Foreign Investors and U.S. Real Estate Considerations
By Mark Chaves, CPA
Over the last several years, much has been written and observed about increasing numbers of foreign investors purchasing U.S. real estate. For many of these investors, this decision has led to some unexpected consequences.
Investing in U.S. real estate might be a tremendous idea for many but only when these investments are structured properly with an appreciation for potential overall tax cost. This requires a clear understanding of the income and estate tax consequences prior to making any U.S. investments.
Individual Tax Rates
Individual foreign investors who realize a gain from the sale of a capital asset are subject to a maximum U.S. tax rate of 20 percent on the gain if the asset was held for more than one year—an important fact given that real property generally qualifies as a capital asset. Meanwhile, individuals who realize capital gains from the sale of assets held for less than one year are generally subject to U.S. federal income tax rates ranging from 10 percent to 39.6 percent, depending on the amount of gain realized. Additionally, state income taxes may apply depending on which state the property is located.
Corporate Tax Rates
Unlike individuals, corporations do not have any preferential tax rates for long-term capital gains (i.e., gains from the sale of capital assets held for more than one year). Corporate gains are generally taxed at rates ranging from 15 to 34 percent regardless of the length of time the asset has been held. State income taxes may also apply in the corporate context.
Entities taxed as partnerships are treated as “flow through” entities under U.S. tax law, which means that all income and deduction items are not taxed at the partnership (entity) level, but are instead taxed in the hands of the partners of the partnership. Partners may be corporate or individual.
Limited Liability Companies
The use of limited liability companies (LLCs) for real estate investment has proliferated over the last ten to fifteen years. LLCs provide good flexibility from a tax planning perspective in that they may be taxed as corporations (i.e., entity pays taxes at corporate rates) or as flow through entities (i.e., taxation occurs at the partner level and not the entity level). Whether an LLC is taxed as a partnership or as a corporation is elective and may be chosen by filing the appropriate forms with the U.S. Internal Revenue Service (IRS).
Estate Tax Issues
U.S. estate tax exposure is an important consideration for foreign investors in U.S. real estate. The reason for this is that foreign investors may be subject to U.S. estate tax if they die while they own U.S. real property. Current U.S. estate tax rates range from 18 percent to 40 percent of the value of real property owned. An estate tax credit for nonresidents of $13,000 per individual is available, but is often insufficient to cover the estate tax on valuable real estate. As a result, foreign individuals with valuable U.S. real estate may be subject to U.S. estate taxes at high rates unless proper planning is done to mitigate the estate tax risk.
Common Planning Alternatives
In order to reduce U.S. estate tax risk, many foreign investors own U.S. real property through a foreign (non-U.S.) corporation. This foreign corporation will then own a U.S. corporation or limited liability company that owns real estate. Structures of this type are common and are effective planning tools for U.S. estate tax purposes. However, as described earlier, corporate long-term capital gains are not subject to preferential capital gains rates. As a result, many investors are surprised to learn that their effective tax rate on profits from the sale of the property owned in corporate form may be as high as 37.63 percent if Florida state income tax rates are considered. Some investors, on the other hand, are willing to incur tax at corporate rates to mitigate any estate tax exposure they may have.
Another planning alternative is to own U.S. real estate through a foreign entity taxed as a partnership for U.S. tax purposes. A foreign national may establish a non-U.S. entity and elect to have that entity taxed as a partnership under U.S. tax law (as discussed above). The non-U.S. entity can own a U.S. LLC that owns real property. Under this structure, any gains from the sale of the U.S. real estate would not be taxed at the U.S. LLC or foreign entity level, but would instead be taxed at the level of the foreign individual investor. Should the property be owned for more than one year, the corresponding gain would be subject to tax at a maximum long-term capital gain rate of 20 percent (i.e., the rate applicable to individuals).
Under this alternative, there is some uncertainty as to whether a foreign entity taxed as a partnership would provide the requisite level of protection from an estate tax standpoint. However, individual investors should discuss the relative risks and rewards of this type of ownership structure prior to investing.
Should a foreign investor choose to invest in U.S. real property through an entity formed in a foreign jurisdiction, care should be taken to choose a corporate jurisdiction that does not expose the investor to unwanted tax consequences in his or her home country.
Many foreign investors hold U.S. real estate through a British Virgin Islands (BVI) entity. Certain countries, however, have tax haven legislation that increases reporting requirements to the investor in his or her home country if the investor owns an entity located in a tax haven jurisdiction. As a result, a BVI entity may not be tax advantageous from a home country perspective since the BVI is a tax haven jurisdiction. Therefore, it is important to choose a foreign jurisdiction that works well from a U.S. planning perspective as well as the perspective of the investor’s home country.
A discussion of foreign investors and U.S. real estate would be incomplete with acknowledging that foreign investors who dispose of U.S. real estate are subject to withholding provisions under the Foreign Investment in Real Property Tax Act (FIRPTA). Under these provisions, a withholding tax of 10 percent of the gross selling price is required upon the sale of U.S. real property by a foreign individual or entity. The withholding tax applies regardless of whether the property is being sold at a gain or a loss.
Some exceptions apply to this requirement. One such exception is that a foreign investor may apply for a “withholding certificate” from the IRS, which may reduce the amount of the required withholding in certain circumstances (e.g., the property is sold at a loss).
It is prudent for a foreign investor to structure their US real estate holdings in such a manner that FIRPTA withholding requirements may be eliminated. This can be accomplished by owning the U.S. property through a U.S. corporate entity or a U.S. LLC that has more than one owner (e.g., an investor and a foreign owned entity).
The old adage that there are only three factors in real estate—location, location, and location—offers an incomplete picture when it comes to foreign investors interested in U.S. real estate. Ample opportunities exist for positive returns and pleasant experiences, but a wise investor is sure to consider the myriad of tax issues prior to making any purchases. With properly structured real estate holdings that are best suited for the individual investor’s objectives, foreign investors are able to prevent any unwanted surprises.
For more information on how to structure an investment in U.S. real estate, contact Mark Chaves at [email protected]