Introduction
Estate tax considerations
Income tax considerations
Low interest rates, a weakened currency and depressed values are making the US real estate market attractive to foreign investors. However, these investors often overlook the fact that direct ownership of US real estate leaves them exposed to steep US taxes during ownership and on disposition or death. The tax consequences of owning US real property individually or through an entity are substantially different, and foreign investors should consider the tax implications of investing in US real property before signing on the dotted line.
No single solution is perfect. The optimal ownership structure depends on the investor, his or her intentions and the property itself. This update considers some of the available alternatives. In this update a 'foreign investor' is an investor who is not a US citizen, green card holder or tax resident.
One of the most onerous taxes in the United States is the federal estate tax, which can reach 40%.
A foreign investor owning US real estate at the time of his or her death will have a US estate and, depending on the property's location, state estate taxes may also apply. Few foreign investors take this into account.
The three principal estate planning alternatives for foreign investors in US real property are:
- life insurance;
- value reduction; or
- avoidance of outright ownership.
Life insurance
Life insurance, with sufficiently large death benefits, can provide the investor's estate with liquidity to pay the US estate tax without forcing the sale of the asset. However, this can be expensive and does not account for appreciation of the value of the property after the policy is obtained.
Value reduction
Estate taxes can also be reduced by lowering the value of the US property with non-recourse mortgages. If the property is subject to a non-recourse mortgage, only the equity's value will be subject to US estate tax.
Conversely, with a recourse mortgage, the property's entire value will be taxed, with only a portion of the mortgage being deductible and only if the investor's worldwide assets are disclosed on a US estate tax return. The preparation of a US estate tax return and the disclosure of worldwide assets can be a costly proposition, and foreign investors often find it an unappealing option.
However, non-recourse mortgages are difficult to obtain and later appreciation in value of the asset will still be included in the foreign investor's US estate.
Bypassing outright ownership
Where the foreign investor does not own the US property directly, no US estate tax should be due on his or her death.
A foreign trust works particularly well if the investor will not use the property as a residence. If a properly structured foreign trust purchases such a property, it will not be included in the investor's US estate.
If the investor intends to use the property as a residence, the investor should not be a trust beneficiary. Instead, the investor's spouse could be a trust beneficiary or fair market rent should be paid to the trust.
Foreign corporate ownership can also shield US real property from estate tax. If a foreign corporation owns the property, the investor's personal use of the property is irrelevant. Ideally, the foreign corporation would purchase the property; otherwise, the investor could contribute the property to the corporation in exchange for shares. However, the transfer of the property to the corporation may give rise to local real estate transfer taxes.
In the income tax context, US real property owned outright or through an entity is called a US real property interest (USRPI). A USRPI includes:
- a direct interest in US real estate;
- shares of US corporations the majority of whose assets consist of USRPIs; and
- pass-through entities that own USRPIs.
Income tax consequences in the United States will be dictated by how the USRPI is owned.
Ownership by individual or foreign trust
The Foreign Investment in Real Property Tax Act of 1980 subjects gains from the disposition of a USRPI to US income tax.
Under the act, a gain realised by a foreign individual or trust on the sale of a USRPI held for personal use for more than 12 months is taxed at the marginal capital gains rate applicable to individuals – currently, up to 23.8%.
The act also imposes a US withholding of 10% of the gross sale price. The foreign investor or trust must still file a US income tax return. If the actual tax liability is lower than the amount to be withheld, the seller may apply for a certificate of non-withholding before the sale to avoid (or reduce) the withholding.
Ownership by foreign corporation
While a gain realised by a foreign corporation on the sale of a USRPI is taxed at higher marginal corporate income tax rates of up to 35%, an appropriate corporate structure can circumvent Foreign Investment in Real Property Tax Act withholding. Moreover, while the rent-free use of the USRPI may cause constructive dividend issues, there are ways to address this.
For further information on this topic please contact Shelly Meerovitch at Katten Muchin Rosenman LLP by telephone (+1 212 940 8800), fax (+1 212 940 8776) or email (shelly.meerovitch@kattenlaw.com). The Katten Muchin Rosenman LLP website can be accessed at www.kattenlaw.com.
