A buddy of mine contacted me in a panic the other day. The top tier law firm he and his wife had engaged to assist with a large U.S. real estate acquisition dropped them in the middle of the transaction! WTF? Oh, as it turns out, they also failed to properly advise them on the U.S. tax implications of the investment!
Here’s a bit of background. My friends, who are nonresident aliens, are in the process of purchasing a multimillion-dollar property in the U.S. Their plan is to rent it out for a few years and then eventually use it as a vacation home.
They hired a top-tier international law firm and a multi-national trust company / company service provider (CSP) to advise them and assist with the transaction.
The law firm advised my friends to purchase the property through a foreign company with a U.S. subsidiary. After having setup the foreign company, the CSP asked whether the U.S. subsidiary needed to be a corporation or LLC. My friends asked their lawyers, and their lawyers told them they no longer had time to assist them with the matter.
Sidebar: Seriously? Dropping a client in the middle of an engagement they’d accepted? Not cool.
This is when my friends contacted me.
Below is a summary of the U.S. taxes foreigners will need to deal with when investing in U.S. real estate. Fortunately, their impact can often be greatly reduced by with proper structuring of the investment.
Learn the structures I have developed for helping my foreign clients invest in U.S. real estate by downloading “How to Structure U.S. Real Estate Investments for Foreigners”.
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Estate Tax
The advice to purchase the property through a foreign corporation was good advice, as it provides U.S. estate tax protection. A nonresident alien’s estate is liable for U.S. estate taxes on the decedent’s U.S. property at rates up to 40% if the aggregate value of such property exceeds $60,000.
This, however, is where the good advice stopped. Their advisors totally dropped the ball on advising my friends on other important tax issues, like income tax and the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”).
Income Tax
If the subsidiary of the foreign corporation were to be established as a U.S. LLC, the foreign corporation itself would be liable for any U.S. income taxes on the rental income and any gain from the sale of the property. This is because, by default, a U.S. LLC with a single owner is treated as a “disregarded entity” for U.S. income tax purposes. As such, its income and loss are allocated to and reported by its owner, in this case the foreign corporation.
In addition to regular corporate income taxes (currently 21%), foreign corporations are liable for a “branch profits tax” of up to 30%. The combination brings the total tax rate to 51%, exclusive of state and local income taxes.
Establishing the subsidiary of the foreign corporation as U.S. corporation, which is itself a taxable entity, would avoid the 30% branch profits tax. That said, dividends paid from the subsidiary to the foreign parent would be subject to withholding tax of up to 30%. There are, however, strategies for minimizing, or eliminating, the withholding tax.
FIRPTA
FIRPTA requires that buyer of U.S. real estate withhold 15% of the gross sales price, subject to certain exceptions, and send it to the IRS if the seller is a “foreign person”. If the withholding is more than the actual tax due, the over-withheld tax will be refunded when the foreign person files their U.S. income tax return reporting the sale. In converse, if the withholding is less than the actual tax due, the under-withheld tax will be due when the foreign person files their U.S. income tax return reporting the sale.
If the subsidiary were established as a U.S. LLC, FIRPTA would apply to the sale of the property by the LLC since it is disregarded for U.S. income tax purposes, and it would be as if the foreign corporation sold the property directly.
FIRPTA doesn’t result in any additional tax, as it is merely a pre-payment of tax. FIRPTA does, however, add complexity and hassle to real estate transactions involving foreign sellers. Because of this many buyers refuse to purchase real estate from foreign sellers, which can limit the buyer pool.
Personal Use
An often overlooked issue, with huge potential negative tax implications, is the personal use of corporate-owned U.S. real estate, whether owned through a U.S. or foreign corporation. One cannot generally personally use corporate property without paying for it. As such, fair market rent should be paid for any personal use of corporate-owned U.S. real estate. Failure to do so could result in rent being imputed to the corporation along with significant penalties and interest.
Conclusion
I advised my friends to setup the subsidiary as a U.S. corporation and pay fair market rent for any personal use of the property. This way they avoid the estate tax, the branch profits tax, and FIRPTA.
My friends already owned a dormant U.S. corporation that had never been used and had no legacy liability. They wondered if they could transfer this corporation to the foreign corporation and then acquire the property through it. The large trust company / CSP they were working with advised them they couldn’t. Obviously, they gave this advice so they could make money incorporating a new corporation. There was no reason why the existing corporation couldn’t be used, and I advised my friends of same. I understand wanting to make money, but don’t be shady and greedy.
Long story short, my friends were happy with my advice. My team took over the transaction and we were able to get everything in place for a timely and successful closing.
We’ve been helping our clients structure their U.S. real estate investments to reduce taxes, protect assets, and increase profits for over 20 years. We know what structure to use when—which is key to a successful U.S. real estate investment.
If you have questions about structuring or restructuring your U.S. investment, please don’t hesitate to contact us here.