US Tax Implications of Real Property Investments by Non-U.S. Investors
Tax Impacts Bulletin, January 2013
By Masa Yamaguchi, CPA, International Tax Manager
Overview
The US real estate markets continue to see strong demand from foreign investors on the back of the notion that they offer attractive investment alternatives to what’s available in their home countries. However, US real property investments could bring foreign investors a number of unintended consequences without proper planning. In this edition of Perkins Bulletin, we explore some advantages and disadvantages of the typical US real estate holding structures involving foreign investors. We also discuss some noteworthy items that could affect foreign investors’ financial goals.
What are your goals for your US real estate investment?
The ultimate goals of acquiring US real property would be different for a foreign investor looking for a single, personal-use vacation house in Palm Springs and a foreign investor who is about to acquire a number of properties in multiple locations for resale in the expectation of future gains. The former investor may hold on to his property without ever disposing of it during his lifetime while the latter investor may repeat a purchase and sale in a relatively short time span when the gain can be realized.
Long-term holding – US estate tax issues
The US federal government imposes the estate tax on the value of assets included in a decedent’s taxable estate in excess of a prescribed threshold. A typical non-resident foreign investor in US real property would be subject to US estate tax on their US real property holdings. Assets which could give rise to the US estate tax for a non-resident foreign investor include, but are not limited to, real property and certain personal property located in the US as well as stock in corporations incorporated in the US. Therefore, a foreign investor who owns real estate in the US without any intention of disposing of it needs to be concerned about his potential exposure to the US estate tax. A different set of rules may apply to any person who is a former US citizen or long-term US resident.
If a foreign investor’s home country imposes a similar kind of tax upon a death, and that country has an effective tax treaty with the US which provides a tax credit for the estate tax paid to the US government, his ownership of the US real property may not create any additional concern, as it is unlikely to materially change the worldwide estate tax exposure. However, countries which have been sending many investors to the US to scoop up real property in recent years (such as Canada, China and Australia) do not generally impose tax by reason of taxpayers’ death in addition to the regular income tax. For investors from such countries, the US estate tax could be a significant and unexpected cost.
The highest US estate tax rate was 35% until December 31, 2012, but it has just been raised to 40%. The US tax treaties with certain countries provide an estate tax exclusion linked to the exclusion available to US citizens. For foreign nationals of such countries, the exclusion amount available is prorated based on the ratio of their US asset holdings to their worldwide asset holdings. The exclusion amount available to US citizens is currently $5.25 million and it continues to be indexed for inflation in future years. Foreign nationals residing in a country which does not receive any such US treaty benefits, or which does not have an effective tax treaty with the US, receive an exclusion amount of only $60,000. The magnitude of the estate tax can be overwhelming as the tax is assessed on the value of assets unlike the income tax that is assessed on the amount of net income or net gain after applicable deductions.
Possible solution: Corporate ownership structure
US estate tax exposure can be relatively easily eliminated for a foreign investor by having a foreign corporation directly hold the investor’s US real estate. This way, the investor then owns shares in the foreign corporation, rather than a piece of real property located in the US. Shares in a corporation incorporated outside of the US are generally not subject to the US estate tax.
The most notable downside about the corporate ownership structure is that the gain on disposition of US real property will be taxed at the corporate income tax rate, which could be as high as 35% (federal) plus state taxes, while the applicable federal rate to individual taxpayers is still limited to 20% after being raised from 15% if the property is held over 12 months. The 3.8% “ObamaCare” surcharge will also apply in 2013. The 20% rate is applicable to individuals whose taxable income is over $400,000 ($450,000 for individuals filing jointly with their spouses) and individuals who do not reach the threshold continue to be taxed at 15%.
Branch Profits Tax
While exposure to US estate tax can be shielded with a foreign corporation holding US real property, that foreign corporation will also be subject to the US Branch Profits Tax (“BPT”) rules. The BPT can be avoided by inserting a US corporation to directly hold the US real property as opposed to having a foreign corporation directly hold the property. A full explanation of the BPT regime is beyond the scope of this article, but it is a way to determine what amount of the US earnings in a given year is deemed to have been distributed to the home office of the foreign corporation. Such a mechanism is necessary to put a US branch of a foreign corporation on equal footing with a US wholly-owned subsidiary corporation of a foreign corporation with respect to the repatriation of the US earnings. Without the BPT, a US branch of a foreign corporation would be exempt from any US federal tax on distributions of US earnings to its home office whereas the actual dividend distributions made by a US wholly-owned subsidiary corporation to a foreign parent corporation would be generally subject to the US withholding tax.
The BPT could be problematic for the following reasons:
- A foreign corporation could be subject to the BPT whether or not any money was actually distributed to it by its US operations.
- The tax is assessed on the amount called the Dividend Equivalent Amount (“DEA”) which is artificially computed based on the amounts of US earnings as well as US net worth.
- It is difficult to predict the BPT effect whereas a foreign parent can directly control tax associated with a US subsidiary.
Whether the existence of the BPT dampens the overall tax efficiency depends on some factors, including:
- Whether a tax treaty exists between the US and a foreign country.
- Whether the treaty eliminates the BPT or provides a partial exemption.
- Whether the treaty reduces the branch profits tax rate, which would be 30% of DEA without any treaty benefits.
A structure in which a foreign corporation owns an interest in a US corporation that in turn directly holds a US real property interest allows you to eliminate exposure to both the US estate tax and BPT.
US Real Property Holding Corporations (“USRPHC”)
When shares in a US corporation are disposed of by a non-US person for a gain, the gain is generally not subject to the US federal income tax. This is true only if the US corporation is not a USRPHC. Shares in a US corporation that is a USRPHC are considered to be a US real property interest (“USPRPI”). The gain on disposition of them by a non-US person is subject to the US federal income tax because it is considered to be income effectively connected with a US trade or business.
A corporation is a USRPHC if 50% or more of the corporation’s certain tested assets consists of USRPI. The tested assets refer to real property and other assets used in a trade or business and therefore investment assets other than real property are generally excluded from the analysis.
In a structure where the USRPI is held by a US corporation which is in turn owned by a foreign corporation, the foreign corporation’s disposition of its shares in the US corporation would trigger a US federal tax filing obligation and, if any gain results, a US federal tax payment obligation as the shares in a USRPHC are considered USRPI. If the US corporation were not a USRPHC, the gain of a foreign investor would not be subject to the US federal income tax.
US Real Property Holding for Gains – Capital Gain v. Ordinary Income
As briefly discussed, gains on sales of real property held more than one year (“long-term capital gains”) in the US are generally taxed at 20% or 15% (depending on the amount of taxable income) for individual taxpayers while the applicable tax rate could be as high as 35% for corporate taxpayers. This tax rate differential may be the main focus for investors whose intention is to sell the properties for future gains, as the differential is quite substantial. Rental income generated by real properties is treated as ordinary income, which is currently taxed at the maximum rate of 35% for corporate taxpayers and 39.6% for individual taxpayers whose taxable income is over $400,000 ($450,000 if filing jointly).
Aside from the changes affecting the individual taxpayers, we may see a corporate income tax rate reduction in 2013 or later so that the maximum rate would be lower than 35% (to align the US corporate tax rates to those of other developed countries). All of these changes that have occurred and that may occur along with the ones related to the US estate tax mentioned earlier will likely influence investors’ decisions as to how they should hold the US real property. Also, they could trigger an opportunity to review current structures and possibly restructure the US real property holdings for some investors who have already invested in the US real property market.
Lower current US rate v. foreign tax deferral
Consideration should be given to how the gain is taxed in the home country, as the eventual overall tax costs of the gain would be primarily decided by the tax rate in the higher tax jurisdiction (as long as the home country allows the foreign investor to claim a credit for the amount of US taxes). For example, if the ultimate tax cost of the gain in the home country is lower than 35%, the foreign investor may be motivated to have the gain taxed at 20% rather than 35% in the US, to directly lower the overall tax costs of the gain. Having the gain taxed at 20% in the US will generally subject the gain to an immediate tax in the home country. On the other hand, if the ultimate tax cost in the home country is higher than 35%, the foreign investor is less likely to be concerned about the tax rate differential in the US and may be more motivated to have the home country tax on the gain deferred to the extent possible.
Many foreign countries do not tax corporate earnings resulting from the active conduct of an overseas business by foreign subsidiaries. If the home country does not tax the US gain recognized by a US subsidiary until the gain is distributed to the ultimate individual foreign investor in the form of dividends, the home country is unlikely to grant a credit for the US tax paid on the gain by the US subsidiary corporation. Where the US gain is not treated by a foreign country as income arising from the active conduct of a business, it is more likely to be subject to the immediate tax in that foreign country possibly with a tax credit for the amount of US taxes paid.
Disadvantages of personal holding
In addition to the US estate tax exposure, liability issues can arise from the personal holding structure especially when there are multiple properties through which active businesses are conducted. The liability issues can be mitigated or eliminated by the purchase of insurance contracts even with the personal holding structure. If the property is a vacation house the use of which is limited to the owner and his family, the liability issues may not be much of a concern.
What if your goals can change? Want more flexibility?
In the real world, investment goals can change over time as investors’ priorities may change. Also, investment decisions are often dictated by changes in investment climate including legislative changes. The use of a partnership structure may make the most sense for foreign investors whose priorities may change in the future as the structure gives more flexibility.
Use of Partnerships
Preferential capital gain treatment
Having a flow-through entity, such as a limited partnership, hold US real estate ensures that the ultimate foreign non-corporate investors will receive preferential capital gain treatment for US tax purposes, as all the tax attributes, including income, deductions, and credits of the partnership, will be passed through to each partner. Limited partners of a limited partnership may also obtain adequate liability protection, as compared with a corporate structure, as the limited partners’ risk is generally limited to the amount they contributed to the partnership.
US estate tax implications
Although there has been much debate as to what determines the situs of a partnership interest in the cross-border tax community, there has not been clear IRS guidance on this topic. It is possible that the situs of a partnership interest should be determined by where the majority of the partners reside, unless there is a statute to the contrary. Factors such as whether the partnership was formed inside or outside the US, whether the partnership survives the death of the partner, and where the majority of business activities are conducted through the partnership may contribute to the determination of the partnership interest situs under certain circumstances.
It is possible that an interest in a partnership that owns US real property can be gifted by a non-US owner of the partnership interest without triggering US gift tax. US gift tax is imposed only on real property and personal tangible property located in the US when the donor is a non-US person according to the applicable provision under US tax law. While the provision makes reference to corporate stock and debt obligations as intangible property, it makes no such reference to other types of intangible property such as partnership interests. Although it has generally been assumed that partnership interests should be treated in the same manner as corporate stock, it is not entirely clear that the IRS would never look through the partnership to subject US real property interests held by the partnership to US gift tax when the partnership interest is gifted by a non-US person. The gift tax rule mentioned above may not apply to certain non-US donors who are former US citizens or long-term US residents.
US check-the-box election
Those who seek more certainty in an attempt to eliminate the US estate tax exposure can still opt for the partnership structure to enjoy preferential capital gain treatment on sales of US real property while they are alive. For an unexpected sudden death of the partner, the deceased partner’s executor can make an election to treat the partnership as a corporation for US federal tax purposes provided that all the other partners consent to the election. Such an election must be made by a date no later than 75 days following the death to make sure that the election was retroactively valid at the time of the death. There is currently nothing explicit to suggest that the post-mortem election is invalid. With the proper election in place, the decedent partner should be treated for US tax purposes as having owned as of the date of death an interest in a foreign entity which is not subject to the US estate tax. , while the preferential capital gain treatment is no longer available on disposition of US real property under what has now become corporate ownership
The election described above is widely referred to as Check-the-Box election, and it basically allows the foreign investors to keep more options alive for a longer period of time in the context of the US real estate investments.
US tax filing obligations
Unlike the corporate or personal ownership structures, in which only the direct owner of US real property interest is generally required to file a US federal income tax return, both a partnership and each partner are required to file a US federal income tax return. This may translate into substantial tax compliance costs especially if there are a number of foreign partners who invest in US real property interest.
Limited Liability Companies (“LLC”)
The use of an LLC has been a popular choice in the US as a vehicle through which a business is carried on. It has the same US tax results as a partnership. However, it can create some unintended consequences in the cross-border context: some foreign jurisdictions treat it as a corporation, while the US either treats it as a pass-through entity or disregards it as a separate entity from its owner. Such inconsistencies can lead to a complete denial of or severe reduction in foreign tax credit in the home country. You should consult an experienced tax advisor before you implement an LLC in the US real property investment projects.
Other miscellaneous considerations
US Federal Tax Withholding Requirements
Generally, a payor of a US source income to a foreign payee is required to withhold US federal income tax at the time of the payment. The rate at which the US tax is withheld on the payment is determined by the type of income under the applicable tax treaty between the US and the applicable foreign country.
Foreign Investment in Real Property Tax Act (“FIRPTA”)
The US Federal income tax withholding on sale of real property located in the US is governed by FIRPTA. When a seller/transferor is a non-US person, the general rule is that a purchaser/transferee of the real property being sold/transferred is required to withhold 10% of the gross sale proceeds (or the fair market value at the time of transfer) and remit the amount to the IRS within a certain period after the sale. This means that the 10% withholding needs to be done even if there is no gain to recognize, or even with a loss on the sale, absent any exemptions provided under FIRPTA. The tax withheld under FIRPTA can be recovered by claiming a refund on a tax return to the extent that the amount withheld exceeds the actual tax liability which arose from the gain for the seller. One of the FIRPTA withholding exemptions applies when the gross sale price is less than $300,000 and the purchaser is prepared to confirm that they intend to use the property for personal use for a period of two years or longer.
Where a foreign investor participates in a real estate project where a number of divided lots are separately sold, the FIRPTA withholding requirements can be extremely problematic as each transaction needs to have 10% of the gross sale proceeds withheld and remitted to the IRS. Such a situation can occur when the real property interest is directly held by a non-US person/entity, which includes foreign corporations, foreign partnerships and foreign nationals. Where the FIRPTA withholding could be problematic, the US real property interest should be directly owned by a US entity so that the sales of the interest would not be subject to the FIRPTA withholding.
Complications in connection with partnership structures
Aside from the FIRPTA withholding, a foreign partner’s distributive share of income earned by a partnership is subject to the US tax withholding under a separate provision (Internal Revenue Code “Section 1446 tax”). Section 1446 tax is typically withheld at the highest rate of tax that is applicable to each foreign partner on a quarterly basis. Thus, it varies depending on whether a foreign partner is a corporate or non-corporate partner. The withheld tax can be recovered to the extent that it exceeds the amount of the final tax liability at the time of filing a US federal income tax return. There is a provision which relieves a US partnership from the FIRPTA withholding requirements when the S.1446 withholding is satisfied, but the same relief is not explicitly made available to a non-US partnership. A foreign partnership can be subject to both of the above mentioned US tax withholding requirements, which makes it impractical to carry on business— especially when a number of separate real property interest sales occur throughout the year. In such a situation, a US partnership may need to be created to directly hold the US real estate interest and have the US partnership owned by a foreign partnership. Since there must be two or more partners for each partnership, a general partner corporation which owns a fraction of the partnership interest must be created at each partnership level in order to complete this particular structure.
Reorganization of US real property interest holding structure
We often see transfers of US real property between related foreign parties. Many of these transfers seem to be made based on the incorrect assumption that the property transfers are nonevent for US tax purposes based on the notion that the ultimate owner did not change and that there is no gain according to the fair market value of the property at the time of the original acquisitions and subsequent transfers. The fact that there is no gain to be recognized alone will not relieve the US real property interest transferee from the 10% withholding required under FIRPTA. Also, when the US real property interest is transferred to an entity which is newly created by the original individual owner of it or vice versa, it is generally an event which requires US tax withholding under FIRPTA. The potential consequences of failing to withhold the required amount include penalty and interest by the IRS on the amount that should have been withheld and remitted to the IRS at the time of the property transfer. This penalty and interest may apply even if there was no gain, as the withholding tax is not based on the gain but on the gross sale price (or fair market value of the property at the time of transfer).
There are quite a few exceptions that can relieve a US real property interest transferee from the FIRPTA withholding but these exceptions generally require proper documents to be filed with the IRS within certain periods of time. The IRS may allow some of such documents to be filed late when the late filing was due to reasonable cause. Otherwise, the IRS could pursue to collect penalties and interest associated with non-withheld amounts until the required amount is remitted to the IRS. If we see any corporate income tax rate reduction in the near future, we could see a lot of restructuring involving the current US real property interest holding structures by foreign investors. Foreign investors are strongly recommended to consult an experienced cross-border tax advisor before making any restructuring attempts associated with US real property interest holdings.