Ownership of US Real Estate by Foreign Persons
Non US purchasers of US real property need tax advice as well as representation by a qualified real estate lawyer. This is true for purchasers of residential real estate as well as commercial property. There are a number of reasons:
1. Non US persons that die owning US real property are liable for the US estate tax based on the fair market value of the property. Although the exemption from the US estate tax has become very generous for US persons, especially after the most recent tax act that became effective at the end of 2012 that provides a $5 million exemption from the tax, the exemption for non US persons remains at $60,000. Many purchases by non US persons that your author has represented have involved properties, including vacation homes that cost them millions of dollars. The marginal rate for the estate tax imposed on the estate of decedents dying after December 31, 2012 is 40%.
2. In order to ensure that taxes owed by non US persons will be collected, the US has imposed withholding requirements on most payments of US source income made to them. These include:
a. a 30% withholding tax on most items of US source income, including interest, dividends, and, importantly, rental income and gain from the sale of US real property; and
b. a requirement that 10% of the amount realized from the sale of US real property be withheld by the buyer and delivered to the US Treasury. The withheld amount is applied against the tax due with respect to gain from the sale.
Although most capital gains derived by non US persons are exempt from US income tax, gain from the sale of US real property by a non US owner is subject to a 30% withholding tax imposed by the US Foreign Investment in Real Property Tax Act. The amount withheld is applied against the tax due. The seller must file a US tax return and pay any amount due or may claim a refund if the amount withheld exceeds the tax.
3. Most non US persons do not wish to become known to the US Internal Revenue Service. Direct ownership will likely require the purchaser to obtain a US taxpayer identification number and file a US tax return at some point in his or her ownership. Returns are not required where taxes due from a non US person are withheld at the source; however, where the tax is not withheld, a US tax return is required. Reporting is also required where treaty benefits are claimed.
4. If US real property, including vacation property, is rented to parties other than family members, it may be treated for tax purposes as property used in a trade or business. The US Tax Court has found that the rental of single property may satisfy this requirement. If a foreign corporation is found to be engaged in a trade or business by renting the property, income including gain from the sale of the property, may become subject to a 30% branch profits tax on distributions to the home company that is in addition to the regular tax. This is the principal reason that non US purchasers are generally advised to avoid ownership of US real property in a foreign corporation. While it seems likely that the occasional rental of a vacation home to non family members would not constitute a trade or business, it is unclear what level of engaging in or management of such rentals would rise to that level.
5. If a non US person spends 183 days in the US during a calendar year, he or she will be treated as a resident alien and become subject to the same tax obligations as a US citizen for that year. If such person becomes domiciled in the US, he or she will become liable for US transfer taxes, including federal estate and gift tax liabilities incurred during any year while a US domiciliary. The strategies discussed below assume that the non US purchaser does not become a resident alien.
For the reasons set forth above, many non US persons hold US real property, including vacation homes, in an entity that enables them to avoid personal contact with the US tax system. If the purchaser wishes to have control over the property while ensuring that his or her estate will not be liable for the US estate tax, it is common to hold title to US real property in a US corporation owned by a foreign corporation. This is the form of ownership that your author has most commonly recommended. Direct ownership of the stock of the corporate owner by a non US person will not avoid the US estate tax in most circumstances because stock in a corporation that owns US real property that comprises more than one-half of its real property plus other business property is treated for tax purposes as though US real property. Such stock is defined as a US real property interest, and the corporation is defined as a US real property holding company.
Although the US estate tax can be avoided by ownership of US real property in a corporation organized in the purchaser’s home country, that structure is generally avoided because of the branch profits tax described above. This tax can be avoided in certain circumstances, particularly if the ownership of the property does not constitute a trade or business, but it is quite impenetrable, introducing a great deal of complexity into the ownership and disposition of the property that is generally avoided.
As described above, most capital gains derived by non US owners from the sale of US property are exempt from US tax, an important exception being the sale of a US real property interest. Therefore if, after the sale of the property, a corporation is no longer a US real property holding company, it can distribute the sale proceeds to its non US parent in liquidation free of US tax. A corporation is no longer a US real property holding corporation and its shares are no longer a US real property interest if it owns no US real property and all of its real property interests owned within the preceding five years have been disposed of in taxable transactions.
Alternatively a purchaser might elect to purchase US real property in a family trust that is not a grantor trust that would cause him or her to be treated as the owner of the property. The purchaser would thereby avoid the US estate tax and eliminate the double level of tax that would be imposed on dividends paid by a US corporation. Distributions to beneficiaries of income and some types of gain would be subject to withholding by the trustee.
If the property is owned in a corporation, fair market rent should be paid for use of the property. Otherwise such use is effectively a taxable distribution from the corporation. In most cases payment of rent to a corporation owning US property should not result in significant tax liability as the rental income will be needed to cover deductible operating expenses of the property. The tax treatment of rent and expenses where the property is owned by a trust is more complex and beyond the scope of this comment.
Many of the adverse consequences described above are considerably ameliorated by income and estate tax treaties between the US and most of the principal countries of the world, significantly excluding many countries that serve as havens for tax avoidance strategies. It is important to determine whether there is an existing treaty with the purchaser’s home country and the benefits provided by the treaty.
Another important consideration is to ensure that the purchaser involves his or her tax adviser in the home country in the creation of the ownership structure. In some matters that your author has advised on the corporate arrangement described above was not favorable in the home country. In that circumstance, ownership of the US corporation by a corporation located in a country that provides tax advantaged ownership such as the Cayman Islands may provide a satisfactory (although complicated) structure.
To ensure compliance with requirements imposed by the Internal Revenue Service, you are informed that any U.S. tax advice contained in this comment is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding U.S. tax penalties.
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