Considerations for Foreign Investors in U.S. Real Estate after Tax Reform by Ken Vitek, CPA
Posted on October 17, 2019
U.S. real estate continued to attract foreign investors during the first half of 2019, thanks, in part, to a growing U.S. economy, low interest rates, and strong underlying fundamentals that support predictable cash flow and property appreciation. At the same time, the U.S. tax landscape has changed with the passage of the Tax Cuts and Jobs Act (TCJA), which leaves unprepared foreign investors at risk of missing important tax-planning opportunities regarding their investments in U.S. real estate.
Navigating U.S. tax laws has always been treacherous for foreign investors. Key challenges they must confront include a myriad of potential tax liabilities that rely on an equally complicated set of rules based on such factors as the residency of property owners, the legal structure of property ownership, and the type or character of income the property generates for the owner. The enactment of the TCJA does little to make this process any simpler. Instead, it highlights an even greater need for investors to reassess their existing strategies and structures and to make changes under the guidance of experienced accounting and legal professionals in order to minimize tax liabilities.
Under U.S. law, the legal immigration status of foreign persons may differ from their tax residency status. In general, once foreign investors are considered resident aliens (RAs), they, like U.S. citizens, must report and pay taxes on their worldwide income. In contrast, nonresident aliens (NRAs) generally have a requirement to pay U.S. taxes only on income from U.S. sources. As if that is not complicated enough, one’s residency status for U.S. income tax purposes differs from his or her domicile, which is a completely separate concept used to determine an individual’s exposure to U.S. gift and estate taxes.
It is important for foreign persons to understand that there is no single structure that is optimal for all investors. Rather, each organizational structure presents different benefits and risks based on the individual owner’s unique facts and circumstances and his or her investment objectives. Therefore, maintaining tax efficiency for foreign investment in U.S. real property is not unlike any other investment. Not only must investors conduct a substantial amount of planning and due diligence at the commencement of the investment, but they must also monitor the tax environment throughout the investment’s life.
From the onset, foreign investors must determine their ultimate goals for investing in U.S. real estate. Are they looking to expand their existing business operations in the U.S., or are they looking to start a new venture stateside? Do they expect their investment to provide rental income, property appreciation, or both? Will they use the property for personal use? Do they have immediate need for cash flow now, or do they plan to reinvest the earnings in future investments? Once these strategic, non-tax decisions have been evaluated, investors are poised to begin identifying the appropriate tax structure for their investments.
Selecting the appropriate structure should include a review of the different categories of income subject to taxation, including rental income from leasing U.S. property, gains from the disposition or sale of U.S. property, and dividend income paid by a holding company to its shareholders. It is equally critical for investors to consider the gift and estate tax consequences associated with their ownership of U.S. real property.
NRAs who acquire U.S. property in their individual names and for their own personal use typically will not have U.S. income tax filing responsibilities until they sell the property. At that time, realized capital gains will be subject to U.S. tax at a rate as high as 20 percent (or 37 percent if the property is sold one year or less after acquisition). While these are the ultimate U.S. tax rates, upon the sale of the property there is generally a 15 percent withholding tax on the gross sales price under the U.S.’s Foreign Investment in Real Property Tax Act (FIRPTA). This withholding tax is applied against the investor’s ultimate U.S. tax liability, and it is not an additional tax; rather, the withholding tax is merely a mechanism to ensure investors satisfy their ultimate tax liabilities.
U.S. property directly held by an NRA who passes away generally will be subject to a 40 percent (maximum rate) U.S. estate tax based on the value of the property at date of death less $60,000. However, depending on the decedent’s domicile, it may be possible for an NRA to minimize his or her exposure to U.S. estate tax when a treaty exists between his or her home country and the U.S.
Foreign investors who generate income from U.S. property that they hold in their individual names (e.g. rental income) will have annual obligations to report and pay U.S. income tax on those amounts regardless of whether they are RAs or NRAs. Moreover, investors should be aware that even if there is no net income earned annually due to various expenses and depreciation deductions, they must file annual U.S. tax returns to avoid disastrous U.S. tax consequences.
From a tax perspective, the main disadvantage of direct foreign ownership in U.S. real estate is exposure to U.S. estate tax. From a non-tax perspective, foreign investors must also consider the lack of asset protection provided by direct ownership, especially when they lease the property.
Ownership Through a Trust
Generally, a trust structure will provide very similar U.S. income tax consequences as the direct ownership option. However, if the trust meets certain conditions, it can potentially provide protection from estate tax exposure, unlike the direct ownership option. Accordingly, the trust structure has the ability to be tax efficient from an income and estate tax perspective.
A drawback to the trust structure is that it is more complicated than the other structures. However, due to a trust’s ability to provide beneficial income and estate tax results, the additional complications of this structure should not cause investors to eliminate it as a potential option.
Ownership Through an LLC
The IRS generally classifies a limited liability company (LLC) with more than one member as a partnership. For U.S. tax purposes, a partnership is considered a “pass-through” entity that passes all of its income to its partners/members who are then subject to income taxes on their share of the LLC’s earnings. Typically, the partnership itself does not pay any taxes. Accordingly, a U.S. real estate investment made through an LLC by an NRA will have similar income tax consequences as the direct investment and trust options. Of course, if the LLC’s partners/members are corporations, the tax consequences will be different. From a U.S. estate tax perspective, it is unclear whether an investment in U.S. real estate via an LLC, or a combination of other U.S. and foreign pass-through entities, provides U.S. estate tax protection.
Ownership Through a Foreign or U.S. Corporation
Prior to the enactment of the new tax law, owning U.S. real estate through a corporate structure required a significant tradeoff. Investors could yield the benefits of U.S. estate tax protection, but they would incur exposure to high U.S. income tax rates (35 percent plus state taxes) on all earnings and gains and another layer of U.S. income tax on non-liquidating distributions.
The TCJA changes this by reducing the corporate rate to 21 percent. Now, with less of a tradeoff between U.S. income taxation and U.S. estate taxation, foreign investors who do not currently use a corporate structure for holding U.S. property should, at the least, take the time to determine whether it may be advantageous to switch to the corporate structure at this time.
As foreign capital continues to flow to the U.S., foreign investors should understand all the potential structures available to them and their related exposure to the various U.S. tax regimes. Since there is no optimal structure that works well in all situations, investors must consider which option fits best for their particular circumstances and objectives.
About the Author: Ken Vitek, CPA, is a director of International Tax Services with Berkowitz Pollack Brant, 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 at firstname.lastname@example.org.