How Some Foreign Investors In US Real Estate Can Avoid 40% Estate Tax

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Since the bursting of the housing bubble in late 2007, foreigners have been snatching up US property at considerable pace and have contributed to the rebounding of prices. The luxury housing market in particular has more than simply recovered in desirable markets like New York and Los Angeles with many properties selling at record prices

According to a July 2017 report by the National Association of REALTORS, from April 2016 to 2017, foreigners purchased 214,885 residential properties – constituting 5% of all US residential property sales. Combined, their purchases totaled $153.0 billion. 

However, I question the accuracy of these figures. 

Why?

Because the National Association of REALTORS failed to describe how they accounted for purchases made by foreigners through domestic entities.

Making real estate purchases through an entity allows foreigners to avoid three unfavorable US tax regimes:

 

  1. 30% Withholding Tax On Rents – Foreign owners of US real estate who receive rental income are subject to a 30% withholding tax on gross rents, without any allowance for deductions. For example, if a foreign landlord receives $100,000 in rent per year, then $30,000 will need to be withheld by the renter or property manager and remitted to the IRS. The foreign owner will receive the remaining $70,000. 

The 30% withholding tax is a flat tax with no possibility of a refund. However, certain treaties may reduce the withholding amount. It is possible to make an election to pay tax on the net benefits (profits), but this requires making a special tax election but most foreigners fail to meet the stringent requirements.

  1. The Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) – When a foreigner sells US property, the buyer is required to withhold 15% of the sales price as a withholding tax and pay it to the IRS, regardless of whether the property is being sold at a gain or loss. 

The foreign investor will receive a refund of any overpayment or any underpayment when they file their US tax return to report the sale. Since the withholding is 15% of the sales price, not the gain, the FIRPTA withholding almost always results in an overpayment, meaning the foreigner is entitled to a refund. However, they usually have to wait until they file their next tax return to claim the refund. 

Furthermore, many buyers won’t purchase property from foreigners because they don’t want to deal with the cumbersome FIRPTA requirements. This, unfortunately, limits the buyer pool for many foreign investors. 

          1.    30% Withholding Tax On Rents – Foreign owners of US real estate who receive rental income are subject to a 30% withholding tax on gross rents, without any allowance for deductions. For example, if a foreign landlord receives $100,000 in rent per year, then $30,000 will need to be withheld by the renter or property manager and remitted to the IRS. The foreign owner will receive the remaining $70,000.

The 30% withholding tax is a flat tax with no possibility of a refund. However, certain treaties may reduce the withholding amount. It is possible to make an election to pay tax on the net benefits (profits), but this requires making a special tax election but most foreigners fail to meet the stringent requirements.

          2.    The Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) – When a foreigner sells US property, the buyer is required to withhold 15% of the sales price as a withholding tax and pay it to the IRS, regardless of whether the property is being sold at a gain or loss. 

The foreign investor will receive a refund of any overpayment or any underpayment when they file their US tax return to report the sale. Since the withholding is 15% of the sales price, not the gain, the FIRPTA withholding almost always results in an overpayment, meaning the foreigner is entitled to a refund. However, they usually have to wait until they file their next tax return to claim the refund. 

Furthermore, many buyers won’t purchase property from foreigners because they don’t want to deal with the cumbersome FIRPTA requirements. This, unfortunately, limits the buyer pool for many foreign investors. 

          3.    Estate Tax – Foreign investors are subject to a US estate tax of up to 40% on their US assets including valued over $60,000 including real estate. For example, if a foreign investor owned US real estate valued at $1.5 million at the time of his death, their estate would have to pay a 40% on $1.44 million – or, $576,000.

While many foreigners easily avoid these unfavorable taxes by making their purchases though a proper entity structure, most are unaware of the need to do so before making their investment. 

Often, the mistake of personally owning property cannot be fixed retroactively because migrating from personal ownership to entity ownership will often trigger tax liabilities. But for a lucky few, the US tax code offers a way out. 

IRC Section 897 allows some foreigners to avoid the 30% withholding tax on rents, FIRPTA withholding, and the estate tax by placing their US real estate into a foreign corporation and electing to treat the foreign corporation as a domestic one for income tax purposes and as a foreign one for estate tax purposes. 

While complex, the Section 897 election may be the only retroactive planning tool available for foreign investors that can be implemented to restructure their US real estate holdings to avoid the taxes discussed above without triggering additional adverse tax consequences.

This strategy is only available to residents of countries that have a comprehensive income tax treaty with the US. 

In addition to tax savings, using an entity to purchase real estate also provides asset protection.

Whether you have already made your purchase or are still shopping, our experts can help you proceed in a tax advantaged fashion. Click the link below to determine what options are available to you. 

 

 

 

 

 

 

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