|The firm has extensive experience in planning for foreign investors in the United States. There are significant income, estate and gift tax consequences with such investments, and the firm often assists such clientele in minimizing the U.S. tax exposure. In addition, we provide business planning advice to establish sufficient asset protection to meet the client’s objectives.
With increased political pressure in South and Central America, the firm has seen significant growth in U.S. investment by foreigners. Foreign investors have a host of planning opportunities but face potential pitfalls in structuring their investments, including but not limited to the U.S. Federal estate tax. The firm assists their foreign clients with structuring such investments to minimize potential income, estate and gift tax ramifications.
Foreign Investment in United States Real Estate
For a look at some of the firm’s international techniques and tax issues, please visit Overview of Planning Techniques.
U.S. Estate Taxation of Foreign Owned Property
U.S. Income Taxation of Foreign Investment
Foreign Investment in United States Real Estate
Summary of Estate, Gift and Income Tax Consequences
Increasingly, ownership of real estate in Florida has been an attractive prospect for citizens of foreign countries. Florida real estate has proven to be a safe investment for both residents of countries whose currencies are volatile and for residents of countries whose currencies are strong in relation to the U.S. dollar. For whatever reason a non-resident alien (“NRA”) acquires real property in the United States, such individual faces the same problem, i.e., the United States income, gift, and estate tax laws.
A. Estate Tax Consequences
A NRA individual will be subject to United States estate tax on that portion of his gross estate (generally all assets owned or controlled by him) situated in the United States. United States real property has a United States situs for estate tax purposes. Accordingly, direct real estate ownership by a NRA should be avoided, since it will subject the NRA individual ownership to U.S. estate taxes in the event of death. If the NRA individual owner is married and is survived by non-U.S. citizen spouse, the estate tax may be deferred until the death of the spouse by the use of a Qualified Domestic Trust ("QDOT"), where the estate tax is deferred until the death of the surviving spouse or the prior transfer of the property outside the U.S.
Stock in a United States corporation also has United States situs for estate tax purposes. However, foreign corporate stock has foreign situs for U.S. estate tax purposes. Accordingly, for estate tax purposes ownership by a foreign corporation or the use of a tiered structure, such as a United States corporation owned by a foreign corporation, would eliminate United States estate tax exposure. It is recommended that a fair market rental be paid for any use of the corporate owned real estate by the non-resident alien individual or his family.
B. Gift Tax Consequences
A gift of United States situs property by a NRA individual is subject to United States gift tax. Real property located in the United States has United States situs. However, all intangible personal property held by a NRA has foreign situs including stock in United States and foreign corporations. Thus, the U.S. gift tax rules differ from the U.S. estate tax rules.
The use of a U.S. corporation or a foreign corporation to own U.S. real estate would result in the ability by the NRA to make gifts without incurring United States gift taxes. However, U.S. estate taxes may be incurred on the death of a NRA who dies owning U.S. corporate stock, as noted above.
C. Income Tax Consequences
Foreign investment in U.S. real estate is subject to special income tax rules which differentiate between whether the non-resident alien's activities are passive or whether they constitute an active trade or business during the ownership of the U.S. real property. In addition, special rules apply to foreign investors even if the investment is made through U.S. entities, such as corporations or partnerships. Thus, if the ownership of U.S. real estate is for other than personal use, it is imperative that a prospective investor seek proper advice in the structuring of both the acquisition of the real estate and also the subsequent investment or business activities.
The Foreign Investment in Real Property Tax Act of 1980 ("FIRPTA") added special rules applicable to the disposition of U.S. real estate by foreign persons. In addition, these rules have been supplemented by the Tax Reform Act of 1984 providing for special withholding provisions and extensive disclosure and reporting requirements.
These provisions require withholding of 10% of the amount realized on any disposition of a United States real property interest ("USRPI"). "Amount realized" means total consideration received for the USRPI and should not be confused with "gain," which takes into account the transferor's basis in acquiring the property.
Stock in a U.S. corporation is a USRPI if 50% or more of the value of the corporation's assets consist of USRPI. Therefore, the stock of a U.S. corporation owning only U.S. real estate is a USRPI which is subject to withholding if transferred by a foreign person. However, dispositions of stock of a foreign corporation owning U.S. corporate stock is not subject to such withholding. Thus, using a tiered structure where the U.S. real estate is owned by a domestic corporation which in turn is owned by a foreign corporation, would result in no withholding tax imposed upon transfers of the stock of the foreign parent corporation.
II. INVESTMENT STRUCTURES
A. Direct Ownership by Foreign Individuals
The most simple structure for an individual foreign investor in U.S. real estate is to own the property directly. The major advantage of ownership individually is that there is no second level of tax on repatriated earnings. In addition, there is a favorable capital gains tax rate upon the sale of real property. If the investor owns multiple properties, losses from unprofitable properties can offset income from profitable properties. One disadvantage of direct ownership by a foreign investor is the higher maximum tax rate for individuals as opposed to the rate for corporations. In addition, if a foreign individual dies while owning U.S. real property, such property will be subject to estate tax. Lastly, an individual owner has to file a U.S. income tax return, thereby revealing his or her identity to the Internal Revenue Service. Another disadvantage is unlimited liability exposure when real estate is owned individually.
B. Ownership by Foreign Corporation
The tax rate on operating a U.S. business with a foreign corporation will be 35% as opposed to the highest individual rate. If multiple properties are owned by the foreign corporation, income and losses from different properties may offset one another, however, each property will be subject to the claims of other properties. The investor will have limited liability. FIRPTA will not apply to the sale of the foreign corporation’s stock since the stock is not considered a United State Real Property Interest (“USRPI”). Neither the stock nor the real estate will be subject to estate tax. In addition, U.S. gift tax will not apply to a lifetime gift of the stock in the foreign corporation.
Although there is no withholding imposed on dividends paid by the foreign corporation to its foreign shareholder, its business location in the United States is considered a branch and therefore subject to the 30% branch profits tax (“BPT”). Therefore, double taxation will result on earnings that are not reinvested in the business. To avoid this double tax, the proceeds of the sale of the real property would have to be followed by liquidation of the entity in the same year.
The name, address and taxpayer identification number of any person who owns 50% or more of the stock must be disclosed on the U.S. tax return.
C. Foreign Investment Through U.S. Company
Ownership in a U.S. corporation will give the nonresident alien individual asset protection. The tax rate on operating the business will be 35% as opposed to the highest individual rate. In addition, the corporation becomes the taxpayer, thereby eliminating the need of the individual to file a tax return in the United States. However, the corporation must disclose the name, address and taxpayer identification number of any person who owns 50% or more of the stock. Losses from one property can be used to offset gains from another. However, the stock of the corporation will be subject to estate tax. In addition, the repatriation of earnings will be subject to double taxation unless the corporation is liquidated after sale of the real property. If liquidation is not possible because the corporation owns multiple properties, the repatriation will trigger double tax.
D. Foreign Corporation (Parent)/ U.S. Corporation (Subsidiary) Structure
The foreign corporation/U.S. corporation structure gives the nonresident alien asset protection as well as eliminates the need to file a U.S. tax return. Only the identity of the foreign corporation will need to be disclosed. Both U.S. estate and gift tax will not apply if stock in the foreign corporation is gifted or transferred at death. The branch profits tax will not apply since there is a U.S. corporation that owns the real estate. Assuming no operating income is to be distributed out of the U.S., once the property is sold, the U.S. corporation can be liquidated and the cash repatriated to the foreign corporation free of any U.S. withholding tax.
It is recommended that non-resident alien persons who desire to acquire U.S. real estate do so through the use of a tiered structure. The real estate would be acquired by a domestic corporation, which would be wholly owned by a foreign corporation. This structure would not be subject to disadvantageous United States estate or gift tax consequences. Moreover, dispositions of the real estate by the U.S. corporation will not be subject to withholding. It should be noted that on sale of the real estate, the U.S. corporation would be subject to income tax on any appreciation in the property over its initial acquisition cost in the same manner as any U.S. corporate taxpayer. However, the proceeds from any sale of the real estate could be distributed to the foreign corporation without any additional U.S. income taxes if the domestic corporation were liquidated at that time.
It should be noted that non-resident alien investors in U.S. real property who have already acquired real estate in a structure other than the structure recommended could re-align their ownership of U.S. real property. Such re-alignment would involve the sale of the property as presently owned or the stock of a U.S. corporate owner. Such a sale would be subject to the withholding tax, but the withholding tax under IRC §1445 could be reduced or eliminated by obtaining a "withholding certificate" issued by the IRS. It should be noted that on the sale of the real estate, the U.S. corporation would be subject to income tax on any appreciation in the property over its initial acquisition cost in the same manner as any U.S. corporate taxpayer. However, the proceeds from any sale of the real estate could be distributed to the foreign corporation without any additional U.S. income taxes if the domestic corporation were liquidated at that time.
U.S. Estate Taxation of Foreign Owned Property
Non resident aliens owning U.S. property at the time of their death may be subject to U.S. estate tax on some or all of such property. A Non resident alien (“NRA”) is an individual who is not a U.S. citizen or resident.
The estate tax is imposed on the value of the gross estate of the NRA decedent, determined in accordance with the Internal Revenue Code. In general, it is that part of the gross estate which is situated in the U.S. The gross estate of a NRA is composed like a U.S. person. Revocable transfers, transfers taking effect on death, transfers with a retained life interest or (to a limited extent) transfers within 3 years of death are includable in the U.S. estate of the NRA if the subject property is U.S. situs property at either the time of the transfer or the time of death of the NRA decedent.
Situs determined by physical location. Mortgages and liens on real property are not real property for this purpose.
Tangible Personal property
Situs determined by physical location.
Stock of a U.S. corporation is U.S. situs and stock of a foreign corporation is foreign situs, regardless of place of management or location of stock certificates.
This is an unsettled area of the law. The IRS takes the position that situs of a partnership interest is where the partnership business is carried on, not where assets are located. It has also been argued that if a foreign partnership is engaged in any U.S. business, the entire value of the decedent’s partnership interest is U.S. situs, notwithstanding foreign assets or income of the partnership.
Situs of currency is its physical location. Currency is treated as tangible personal property for estate and gift tax purposes.
Debt Obligation of a U.S. Person
A debt obligation by a U.S. person is U.S. situs property. There are exceptions for (1) obligations of U.S. corporations whose gross income is non-U.S. source derived from an active foreign business, (2) bank deposits and (3) portfolio debt obligations.
The physical location of the assets of a sole proprietorship controls the situs determination of the proprietorship. Goodwill may also be deemed located in U.S.
Property held through a revocable or grantor trust of which the decedent is the grantor can be U.S. property to the extent there is income from U.S. situs property.
Intangible Personal Property
Intangible personal property is U.S. situs property if it is issued by or enforceable against a resident of the United States or U.S. corporation or U.S. Governmental unit. However, if the written evidence of the intangible itself is deemed as being the property, then the situs rules of tangible personal property apply.
There are certain items of property which would be deemed to be U.S. situs property, but which are afforded special treatment under the Internal Revenue Code, and are therefore deemed to be foreign situs property:
- Deposits with a foreign branch of a U.S. corporation or partnership if the branch is engaged in the commercial banking business.
- Proceeds of life insurance policies on the life of a nonresident alien, even if paid by a U.S. insurance company. However, proceeds on the life of another are U.S. situs property, since they are treated as a debt of the insurance company.
- Works of art on loan to a U.S. museum, being shown on a not-for-profit basis, are not U.S. situs property.
It should be noted that U.S. gift tax applies only to transfers of tangible property (real property and tangible personal property, including currency) physically located in the U.S. at the time of the gift. It does not apply to intangible property such as stock in U.S. or foreign corporations, even though such property is includible in the U.S. gross estate for estate tax purposes. A gift of cash to enable a purchase of U.S. real property may be treated as gift of realty.
U.S. Income Taxation of Foreign Investment
Foreign persons investing in U.S. property or businesses may be subject to U.S. income tax on some or all of the income generated through such investment. A Foreign person is an individual (or entity) who is not a U.S. citizen and not a resident alien. Several concepts are fundamental to understanding U.S. income taxation of foreign investors.
In order to determine whether at item of income is taxable in the U.S. you must determine its source. The source of gains derived by a foreign taxpayer from the sale or exchange of personal property depends on whether the income is attributable to an office or other fixed place of business of the seller in the United States.
Dividends are U.S. source if paid:
- By a U.S. corporation. There is an exception for dividends received from certain corporations whose gross income is non-U.S. source derived from an active foreign business; or
- By a foreign corporation if 25% or more of the gross income of such corporation is effectively connected with the conduct of a trade or business within the U.S. In that event only a portion of the dividends would be taxable in the U.S.
The source of interest generally is determined by the residence of the obligor, with exceptions.
Not U.S. source:
- Interest paid by a foreign commercial banking branch of a domestic corporation; and
- Interest paid by an NRA or nonresident U.S. citizen, whether or not engaged in a trade or business within the U.S.
- Interest paid by a resident alien or by a domestic corporation. There is an exception for interest received from certain payors whose gross income is non-U.S. source derived from an active foreign business; and
- Interest paid by a foreign corporation, to the extent paid by a U.S. branch.
Royalties are U.S. source if from property located in the U.S., or from the use of property in the U.S.; otherwise, the payments are foreign source income.
Personal Service Income
Personal services performed in the U.S. generates U.S. source income.
Income from the sale of inventory in the U.S. is U.S. source unless the inventory is (1) sold for use, disposition or consumption outside the United States and (2) a foreign office of the Seller materially participated in the sale. In that event the income is foreign source.
Rent and Gain from Real Property
Rents and gains from the sale or exchange of real property are U.S. source if the real property is located in the U.S.
Effect of Treaties
Various U.S. income tax treaties may cause modifications of these source rules.