FOREIGN INVESTMENT IN U.S. REAL ESTATE
ISSUES AND STRUCTURES
A General Discussion
Foreigners continue to buy and invest in U.S. real estate, often because they see a lack of acceptable global alternatives. One recent survey found that
95% of respondents (Association of Foreign Investment in Real Estate) confirmed their plans to increase or at least maintain their level of U.S. investment in U.S. real estate.
California is of interest to many foreigners, and for various reasons. Just for example, some will purchase a home (often quite expensive) to allow their child or children to establish "residency" for high school or university purposes, or for investment, or to use as a vacation home, and many express their desire to have funds in the U.S. as a "haven".
EB5 Investors, those who invest $500K to $1 million (depending on location), to expedite the issuance of a Green Card, have funded many large real estate projects, including farms, high-rise buildings, shopping centers, and other large and smaller developments in California and in other States.
The top five countries for EB5 investment have been China, South Korea, Taiwan (region), Iran and Venezuela. Reports show that Chinese investors account for an overwhelming 70% of the total EB5 investment, followed by 9% from South Korea, with the rest of the top five countries each accounting for less than 3% (various sources report this).
China has recently imposed restrictions on the export of capital for investment, and there is evidence that EB5 activity is being adversely affected.
The EB5 Regional Center Program is up for renewal and there can be no certainty that it will be renewed. The details of this situation and of EB5 investment is beyond the scope of this Letter.
FIRPTA (Foreign Investment in Real Property Tax Act), imposes U.S. income tax on foreigners disposing of United States real estate, or of "real property interests". U.S. Tax is imposed at regular tax rates on the amount of gain considered recognized for the type of taxpayer. A U.S. buyer of U.S. real estate from a foreigner is required to withhold tax (usually 10% of the total price) from funds paid to the foreign seller. Tax Treaties may have specific relevance, but FIRPTA generally applies. The general and pervasive rule is that direct foreign owners of U.S. real estate pay taxes like any Citizen or Resident related to that real estate.
The foreign seller of real estate can apply for a refund if appropriate, or obtain a Certificate from the IRS to reduce the amount of tax to be withheld, based on the seller's maximum U.S. tax liability, but this all requires time and the maintenance of very accurate records.
It should be noted that the foreign seller is generally not subject to capital gains tax except as related to real estate. "Real estate" usually includes, for example, real estate held in a U.S. or foreign corporation or other entity, as a "real property interest".
OBJECTIVES FOR INVESTMENT INFLUENCE STRUCTURE
The foreign buyer of U.S. real estate should determine which of the following objectives are most important:
- Anonymity: to avoid having the buyer's name on a recorded public document.
- Beneficiary: ensuring that the property goes to the selected beneficiaries without unnecessarily negative tax or other consequences.
- Protection from creditor: Protecting U.S. (or foreign) beneficiaries from creditor claims.
- Estate Tax: Avoiding U.S. estate taxes on the death of the property's beneficial owner(s).
- Step-up basis: Obtaining a tax basis "step-up to market value" at the death of the beneficial owner.
- Income tax: Minimizing income tax on sale of the property, and/or taking advantage of the long-term capital gains tax rates.
- Compliance reporting: Avoiding compliance reporting and contact with the US tax system; a foreign real property owner may be required to file a real property investment information form.
- Rental income taxation: Avoiding "imputed" rental income, and/or the 30% or treaty rate withholding on rental income on funds transferred to the foreign owner.
- Branch profits tax: Avoiding the branch profits tax which imposes a 30% tax of the U.S. profits of foreign corporations (whether remitted overseas.
- Home country tax: Finally, the Buyer's "home country" tax and other relevant issues must be considered.
After determining the objectives, the next step may be to determine the way in which title to the property is taken.
A. TITLE HELD IN BUYER'S OWN NAME
The advantages to holding title in the Buyer's own name include:
- Profits on sale can be taxed at low capital gains rates;
- Minimal cost, with no expense to maintain a domestic or foreign entity;
- On death of the property owner, the property will receive a "stepped-up" tax basis to market value, which could eliminate or at least greatly reduce taxable profit on sale;
- The property can be easily transferred on death to a beneficiary, by a simple will or trust (but see below with reference to non-US citizen beneficiaries);
- The foreign buyer can take advantage of statutory tax free exchanges (for domestic property only).
- The disadvantages to holding title in the foreigner's own name include:
- Loss of Privacy, as title is evidenced by a recorded deed;
- At death of the owner, the market value of the property may be subject to US estate tax;
- If a beneficiary is not a U.S. Citizen, regardless of U.S. residency, the estate will receive minimal estate tax exclusion (currently $134,000). Note that for estate tax purposes, any mortgage on the property will not be allowed as a deduction from market value unless it is "non-recourse". However, a Qualified Domestic Trust for a foreign spouse can avoid the estate tax but this subject is beyond the scope of this article.
B. TITLE HELD BY U.S. LIMITED LIABILITY CORPORATION (LLC) OR PARTNERSHIP
The property can be held by a domestic or foreign LLC, or a limited or a general partnership. In any of these, a foreign member or partner is required to obtain a U.S. tax number and to file U.S. tax returns to report U.S. source income. Residential property may not produce income, but a tax number is nevertheless required. The IRS will not issue an ITIN to a foreigner unless the application includes original documentation such as a passport or birth certificate, or a copy certified by the issuing agency. Some Countries have appointed agents to theoretically expedite this process; the current U.S. political climate may adversely affect this process.
Limited Partnerships, requiring a General Partner, may be used for larger projects, but general partnerships are not usually recommended.
For residential property, the LLC may be used to hold Title, and advantages include the following:
- A level of privacy. Although the Manager of the LLC must usually be disclosed in a public record (not in all States), the actual beneficial ownership can often remain confidential. (Reporting of beneficial ownership on Federal and perhaps State forms may be required).
- Asset protection, given the documents are properly drafted, which may be important if the buyer or beneficiary has other U.S. business activities;
- Availability of long term capital gains tax treatment on sale;
- Many States have reduced the level of asset protection afforded by the LLC, especially for single member ownership. This includes California;
- At the beneficial owner's death, the beneficiary receives a step-up in tax basis to market value;
- The LLC form provides flexibility in estate and gift planning, with possible reduced values for gift tax purposes on gifts of Membership interests (the IRS continues its effort to reduce or eliminate discounts).
C. TITLE HELD BY U.S. CORPORATION
Using a U.S. corporation to hold title, include the following advantages and disadvantages:
- Corporations do not "die", and stock in a U.S. corporation is deemed "sited" in the U.S. and may therefore be subject to U.S. estate and gift tax;
- Loss of anonymity, as most states require that the names of officers and directors be filed in a public document;
- Foreign ownership of a real estate holding U.S. corporation may require reporting to the Treasury depending on activity and percentage of ownership;
- Possible limit to personal liability;
- U.S. income may be offset by depreciation and other expenses.
D. FOREIGN CORPORATE OWNERSHIP
Holding title through a foreign or "offshore" corporation, by a nonresident alien, can have some of the following advantages:
- Shares of stock in an offshore corporation are not considered "sited" in the U.S., and should not therefore be included in a non-resident alien's U.S. estate. There are gifting opportunities;
- The corporate stock of an offshore corporation might be sold to a buyer, and title to the property does not change; and, at least technically, the property itself is not sold and therefore there is arguably no tax due. However, this form of sale can rarely be accomplished and then only at a discount, as the buyer, whether domestic or foreign, does not get the benefit of a new tax basis equal to the purchase price;
- A possible shield to personal liability.
Disadvantages of the foreign corporate structure include:
- Capital gains tax rates are not available to a corporation;
- If the owner or other US or foreign employee occupies the property, the IRS may "impute" rental income, based on an assessment of reasonable rental value;
- Profits realized by a foreign corporation are taxable in the U.S., for example, from rental income or imputed rental income, requiring a tax return;
- Possible exposure to the Branch Profits Tax, as accumulation or remittance of profits overseas may be subject to the "branch profits tax";
- If a U.S. taxpayer owns or controls the offshore corporation, it is a "controlled foreign corporation" with numerous reporting and tax issues.
- A U.S. beneficiary will usually want to immediately dissolve the foreign corporation.
E. TITLE HELD BY FOREIGN TRUST
Holding title to residential property through a Foreign Trust may offer several advantages, especially if there are no actual or potential U.S. beneficiaries. Advantages may include:
- Asset protection;
- No U.S. reporting or tax returns if no U.S. source of income;
- Usually no exposure to U.S. estate or gift tax;
- The Trust can provide for continuing use by subsequent foreign beneficiaries.
- "Imputed rental income" should not apply if the residence is used by family members or employees;
- Foreign Trusts are eligible for capital gains tax rates, but the current tax exclusion on sale of a principal residence will normally not apply.
Use of a Foreign Trust may not be of interest if the person expects to become a U.S. resident or Citizen; the Trust would become a transparent "grantor trust" resulting in substantial reporting requirements.
If a U.S. Citizen or Resident uses the property, the IRS will consider that a distribution from the foreign Trust to such person, with tax consequences.
Disadvantages of the use of a foreign trust to hold title will arise if the beneficiary is a U.S. taxpayer, and/or if the property realizes income, which will require a tax return. Sale proceeds from a U.S. buyer will be subject to withholding.
No form of title is perfect, and each form has both advantages and disadvantages. The foreign buyer's long term objectives must be clearly determined as a prerequisite to selecting how to hold title to US residential real estate.
FINANCING; PATRIOT ACT
All U.S. banks and financial institutions must "know their client". A U.S. bank will require much information on a foreign individual and entity including a foreign trust. An entity may be required to register to do business in the particular state. The foreign owner or entity might consider using an accounting firm or other agency to manage the property and pay the expenses, to avoid having a U.S. bank account.
If a foreign buyer can overcome the due diligence hurdle, he/she must recognize that the form of title will be significant to the lender, which must, at the very least, determine if the borrower has the income and assets to justify the loan, and these days that is often problematic regardless of wealth.
Foreign buyers often have no U.S. source income, and a U.S. lender, certainly in today's market, will generally have, to say the least, reservations before issuing a loan based on foreign assets. However, if all "due diligence" and other requirements are met, there are lenders who will finance a foreign buyer.
Allowable interest payments and property taxes are tax deductible but only against U.S. source income. If the foreign buyer has no U.S. source income, these deductions may be worthless.
TITLE COMPANY REPORTING
FINCEN (Financial Crimes Enforcement Network) has renewed the obligation for title companies to report the names of persons, and persons behind "shell companies", which buy "luxury properties" for cash, in the following Cities: Los Angeles, San Francisco, San Diego, Miami, San Antonio, New York City. It should be noted that one Journal states that 30% of purchases covered by this order involve persons previously named in suspicious transaction reports filed by a bank or other financial institution. (STEP, April 2017).
INCOME TAX AND U.S. RESIDENCY
A Resident is subject to income tax on worldwide income, usually with a tax credit if a Treaty Country is involved. The basic rules of residency are as follows. A foreigner becomes a U.S. tax resident by having a Green Card, or simply by remaining in the U.S. 183 days or more in any single calendar year, or, by being in the US for a total of 183 days as determined over a three-year period by the following formula:
- All the day's present in the current year, and
- 1/3 of the day's present in the preceding year, and
- 1/6 of the day's present in the next preceding year.
There are limited exceptions usually established by Treaties.
ESTATE TAX AND "DOMICILE"
Unlike income tax, estate tax for a non-Citizen is based on "domicile", loosely defined as the place one ultimately treats as "home" (many cases on this issue). If another domicile can be established, non-U.S. sited assets may be excluded from a U.S. estate.
The U.S. estate with U.S. "sited" assets of a nonresident alien, which go to a non-Citizen beneficiary, have a very limited estate tax exemption ($60,000).
The U.S. estate, even of a Citizen, with assets which go to a non-Citizen spouse, also have special requirements to preserve the current estate tax exemption.
The nonresident alien seeking to buy U.S. real estate should consider his/her long-term objectives, and beneficiaries. Often the purchase is made in the buyer's own name, who later seeks more sophisticated planning. While not optimum, it is usually still possible to re-structure the investment to meet the required objectives.