Complex Tax Issues Await Russian Investors in U.S. Real Estate by Ken Vitek, CPA
Posted on November 09, 2016
Global uncertainty continues to fuel international investment in U.S. real estate due to the low capital costs in the form of near record low interest rates as well as the potential for significant yields. However, Russian investors who are not considered U.S. citizens face a complex U.S. tax system that can lead to negative tax consequences when they own interests in U.S. real property. To address this challenge, savvy investors must engage in advanced planning to select the most tax-efficient structure for their real estate transactions stateside.
Tax Liabilities Based on U.S. Residency
The U.S. system of taxation categorizes foreign individuals as resident aliens or non-resident aliens, depending on whether or not they meet certain tax residency thresholds, including, but not limited to, a complex calculation of the number of days they have a physical presence in the U.S., their “connection” to another country and/or the existence of a tax treaty between the U.S. and their home countries. In the simplest terms, resident aliens are required to report and pay income tax on their global income, whereas non-resident aliens pay tax only on income derived from U.S. sources. Therefore, foreign investors should plan in advance to ensure they are not inadvertently subject to U.S. tax on their global income.
When a Russian investor meets the definition of a non-resident alien (NRA), he or she may be able to further minimize taxes and other expenses by purchasing and owning U.S. real estate directly or indirectly through a corporation or some other type of entity.
NRAs who invest in U.S. real estate may be subject to several different types of federal tax, including income tax on rental profits, income tax on property sales, and estate tax on the transfer of property to heirs. In addition, the Foreign Investment in Real Property Tax Act (FIRPTA) generally requires that individuals purchasing a U.S. real property interest from sellers who are NRAs or foreign entities must withhold 15 percent of the gross purchase price and remit such withholding to the U.S. tax authorities. It should be noted that there are a few exceptions to the general withholding rule, and with proper planning and the appropriate set of facts, the withholding may be reduced or eliminated.
Structuring Investment in U.S. Real Estate
The U.S. tax code and corresponding regulations have a lengthy list of rules that apply to NRA investments in U.S. real estate, including U.S. real property, a U.S. real property interest (USRPI) or a U.S. Real Property Holding Company (USRPHC).
A USRPI refers to direct ownership of real estate located within the U.S. as well as indirect ownership of U.S. real estate through domestic or foreign entities. It also means any interest, other than one solely as a creditor, in any domestic corporation unless the corporation was at no time a USRPHC during the shorter of the period during which the interest was held, or the 5-year period ending on the date of disposition. If on the date of property disposition the corporation did not hold any USRPIs, and all of the interests held at any time during the shorter of the applicable periods were disposed of in transactions in which the full amount of any gain was recognized, the interest in the corporation is not a USRPI. In general, a domestic corporation meets the definition of a USRPHC if the fair-market value of the U.S. real estate equals or exceeds 50 percent of the total value of the corporation’s property interests, including real estate located outside the United States and other business assets.
Foreign investors should consider using one of the following structures when investing in U.S. property.
Direct Ownership. The primary benefit of owning property directly is that the NRA should be able to utilize the preferential long-term capital gain tax rates when the property is sold. When an NRA invests in a permanent residence in the United States, he or she typically will not qualify for a property tax reduction via the homestead exemption. In addition, they may be subject to FIRPTA withholding requirements when they sell the property, and they could leave their heirs with estate tax liabilities when they pass away.
Domestic Corporation. Investment in U.S. real property interests via a domestic corporation is another option. The domestic corporate structure eliminates the FIRPTA withholding requirements, and it also eliminates the need for investors to file U.S. individual income tax returns with the IRS. The disadvantages of this approach include ineligibility to utilize the preferential long-term capital gains tax rates as well as exposure to double taxation, in which the corporation pays corporate taxes and withholds 30 percent of dividend payments for tax purposes (absent a qualifying income tax treaty). Furthermore, if a foreign person passes away while owning shares of a U.S. corporation, the decedent may be subject to U.S. estate tax based on the value of such shares.
Foreign Corporation. Another traditional approach for NRAs to own USRPIs is through a foreign corporation. The U.S. tax implications associated with the foreign corporate structure are fairly similar to those of the domestic corporate structure, but with one notable exception: Generally, shares of a foreign corporation, even though the foreign corporation owns USRPIs, are not subject to the U.S. estate tax regime. Accordingly, a NRA that invests in USRPIs via a foreign corporation should be able to mitigate his or her U.S. estate tax exposure.
Russian investors may opt to rely on a more complex tax-minimizing structure, including one in which a foreign corporation owns a domestic corporation that owns U.S. real property interests. This structure reduces exposure to estate tax liability on the transfer of such stock and to FIRPTA withholding on the sale of stock in the foreign corporation.
Alternatively, NRAs can establish trusts and so-called “pass-through” entities or corporations to hold USRPIs. These complex structures may provide the NRA with the ability to utilize the preferential long-term capital gains tax rates while also achieving U.S. estate tax protection. Furthermore, Russian investors should consider the implications of the U.S. – Russia Income Tax Treaty to determine if there are any provisions that provide preferential U.S. tax treatment.
As Russian investors continue to chase yields in U.S. real estate, they must devote significant time and attention to tax-planning risks and opportunities.
About the Author: Ken Vitek, CPA, is a senior manager with Berkowitz Pollack Brant’s International Tax Services practice, where he provides income and estate tax planning and compliance services to high-net-worth families and closely held businesses with an international presence. He can be reached at the CPA firm’s Miami office at (305) 379-7000 or via email at firstname.lastname@example.org.