There is some exciting news for foreign investors due to recent geo-political developments and the emergence of several financial factors. This coalescence of events, has at its core, the major drop in the price of US real estate, combined with the exodus of capital from Russia and China. Among foreign investors this has suddenly and significantly produced a demand for real estate in California.
Our research shows that China alone, spent $22 billion on U.S. housing in the last 12 months, much more than they spent the year before. Chinese in particular have a great advantage driven by their strong domestic economy, a stable exchange rate, increased access to credit and desire for diversification and secure investments.
We can cite several reasons for this rise in demand for US Real Estate by foreign Investors, but the primary attraction is the global recognition of the fact that the United States is currently enjoying an economy that is growing relative to other developed nations. Couple that growth and stability with the fact that the US has a transparent legal system which creates an easy avenue for non-U.S. citizens to invest, and what we have is a perfect alignment of both timing and financial law… creating prime opportunity! The US also imposes no currency controls, making it easy to divest, which makes the prospect of Investment in US Real Estate even more attractive.
Here, we provide a few facts that will be useful for those considering investment in Real Estate in the US and Califonia in particular. We will take the sometimes difficult language of these topics and attempt to make them easy to understand.
This article will touch briefly on some of the following topics: Taxation of foreign entities and international investors. U.S. trade or businessTaxation of U.S. entities and individuals. Effectively connected income. Non-effectively connected income. Branch Profits Tax. Tax on excess interest. U.S. withholding tax on payments made to the foreign investor. Foreign corporations. Partnerships. Real Estate Investment Trusts. Treaty protection from taxation. Branch Profits Tax Interest income. Business profits. Income from real property. Capitol gains and third-country use of treaties/limitation on benefits.
We will also briefly highlight dispositions of U.S. real estate investments, including U.S. real property interests, the definition of a U.S. real property holding corporation “USRPHC”, U.S. tax consequences of investing in United States Real Property Interests ” USRPIs” through foreign corporations, Foreign Investment Real Property Tax Act “FIRPTA” withholding and withholding exceptions.
Non-U.S. citizens choose to invest in US real estate for many different reasons and they will have a diverse range of aims and goals. Many will want to insure that all processes are handled quickly, expeditiously and correctly as well as privately and in some cases with complete anonymity. Secondly, the issue of privacy in regards to your investment is extremely important. With the rise of the internet, private information is becoming more and more public. Although you may be required to reveal information for tax purposes, you are not required, and should not, disclose property ownership for all the world to see. One purpose for privacy is legitimate asset protection from questionable creditor claims or lawsuits. Generally, the less individuals, businesses or government agencies know about your private affairs, the better.
Reducing taxes on your U.S. investments is also a major consideration. When investing in U.S. real estate, one must consider whether property is income-producing and whether or not that income is ‘passive income’ or income produced by trade or business. Another concern, especially for older investors, is whether the investor is a U.S. resident for estate tax purposes.
The purpose of an LLC, Corporation or Limited Partnership is to form a shield of protection between you personally for any liability arising from the activities of the entity. LLCs offer greater structuring flexibility and better creditor protection than limited partnerships, and are generally preferred over corporations for holding smaller real estate properties. LLC’s aren’t subject to the record-keeping formalities that corporations are.
If an investor uses a corporation or an LLC to hold real property, the entity will have to register with the California Secretary of State. In doing so, articles of incorporation or the statement of information become visible to the world, including the identity of the corporate officers and directors or the LLC manager.
An great example is the formation of a two-tier structure to help protect you by creating a California LLC to own the real estate, and a Delaware LLC to act as the manager of the California LLC. The benefits to using this two-tier structure are simple and effective but must one must be precise in implementation of this strategy.
In the state of Delaware, the name of the LLC manager is not required to be disclosed, subsequently, the only proprietary information that will appear on California form is the name of the Delaware LLC as the manager. Great care is exercised so that the Delaware LLC is not deemed to be doing business in California and this perfectly legal technical loophole is one of many great tools for acquiring Real Estate with minimal Tax and other liability.
Regarding using a trust to hold real property, the actual name of the trustee and the name of the trust must appear on the recorded deed. Accordingly, If using a trust, the investor might not want to be the trustee, and the trust need not include the investor’s name. To insure privacy, a generic name can be used for the entity.
In the case of any real estate investment that happens to be encumbered by debt, the borrower’s name will appear on the recorded deed of trust, even if title is taken in the name of a trust or an LLC. But when the investor personally guarantees the loan by acting AS the borrower through the trust entity, THEN the borrower’s name may be kept private! At this point the Trust entity becomes the borrower and the owner of the property. This insures that the investor’s name does not appear on any recorded documents.
Because formalities, like holding annual meetings of shareholders and maintaining annual minutes, are not required in the case of limited partnerships and LLCs, they are often preferred over corporations. Failing to observe corporate formalities can lead to failure of the liability shield between the individual investor and the corporation. This failure in legal terms is called “piercing the corporate veil”.
Limited partnerships and LLCs may create a more effective asset protection stronghold than corporations, because interests and assets may be more difficult to reach by creditors to the investor.
To illustrate this, let’s assume an individual in a corporation owns, say, an apartment complex and this corporation receives a judgment against it by a creditor. The creditor can now force the debtor to turn over the stock of the corporation which can result in a devastating loss of corporate assets.
However, when the debtor owns the apartment building through either a Limited Partnership or an LLC the creditor’s recourse is limited to a simple charging order, which places a lien on distributions from the LLC or limited partnership, but keeps the creditor from seizing partnership assets and keeps the creditor out the affairs of the LLC or Partnership.
Income Taxation of Real Estate
For the purposes of Federal Income tax a foreigner is referred to as nonresident alien (NRA). An NRA can be defined as a foreign corporation or a person who either;
A) Physically is present in the United States for less than 183 days in any given year. B) Physically is present less than 31 days in the current year. C) Physically is present for less than 183 total days for a three-year period (using a weighing formula) and does not hold a green card.
The applicable Income tax rules associated to NRAs can be quite complex, but as a general rule, the income that IS subject to withholding is a 30 percent flat tax on “fixed or determinable” – “annual or periodical” (FDAP) income (originating in the US), that is not effectively connected to a U.S. trade or business that is subject to withholding. Important point there, which we will address momentarily.
Tax rates imposed on NRAs may be reduced by any applicable treaties and the Gross income is what gets taxed with almost not offsetting deductions. So here, we need to address exactly what FDAP income includes. FDAP is considered to include; interest, dividends, royalties, and rents.
Simply put, NRAs are subject to a 30 percent tax when receiving interest income from U.S. sources. Included within the definitions of FDAP are some miscellaneous categories of income such as; annuity payments, certain insurance premiums, gambling winnings, and alimony.
Capital gains from U.S. sources, however, are generally not taxable unless: A)The NRA is present in the United States for more than 183 days. B) The gains can be effectively connected to a U.S. trade or business. C) The gains are from the sale of certain timber, coal, or domestic iron ore assets.
NRA’s can and will be taxed on capital gains (originating in the US) at the rate of 30 percent when these exceptions apply.Because NRA’s are taxed on income in the same manner as a US taxpayers when that income can effectively be connected to a US trade or business, then it becomes necessary to define what constitutes; “U.S. trade or business” and to what “effectively connected” means. This is where we can limit the taxable liability.
There are several ways in which the US defines “US trade or Business” but there is no set and specific code definition. The term “US Trade or Business” can be seen as: selling products in the United States (either directly or through an agent), soliciting orders for merchandise from the US and those goods out of the US, providing personal services in the United States, manufacturing, maintaining a retail store, and maintaining corporate offices in the United States.Conversely, there are highly specific and complex definitions for “effectively connected” involving the “force of attraction” and “asset-use” rules, as well as “business-activities” tests.
Generally and for simplistic explanation, an NRA is “effectively connected” if he or she is engaged as a General or limited partner in a U.S. trade or business. Similarly, if the estate or trust is so engaged in trade or business then any beneficiary of said trust or estate is also engaged
For real estate, the nature of the rental income becomes the critical concern. The Real Estate becomes passive if it is generated by a triple-net lease or from lease of unimproved land. When held in this manner and considered passive the rental income is taxed on a gross basis, at a flat rate of 30 percent with applicable withholding and no deductions.
Investors should consider electing to treat their passive real property income, as income from a U.S. trade or business, because the nature of this type of holding and loss of deduction inherent therein is often tax prohibited. However, the election can only be made if the property is generating income.
If the NRA owns or invests in or owns unimproved land that will be developed in the future, he or she should consider leasing the land. This is a great way to generate income. Investment in income-generating allows the NRA the ability to claim deductions from the property and generate a loss carry-forward that will offset income in future years.
There are many tools we can use to assist our NRA clients in avoiding taxation on Real Estate income property, one of which is ‘portfolio interest’, which is payable only on a debt instrument and not subject to taxation or withholding. There are several ways to fit within the confines of these ‘portfolio interest’ rules. NRAs can participate in the practice of lending through equity participation loans or loans with equity kickers. An equity kicker is like a loan that allows the lender to participate in equity appreciation. Allowing the lender to convert debt into equity in the form of a conversion option is one way that this can be accomplished as these provisions usually increase interest rates on a contingent basis to mimic equity participation.
There are two levels of tax applicable to a foreign individual or a foreign corporation who owns a U.S. corporation.
The U.S. corporation will be subject subjected to a 30 percent withholding tax on its profits, when the income is not re-invested in the United States and there will be a tax on dividends paid to the foreign shareholders as well. When the U.S. business is owned by a foreign corporation, whether directly or through a disregarded entity, or through a pass-through entity. The branch profits tax replicates the double tax.
The U.S. has treaties covering the ‘branch profits tax’ with most of the European nations, reducing the tax to between 5 and 10 percent. The 30 percent tax is onerous, as it applies to a “dividend equivalent amount,” which is the corporation’s effectively connected earnings and profits for the year, less investments the corporation makes in its U.S. assets (money and adjusted bases of property connected with the conduct of a U.S. trade or business). The tax is imposed even if there is no distribution.
Foreign corporations are taxed on their effectively connected income and on any deemed dividends, which are any profits not reinvested in the United State under the branch profits tax.
The rules applicable to the tax on the disposition of real estate are found in a separate regime known as the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA).
Generally, FIRTPA taxes an NRAs holdings of U.S. real property interest (USRPI) as if he or she were engaged in a U.S. trade or business. As mentioned earlier, this means that the traditional income tax rules that apply to U.S. taxpayers will also apply to the NRA. Obligation to withhold 10 percent of the amount realized on any disposition falls on purchasers who acquire a USRPI from an NRA.
Ownership and interests of Real Estate Property include: fee ownership, co-ownership, leasehold, timeshare, a life estate, a remainder, a reversion or a right to participate in the appreciation of real property or in the profits from real property. For purposes of definition interest in real property would include any ownership of personal property used to exploit natural resources, land, buildings, mineral deposits, crops, fixtures, operations to construct improvements, the operation of a lodging facility, or providing a furnished office to a tenant (including movable walls or furnishings) as well as Improvements, leaseholds, or options to acquire any of the above.
There are several ways in which a partnership interest is treated as a USRPI: A domestic corporation will be treated as a U.S. real property holding corporation (USRPHC) if USRPIs are equal to or exceed 50 percent of the sum of the corporation’s assets. OR when 50 percent or more of the value of the gross partnership assets consists of USRPIs – Or when 50 percent or more of the value of partnership gross assets consist of USRPIs plus cash and cash equivalents. The disposition of partnership interest will be subject to FIRPTA. To the extent that such partnership continues to own USRPIs they will remain subject to this withholding.
The good news is that disposition of an interest in a USRPHC is subject to the FIRPTA tax and withholding but is not subject to state income tax. There is an obvious benefit when compared with the disposition of a USRPI owned directly. USRPI which are owned directly are subject to the lower federal capital gains rate as well as state income tax. If, however on the date of the disposition the corporation had no USRPIs and the totality of the gain was fully recognized (no installment sales or exchanges) on the sale of any USRPIs sold within the past five years Then this disposition cannot be subject to these rules.
Any USRPI sold by an NRA (individual or corporation) will be subject to 10 percent withholding of the amount realized. Withholding applies even if the property is sold at a loss.
The purchaser must report the withholding and pay over the tax, using Form 8288 within 20 days of the purchase. This is to be duly noted because if the purchaser fails to collect the withholding tax from the foreigner, the purchaser will be liable for not only the tax, but also any applicable penalties and interest. The withheld taxes are later credited against the total tax liability of the foreigner.
Instances wherein withholding is not required, are the following:
The seller provides a certificate of non-foreign status. Property acquired by the purchaser is not a USRPI. The transferred property is stock of a domestic corporation and the corporation provides a certificate that it is not a USRPHC.
The USRPI acquired will be used by the purchaser as a residence and the amount realized by the foreigner on the disposition is $300,000 or less. The disposition is not subject to tax, or the amount realized by the foreigner on the disposition is zero.
Estate and Gift Tax: In determining who is an NRA and who is excluded the test is completely different for estate tax purposes. The focus of inquiry will centers around the decedent’s residence. This test is very subjective and focuses primarily on intent.The test considers factors from across the board, such as how long the NRA has been in the United States, how often he or she travels as well as the size, and cost of home in the United States. The test will also look at the location of NRA’s family, their participation in community activities, participation in U.S. business and ownership of assets in the United States. Voting is also taken into consideration.
A foreigner can be a U.S. resident for income tax purposes but not be domiciled for estate tax purposes. An NRA, whether a nonresident alien or non-domiciliary, will be subject to a different transfer taxes (estate and gift taxes) than a U.S. taxpayer. Only the gross part of the NRA’s Estate that at the time of death is situated in the United States will be taxed with the estate tax. Although the rate of NRA’s estate tax will be the same as that imposed on U.S. citizens and resident aliens, the unified credit is only $13,000 (equivalent to about $60,000 of property value).
These may be ameliorated by any existing estate tax treaty. European countries, Australia, and Japan enjoys these treaties, The U.S. does not maintain as many estate tax treaties as income tax treaties.
The IRC defines the following property as situated in the United States: A) Shares of stock of a U.S. corporation. B) Revocable transfers or transfers within three years of death of U.S. property or transfers with a retained interest (described in IRC Sections 2035 to 2038). C) Debt issued by a U.S. person or a governmental entity within the United States (e.g., municipal bonds).
Real estate in the United States is considered U.S. property when it is physical personal property such as works of art, furniture, cars, and currency. Debt, however is ignored if it is recourse debt, but gross value is included, not just equity. U.S.-situs property is also a US property if it is a beneficial interest in a trust holding. Life insurance is NOT included as U.S.-situs property.
The estate tax returns must disclose all of the NRA’s worldwide assets, in order to determine the ratio that the U.S. assets bear to non-U.S. assets. The gross estate is reduced by various deductions relating to the U.S.-situs property. This ratio determines the percentage of allowable deductions that may be claimed against the gross estate.
As mentioned earlier, when real estate is subject to a recourse mortgage, the gross value of the real estate is included, offset by the mortgage debt. This distinction is very relevant for NRAs whose debts are subject to apportionment between U.S. and non-U.S. assets and therefore not fully deductible.
Accurate planning is crucial. Let us illustrate: An NRA can own US property through a foreign corporation and this property is not included in the NRA’s estate. This means that the US Real property owned by the NRA has now effectively been converted into a non-U.S. intangible asset.
And with Real Estate that was not initially acquired through a foreign corporation, you can still avoid future taxation to the estate by paying an income tax today on the transfer of the real estate to a foreign corporation (usually treated as a sale).
An NRA donor is not subject to U.S. gift taxes on any gifts of non-U.S. situs property gifted to any person, including U.S. citizens and residents. Gift taxes are imposed on the donor. Gifts from an NRA that are in excess of $100,000 must reported on Form 3520.46 by citizens and residents, however, Gifts of U.S.-situs assets are subject to gift taxes, with the exception of intangibles, which are not taxable.
If it is physically located in the United States tangible personal property and real property is sited within the United States. The lifetime unified credit is not available to NRA donors, but NRA donors are allowed the same annual gift tax exclusion as other taxpayers. NRA’s are also subject to the same rate-schedule for gift taxes.
The primary thrust of estate tax planning for NRAs is through the use of; the following: Foreign corporations to own U.S. assets, and the gift tax exemption for intangibles to remove assets from the United States. It is very important that the corporation have a business purpose and activity, lest it be deemed a sham designed to avoid U.S. estate taxes. If the NRA dies owning shares of stock in a foreign corporation, the shares are not included in the NRA’s estate, regardless of the situs of the corporation’s assets.
Let us break this down into one easy to read and understand paragraph:
In a nutshell, shares in U.S. corporations and interests in partnerships or LLCs are intangibles and the gift of an intangible, wherever situated, by an NRA is not subject to gift tax. Consequently, real estate owned by the NRA through a U.S. corporation, partnership, or LLC may be removed from the NRA’s U.S. estate by gifting entity interests to foreign relatives.
Ownership Structures: Here we discuss the ownership architectures under which NRA’s can acquire Real Estate. The NRA’s personal goals and priorities of course dictate the type of architecture that will be used. There are advantages and disadvantages to each of these alternatives. Direct investment for example, (real estate owned by the NRA) is simple and is subject to only one level of tax on the disposition. The sale is taxed at a 15 percent rate If the real estate is held for one year. There are many disadvantages to the direct investment approach, a few of which are: no privacy, no liability protection, the obligation to file U.S. income tax returns, and if the NRA dies while owning the property, his or her estate is subject to U.S. estate taxes.
When an NRA acquires the real estate through an LLC or an LP, this is considered an LLC or a limited partnership structure. This structure provides the NRA with protection of privacy and liability and allows for lifetime transfers that escape the gift tax. The obligation to file U.S. income tax returns and the possibility for U.S. estate tax on death remain, however.
Ownership of real estate through a domestic corporation, will afford privacy and liability protection, obviate the foreigner’s need to file individual U.S. income tax returns and allow lifetime gift tax-free transfers. *this refers to a C corporation, since a foreign shareholder precludes an S corporation.
Ownership of stock will not trigger a return filing obligation, unlike engaging in a U.S. trade or business which requires a U.S. tax return
Ownership of real estate through a domestic corporation has three disadvantages: Federal and state corporate income tax at the corporate level will add a second layer of tax. Dividends from the domestic corporation to its foreign shareholder will be subject to 30 percent withholding. Shares of the domestic corporation will be included in the U.S. estate of the foreign shareholder.
Furthermore, the foreign shareholder will be subject to FIRPTA, because the corporation will be treated as a USRPHC (upon the disposition of the stock in the corporation). The purchaser of the shares is then required the file a U.S. income tax return with 10 percent tax withholding. Actual ownership of the real estate may be held by the U.S. corporation directly, or by a disregarded entity owned by the corporation or through a U.S. partnership. An LLC that chooses to be taxed as a corporation can also be the corporation.
There are several advantages to foreign corporation ownership:
Liability protection- There is no U.S. income tax or filing requirement for the foreign shareholder. Shares in the foreign corporation are non-U.S. assets not included in the U.S. estate.
Dividends are not subject to U.S. withholding. There is no tax or filing requirement on the disposition of the stock. There is no gift tax on the transfer of those shares of stock.
Disadvantages of using the foreign corporation: A) just like with the domestic corporation, there will be corporate level taxes, because the foreign corporation will be deemed engaged in a U.S. trade or business. B) Possibly the largest disadvantage of ownership of U.S. real estate through a foreign corporation would be that the foreign corporation will be subject to the branch profits tax.
One of the most advantageous structure for ownership of U.S. real estate by NRAs is a hybrid foreign and U.S. corporation. It runs like this: The NRA owns a foreign corporation that in turn owns a U.S. LLC taxed as a corporation. The benefits to this type of structure is paramount to a good tax shield and offers: privacy and liability protection, escaping U.S. individual income tax filing requirements and it also avoids U.S. estate taxes. On top of that it allows for gift tax-free lifetime transfers, and avoids the branch profits tax.
The beauty and benefit of this is that the timing and the amount of this dividend is within the NRA’s control even though distributions from the U.S. subsidiary to the foreign parent are subject to the 30 percent FDAP withholding.
There are many things to consider and several structures available to limit tax liability, preserve and protect anonymity and increase profits of US Real Estate investments by foreign investors. We must keep in mind that each investment presents its own challenges and no structure is perfect. Advantages and disadvantages abound which will require a tailored analysis in light of the individual or group objectives.