U.S. situs,14 shares of a foreign corporation have a non-U.S. situs.15 If corporate formalities are not respected, a foreign corporation may be disregarded and the foreign corporation’s assets may be deemed owned by the shareholders.16
FIRPTA Withholding. The foreign corporation’s taxable sale of the U.S. real prperty is subject to FIRPTA. A sale of the stock in the foreign corporation is not subject to FIRPTA. A foreign corporation may elect, under §897(i) to be treated as a U.S. corporation provided each corporation is a resident of a treaty country and the treaty provides for non-discriminatory treatment for treaty partner residents. By making an “i” election, the foreign corporation can utilize non-recognition provision, still avoid U.S. estate tax and defer FIRPTA withholding under §1445. The disadvantage of the “i” election is the foreign corporation stock is treated as a USRPI.17
The advantages of investing through a domestic corporation (i.e., one incorporated in one of the fifty states or the District of Columbia) include providing limited liability for its shareholders, avoiding the branch profits tax, and avoiding FIRPTA withholding. However the disadvantages include exposure to U.S. estate tax (although not U.S. gift tax), ordinary income tax rates, and imputed rent.
Income Tax. A corporation’s capital gains are subject to ordinary income tax rates and do not benefit from the lower capital gains tax rates. If held through a corporation, the tax rates tend to be higher (15% on gains only up to $50,000 and effectively up to 34% on amounts over $75,000).
Imputed Rent. The personal use of the real property by owners of the company may trigger imputed rent.
Gift Tax. Exemptions from gift tax by a foreign individual include gifts of stock in a domestic or foreign corporation and a domestic or foreign partnership. Thus, if U.S. real property is gifted, the donor is subject to U.S. gift tax at fairly onerous rates. However, if the U.S. real property is owned through a U.S. (or foreign) corporation and the U.S. (or foreign) corporate stock is gifted by the non-resident alien, the transfer is exempt from U.S. gift tax.18 FIRPTA withholding does not apply to gift transfers.
Estate Tax. After repeal, shares of stock in a U.S. corporation by a foreign individual will be exposed to U.S. estate tax. The exemption amount is only $60,000 with rates of 55% (2011).
FIRPTA. The sale of property by a U.S. corporation will be exempt from FIRPTA, however the sale of a USRPI would be subject to FIRPTA.
U.S. Corporation Owned by Foreign Corporation
Some investors incorporate in a jurisdiction with a favorable income tax treaty with the U.S. Most treaties have a limitation of benefits rule — an anti treaty shopping rule — which limits treaty benefits to those who are a qualified resident of the treaty country. Although many foreign investors like the unanimity of purchasing through a foreign corporation, the branch profits tax, higher income tax rates on capital gains and FIRPTA may cause the investor to look at different alternatives.
The advantages of a tiered structure include avoiding U.S. estate tax, avoiding the branch profits tax, and avoiding double taxation upon a liquidating distribution. After the property is sold in a taxable transaction, a single level of tax is paid, the proceeds can be distributed to the foreign corporation free of U.S. withholding tax. The foreign corporation can thereafter pay the proceeds to its nonresident alien shareholder with no U.S. tax impact. The disadvantages include the higher ordinary income tax rates, imputed rent for personal use, and no inside basis step up.
Partnership or LLC
If a non-resident alien invests through a partnership (whether foreign or domestic) or a limited liability company (LLC) taxed as a partnership, the estate tax treatment may not be so clear. Further, owning through a partnership requires more than one investor, which could cause additional complications. Owning U.S. real property through a single member LLC, while permitted, would be considered a disregarded entity for income, estate, and gift tax purposes and subjected to U.S. estate tax. For a partnership or LLC, the foreign partner will be deemed to be engaged in a U.S. business if the partnership is so engaged and for U.S. income tax purposes, the investor’s U.S. income tax treatment is similar to that of individual ownership. The major advantages of investing through a partnership/LLC are a step up in basis and a lower capital gains tax rate. However, this may be overshadowed by the concern that an interest in a partnership or LLC will be treated as U.S. situs and subject to U.S. estate tax. If the property is income producing, there may be withholding by the LLC/Partnership on the investor’s deemed share of profits, there is possible imputed rent if the foreign owner uses the property, and it may cause inclusion in the foreign investor’s estate (a IRC §2036 issue).
Income Tax and Withholding on Foreign Partners. Partnerships enjoy the lower preferential capital gains tax rate. When a nonresident alien owns a partnership conducting business in the U.S., then the partnership must withhold U.S. tax on the partnership’s effectively connected income attributable to foreign partner regardless of whether distributions are being made to the foreign partner.19 Often, the nonresident alien will form a U.S. corporation to invest in the partnership in order to avoid this withholding requirement. However, by so doing, the investor will have created the two tiered system and will be dealing with ownership through a U.S. C- corporation. Given the vague treatment of a partnership interest for U.S. estate tax purposes discussed below, the partnership may not be an ideal form of ownership of U.S. real property.
Imputed Rent. If the property is used personally, the imputed rent issue also arises.
Gift Tax. Gifts of partnership interests as non U.S. situs intangible property should be exempt from gift tax by a foreign owner; however, the U.S. tax treatment of gifts of a partnership interest is not clear. There are cases and other authority finding that in some instances, the gift of a partnership interest is an intangible and others finding that if the partnership holds U.S. real estate, it is a gift of the underlying asset.20 Further, under anti-abuse theories, if the partnership is created for the sole purpose of circumventing the gift tax, then the Service may be successful in arguing it is a gift of a U.S. situs asset.21
The situs of a partnership interest owning U.S. real property can be vague because the Internal Revenue Code and Treasury Regulations do not define a partnership interest (neither foreign nor domestic) as U.S. situs or non U.S. situs for estate tax purposes.22 So, the safest view from a planning perspective is to treat a partnership interest which is engaged in a U.S. trade or business as U.S. situated.
To insulate the foreign investor, a two-tiered partnership approach may be considered.23 Under this approach, the foreigner takes title to the U.S. real property first by owning a majority interest in a foreign partnership with a foreign corporation holding the minority interest. That foreign partnership, in turn, is a majority-limited partner in a U.S. partnership which holds title to the U.S. real estate. Through this layering, the following results occur: 1) the foreign investor is able to avoid U.S. corporate tax on the sale of the real property and enjoy the lower 15% capital gains tax rates vehicle and 2) the foreigner investor insulates himself on the estate tax side since he will be owning a limited partnership interest in the U.S. partnership which is involved in a U.S. trade or business (i.e., that of owning U.S. real property).
Some authorities24 indicate that given the anti abuse regulations25, the Service could impose gift tax on the grantor of a gift of a partnership interest who does not pay a gift tax, and the assets of the partnership if given directly, would be subject to gift tax.
Estate Tax. The U.S. estate tax arguably does not apply to a partnership that is not engaged in a U.S. trade or business. So, if the U.S. real property interest is un-rented residential real estate or raw land held for investment, a partnership interest (or LLC interest taxed as a partnership) may not be considered U.S. situs and not includable in the decedent’s U.S. estate. Nonetheless, the disposition of such interest would still be considered effectively connected to a U.S. trade or business.
FIRPTA. A sale of a U.S. real property by a foreign partnership would be subject to FIRPTA withholding.
Using a trust may be a viable alternative to the other entity structures. If a foreigner invests in U.S. real property through a trust, one must determine if it is a grantor trust (whether foreign or domestic) or a non-grantor trust (whether foreign or domestic). If the trust is a grantor trust (whether foreign or domestic) with a foreign grantor, then the look through provisions will apply and generally no income tax advantage would be gained (it will be the same as the discussion for direct investment). The foreign grantor would be treated as if he owns the U.S. real property directly. If, however, the foreign individual takes title in a foreign non-grantor trust, then the trust is taxed the same as a non-resident alien holding title directly. If he uses a non-grantor trust (foreign or domestic), it must be irrevocable. If structured correctly, there should be no estate tax at the grantor’s death if he retained no powers. His family members as beneficiaries could use the property without imputed rent; however, the use of the property by the grantor may have IRC §2036 issues. If there is no inclusion, there will be no basis step up. If it is a foreign trust, there will be FIRPTA upon a disposition.
Income Tax. For a foreign non-grantor trust, the proceeds of sale will generate capital gain (or loss); however, if the proceeds are accumulated and later distributed to U.S. beneficiaries, they will convert to ordinary income.
Imputed Rent. If one of the trust beneficiaries personally uses the property, there is no imputed rent.
Estate Tax. The one advantage of a foreign non-grantor trust is that assuming the foreign individual sets up the trust with non-U.S. situs assets and can avoid inclusion in his estate under IRC sections 2035-2038, then the foreign individual may be able to avoid inclusion in his or her estate at death. If the trust is a domestic non-grantor trust, then it will be a U.S. taxpayer and will be taxed under the typical rules for U.S. non-grantor trusts at compressed income tax rates. One must be extremely cautious of the section 2104(b) trap. If the grantor transfers U.S. situs property into a trust and later converts it to non-U.S. situs, it will retain its original character as U.S. situs and be subject to U.S. estate tax at the grantor’s death.
FIRPTA. For foreign estates and foreign non-grantor trusts, the withholding obligation arises on a distribution of cash or property to the beneficiary and not on a disposition of a USRPI.26 If a domestic trust or estate has a foreign beneficiary and disposes of a USRPI, the fiduciary may be required to withhold.27
Given the estate tax ramifications of a non-resident alien’s holding U.S. real property either directly or through a partnership or domestic corporation, many non-resident aliens prefer to hold U.S. real property interests through a foreign corporation or to purchase a life insurance policy sufficient to cover the estimated estate tax liability. The problem with owning U.S. real property interests through a foreign corporation is the branch profits tax, although several treaties substantially reduce this. If no such treaty applies, then a tandem structure of a U.S. subsidiary owned by a foreign parent may be preferred. This structure permits the avoidance of U.S. estate tax and the avoidance of the branch profits tax. Alternatively, structuring foreign investment in U.S. real property through debt can be attractive because, if structured properly, both the interest and the note can be exempt from income and estate tax under the portfolio interest exception. With proper drafting, having the foreign individual fund a non-grantor trust with non-U.S. situs assets and then having the trust purchase the property may be a good long-term solution to avoid U.S. estate tax and imputed rent issues and enjoy capital gains tax rates.
Foreign investors are recognizing the financial opportunity for investment in the U.S. real estate market. However, before ratifying a real estate contract for the purchase of property on U.S. soil, the foreigner should seek competent legal advice in order to properly structure the investment, taking into account with due consideration the investor’s goals and the possible treaty benefits that may apply. After-the-fact structuring poses many hurdles, and given the complexity of the U.S. tax laws, one less hurdle, the better.
Contact the author:
Leigh-Alexandra Basha, Esq.
Holland & Knight LLP
1 For example, on a $1 million investment with an $800,000 non recourse loan, the $200,000 net value less the $60,000 applicable exclusion amount results in a federal estate tax bill of $63,000 instead of approximately $500,000.
2 I.R.C. §871.
3 I.R.C. §1(h)(1).
4 I.R.C. 1(h)(1)(D)
5 Regs. §20.2106-2.
6 For example, the decedent has a $10 million USD world wide estate including his Miami condo worth $1 million USD. He has a mortgage encumbering the condo of $900,000, thinking that only the $100,000 of net equity would be subject to U.S. estate tax. However, because the mortgage is with recourse, only a proportionate amount of it is deductible on the U.S. return. The proportion is the 10% (i.e., the ratio his U.S. estate ($1,000,000 condo being his only U.S. asset) bears to his world wide estate ($10 million). Thus only 10% of his $900,000 mortgage or $90,000 is deductible. His U.S. taxable estate is $910,000). If the decedent has other expenses (e.g., funeral, administration etc.) then 10% of those expenses may also be taken as a deduction on the U.S. return.
7 I.R.C. §1445.
8 I.R.C. §884.
9 Reg. §1.884-2T(a)(i); Rev. Rul. 86-17, 1986-2 C.B. 379.
10 Reg. §1.884-2T(a). To qualify for the exemption from the BPT, none of the assets of the liquidated foreign corporation can be used by the shareholder or any related person in a U.S. trade or business for three (3) years following the termination.
11 A list of such treaties is found in the Treasury Regulations. I.R.C. §1.884-1(g)(3) and (4).
12 I.R.C. §1.884 (f) (c)(i).
13 I.R.C. 2501(a)(2)
14 I.R.C. §2104(a).
15 Regs. §20.2105-1(f).
16 Fillman v. U.S., 355 F.2d 632 (Ct. Cl 1966). PLR 7731043.
17 Note: There is a special minimum tax rate of 26% - 28% on an NRA’s U.S. real property gains for the taxable year. I.R.C. §897(a)(i).
18 I.R.C. section 2501(a)(2).
19 I.R.C. §1446 is another withholding provision requiring domestic partnership to withhold tax on distributions to foreign partners. §1446 withholding tax applies to the effectively connected income of a domestic partnership to the extent that it is allocable to foreign partners.19 The tax to be withheld is the highest rate of income tax applicable to each particular foreign partner, to the extent of the partner’s allocable share. This may work a hardship on the partnership’s cash flow and resources.
20 Bodgett v. Silberman, 277 US 1 (1028) held that the interest in a partnership owned by the decedent was an intangible for state inheritance tax purposes. Ltr Rul 7737063 and Rev Rul 55-143, 1955-1 CB 465 found a partnership interest to be an intangible not subject to gift tax. GCM 18718, 1937-2 CB 476, declared obsolete 1970-1 CB 280 concluded that the interest in a partnership is itself personal property.
21 Reg. §1.701-2.
22 The Service may determine a partnership interest under one of two theories: the entity theory or the aggregate theory.22 Under the entity theory, the partnership interest is an intangible and not subject to gift tax. Under the aggregate theory, the nonresident donor of the interest in the partnership look to the underlying assets to determine if any of them, given separately, would generate a gift tax for a partnership holding U.S. real estate for example. Old case law points to the partnership interest being an intangible for purposes of the estate tax. The Service determines the situs of the partnership interest according to where the partnership conducts its business rather than the situs of the assets it holds.
23 This approach is suggested by several authorities including Rhoades & Langer and Robert Hudson.
24 Rhoades and Langer.
25 Regs. §1.701-2.
26 The fiduciary must maintain a special USRPI account to withhold 35% of any distributions to a foreign beneficiary up to the balance of the USRPI account. Reg. §1.445.5(c)(l)(III)(A).
27 If a grantor trust has a foreign owner, the fiduciary must withhold a tax of 35% of the gain the trust realizes on the disposition of a USRPI, to the extent the gain is allocated to the foreign person. Regs. §1-1445-5(c)(l)(iii)(A).