Foreign investors see the United States as a stable and secure place to invest in real estate (Zimmerman, 2008). Foreigners easily can purchase real property in the United States unlike some countries that make it difficult for foreigners to own real estate (Gudelis, 2008). The weakening of the U.S. dollar and lower real property prices due to foreclosures make these investments even more attractive for foreign investors (Gudelis, 2008). Though real property can be easy to purchase for foreigners there are reporting requirements and tax consequences that must be considered if penalties and interest are to be avoided (Rothschild, 2008).
A foreign citizen planning to purchase U.S. real property has many considerations to make prior to consummating any real estate transaction. A foreign investor can use several structures to purchase real property such as directly or through some type of business entity. How the property will be used is important as well. Both structure and use will have different tax consequences and may be governed by different regulations.
Purchasing real property directly is not always the best choice, so looking at other entity structures can be worthwhile (Zarb, 2007). Besides purchasing property there are several business structures available for purchasing real property through and since structure can have a dramatic tax consequence it’s important to consider these alternatives (Domanski, 2006). It is also possible to purchase real estate through several types of corporations and pass through entities, though further consideration should be given to the particular form used (Deloitte, 2006). Real property can be purchased through a domestic or foreign trust. Real estate may also be part of a private equity investment fund over the last several years this has become a more common transaction within these funds (Beyazee, 2007). Which structure is best can only be based on an individual’s unique situation.
Changing the ownership structure after the fact can be time consuming and costly though it may still be possible to avoid income tax (Hermann, 2008). Real property can be transferred into a new business as long as it meets the IRS regulations for the various business forms. While a quit claim deed may transfer property between entities in most cases it will also subject the entity to several types of taxes including income tax. Real estate is also often also part of reorganizations which can be structured in a way to defer income tax liability (Levy, 2008). Non-recognition transactions can be very complicated and it would be wise to employ a tax professional when performing these transactions.
Consulting with a good tax accountant or tax lawyer familiar with applicable laws can help a foreign investor to limit their U.S. tax exposure (Levy, 2008). In 1980, the Foreign Investment in Real Property Tax Act (FIRPTA) was passed creating code sections 897, 1445 and 6039C making most foreign investments in U.S. real estate taxable (Levy, 2008). The basic idea of the tax act was that foreigners should pay income tax on U.S. real property interests (USRPI), so definitions and rules are defined in these code sections. The code also discloses what circumstances might create a non recognition transaction which can be very tricky even for a competent tax professional (Levy, 2008).
It is important for foreign investors to understand that property transfers will often have tax consequences as well regardless of the structure (Domanski, 2006). While it is true that real property can not be physically moved, it can be transferred in several ways. During a corporate reorganization stock maybe transferred or swapped, this transaction can create a taxable event for the shareholders even though the corporation may not have a taxable event (Levy, 2008).
A resident alien is taxed on their worldwide income and in many cases taxed similarly to U.S. citizens. Non-resident aliens are often subject to different rules and are not subject to U.S. tax on their worldwide income. Rental income earned on U.S. real property is subject to different rules depending on how it is owned. The major issues come at the time of disposition, but how property was purchased and used can alter the tax consequences at disposition. There are reporting requirements that may be required at time of purchase as well as at time of disposition (Rothschild, 2008).
The first consideration with real estate is how to make the purchase many agree that how the deal is structured is very important (Lifson, 2007). There are several ways for non-resident aliens to structure their real property purchases (McCullough, 2006). A foreign investor can purchase property directly as an individual, through a domestic corporation or through a foreign corporation (McCullough, 2006). A foreigner can also receive real property in a trust, as part of an inheritance or as a gift. Individuals also might own fractional pieces of real property through a partnership. All of these different forms can have different tax consequences for a foreigner.
It is important for nonresident aliens to understand how each of these options affects them. There are advantages and disadvantages to all of these investment structures so the right choice of structure will depend on the unique circumstances of each investor (McCullough, 2006). Direct investment usually yields the lowest income tax rate, but can subject someone to estate taxes down the road. Other forms may allow a foreigner to avoid U.S. income tax, but great care must be taken to insure that legitimate business structures are used and the corporation or partnership is created properly.
Nonresident aliens also have other taxes that should be considered besides federal income tax. A foreigner may also be subject to state income and estate tax even when federal income or estate tax doesn’t apply (Hermann, 2008). Foreigners can also be subject to other taxes as well on their real estate purchases such as property tax and excise taxes. Often the largest tax consideration is estate tax that can come as a surprise.
Direct ownership of U.S. real property by a non-resident alien is probably the least complex structure and has some advantages. A principle advantage is the long term income tax treatment currently at 15 percent (Mirabito & Rosenberg, 2006). Another advantage is possibly avoiding some unintended tax issues such as triple taxation that can occur when a U.S. parent company owns a foreign wholly owned subsidiary that disposes of U.S. real property held by the foreign corporation (Autrey & Arney, 2007). Another advantage is that the transaction is more transparent and less subject to IRS scrutiny.
Foreign investors looking to purchase real property that will become a future residence should consider direct ownership. Section 121 personal residence gain exclusion rules apply to foreign investors, but additional rules must be met (IRS, 2007). A foreign investor currently must live in the residence 50 percent of the time over the course of the two 12 month periods (IRS, 2007). A foreign investor is also limited to home purchases of $300,000 or less (IRS, 2007). The Housing Assistance Tax Act of 2008 has modified some of the rules for section 121 gain recognition by making it necessary in some cases to allocate some of the gains to periods of nonqualified use thereby reducing the deduction that might be received (Perkins, 2008).
There are a number of disadvantages to direct ownership as well (McCullough, 2006). A direct owner will be required to file a U.S. income tax return because the real property creates the assumption of a business or trade (McCullough, 2006). Also a direct owner can be exposed to estate tax issues which can often times involve higher tax rates (McCullough, 2006). A direct owner will pay income tax at the time real property is disposed of, which may not necessarily be true under other structures.
When real property is disposed of it is treated as though the individual was in a trade or business under code section 897. Section 897 rules do not affect residency status, so foreign real property holders need to review residency separately from their real property holdings. Though real property is treated as a trade or business at disposal any rental income may be treated differently (Frame, 2008).
U.S. real property held in connection to a domestic corporation that is a United States Real Property Holding Corporation (USRPHC) will generally be considered a trade or business (Frame, 2008). Typically a domestic corporation will be considered a USRPHC unless documentation is provided that supports otherwise (Frame, 2008). A foreign owned domestic corporation that is not a USRPHC may be able to avoid U.S. income tax when real property that is not a USRPI is disposed of (Frame, 2008).
Taxes will be due unless the domestic corporation can show that it was not a real property holding corporation covered under Code Sec. 7874(a)(2)(B)(ii). A foreign corporation owning a U.S. domestic corporation may have issues with inversion in the case of a bankruptcy (Latham & Watkins, 2008). The result of an inversion would likely be a surrogate foreign corporation which would lose any advantages a foreign domestic corporation might have (Latham & Watkins, 2008).
A foreign corporation can also elect to be taxed as a domestic corporation if they qualify under code section 897(i) (Martin, 2003). The corporation must be a USRPHC, must hold U.S. real estate and must be entitled to this treatment under a tax treaty (Martin, 2003). All shareholders must also consent to this election for it to apply (Martin, 2003). Under this treatment a foreign corporation will not be subject to the 35 percent withholding tax treatment (Martin, 2003).
Ownership of real property through a foreign corporation will typically mean that 35 percent of any gain at disposition will be withheld from dispositions of real property (Martin, 2003). Code section 897 is very clear in that any USRPHC that holds U.S. real estate generally will be considered to hold a USRPI subject to U.S. income tax (Levy, 2008). Levy (2008) states that creating a transaction that would not be considered a USRPI can be quite difficult and may not always produce the desired results.
There are a few exceptions under section 897 where a USRPHC interest would not be considered a USRPI and therefore would not be subject to U.S. income tax (Levy, 2008). There are three exceptions noted under section 897(c) that would provide an event not subject to U.S. income tax with regards to FIRPTA (Levy, 2008). These exceptions are the section 897(c)(1)(B) FIRPTA cleansing exception, the section 897(c)(3) publicly trade exception and the section 897(h)(2) domestically controlled QIE exception (Levy, 2008). All three exceptions can be very difficult to create successfully (levy, 2008).
It is not uncommon for nonresident aliens to purchase U.S. real estate through a foreign corporation (Suarez, 2008). This is often done to limit tax liability, but primarily done to avoid U.S. income tax as well as estate taxes (Suarez, 2008). This means of purchasing property can also be a way to pass on U.S. real property to estate beneficiaries without paying U.S. taxes (Suarez, 2008). As stated earlier this type of transaction has become increasingly difficult to create successfully (Levy, 2008).
There are many risks in taking this approach in purchasing real property. These risks include a situation coming up that requires a transfer to be made before death (Suarez, 2008). If the IRS determines that the foreign corporation is a sham any beneficial tax status will be dissolved (Suarez, 2008). FIRPTA requirements must be met to insure that the transaction receives favorable tax treatment (Suarez, 2008).
Foreign corporations will also be subject to the branch profits tax (Hornberger, 2003). A foreign corporation that has income that is effectively connected to a trade or business in the United States will be subject to a 30 percent branch profits tax unless the income is a result of the sale of a USRPHC interest (Levy, 2008).
Stockholders owning less than five percent of the corporate stock in a USRPHC are exempt from paying income tax on the disposal of USRPIs though they may still be subject to withholding (Stevens & Harvel, 2008). This is one of the few exemption found in code section 897(c). Stockholders holding more than five percent will be subject to income tax on the disposal of a USRPI (Stevens & Harvel, 2008).
Real property can be purchased through a foreign partnership as well which has some distinct advantages (Suarez, 2008). Though a foreign partnership is not like to avoid income tax on the disposal of U.S. real property these transactions will be taxed at the lower individual income tax rates rather than corporate tax rates (Suarez, 2008). This business form offers some protection while allowing for lower taxes making them a good option.
Several indirect means are available for purchasing real estate; some of these may even offer nontaxable income (Glicklich & Turner, 2008). There are narrowly defined exceptions that can allow for Sovereign wealth funds (SWF) holding real property investments to be non taxable transactions (Glicklich & Turner, 2008). REITs or Private Investment Funds are additional forms of indirect investments that typically would be subject to income tax when real property is disposed of (Stevens & Harvel, 2008).
Foreign ownership of real property through either a domestic or foreign trust may shield some income tax liability or estate tax consequences, but proper planning is necessary (Suarez, 2008). Many nonresident aliens choose not to invest in real estate through a trust for fear that the trust maybe recharacterized as an “association taxable as a corporation” (Suarez, 2008). Trusts can be taxable for both income and estate tax purposes if some measure of ownership is retained by the grantor or they are not properly established.
Foreign real property is not eligible for a 1031 exchange with U.S. real property under codes section 1031(h)(1) (Smith, 2007). A foreign investor though is eligible to do a 1031 exchange of like-kind property where both properties are within the United States or the Virgin Islands (Martin, 2003). The same rules apply to foreign investors as apply to US citizens and resident aliens performing a 1031 exchange.
There are several important considerations with any 1031 exchange to insure that non-recognition income tax occurs (Rydstrom, n.d.). The main consideration is the real property must be considered like kind property (Rydstrom, n.d.). Taxable boot will be created if any cash is received in the transaction or the mortgage amount is reduced.
Typically the largest tax concern that a foreign individual might have would be estate tax consequences (Rothschild, 2008). In 2008, the federal estate tax rate is progressive and can go as high as 45 percent (Rothschild, 2008). There are also maybe state estate taxes consequences depending on the state where the real property is located (Rothschild, 2008). U.S. citizen are eligible in 2008 to a $2 million dollar exemption where as a non-resident alien is only eligible to a $60,000 exemption in 2008 (Rothschild, 2008).
Planning for estate tax consequences can often be at odds with income tax considerations and so a tax planner needs to consider the needs of their client (Mirabito & Rosenberg, 2006). A nonresident alien spouse married to a US citizen quite likely will be subject to U.S. estate taxes (Hauser, Wickersham & Taft, 2003). A nonresident may be subject to estate tax on U.S. real property but other issues must be considered because it is possible that worldwide assets may be subject to U.S. estate even though a foreigner is a nonresident alien for income tax purposes (Hauser, et al, 2003).
There are three separate jurisdictional bases for estate taxes with separate consequences theses are citizenship, domicle and situs of the assets (Hauser, et al, 2003). It is possible to be a U.S. citizen and never lived in the United States or lived their only briefly (Hauser, et al, 2003). Domicile can be a very subjective test where one living in the U.S. for only a short time may create a domicle and thereby be subject to U.S. estate tax on their worldwide assets (Hauser, et al, 2003). U.S. real property will be subject to estate taxes in most cases if owned directly (Hauser, et al, 2003).
There are a number of traps for unwary foreign investors when purchasing U.S. real property. It is important to consider how any purchase is structured in order to meet each individuals needs. Direct ownership may reduce the rate of income tax paid, but will mean the individual is subject to potential estate taxes and will lose some of the exceptions that might avoid income tax altogether.
In nearly all cases income and gains must be recognized on the use and disposal of U.S. real property by non resident aliens. There are exceptions that may allow nonresident aliens to avoid gains recognition, but all of these situations require proper attention to detail and can be quite complex. Unintended consequences may result for foreign investors that do not pay attention to the details and follow the required steps to avoid gains recognition.