Representation of foreign individuals who wish to purchase US residential property should include careful attention to the manner in which the income and gain from the property will be taxed in addition to the other aspects of ownership. In addition, it is important to be aware of the manner in which the US imposes its estate tax on foreign owners.
The following considerations should be taken into account in order to determine how to achieve an ownership structure that will be most suitable for the client.
1. Involve Home Country Counsel in the Purchase
The purchaser’s home country counsel should be involved from the outset as the home country’s tax laws may significantly affect selection of the most appropriate form of ownership. For some countries this may require including an offshore entity between a US entity as owner of the property and the owner in the home country in order to achieve the most favorable tax structure. However, inserting an offshore owner in this manner introduces expense and complexity that is best avoided if possible
2. The US Estate Tax must be Taken into Account
Under existing law, the US estate tax is imposed at the death of foreign individuals owning US real property based on the entire value of the property that exceeds $60,000. Because many if not most foreign purchasers acquire valuable properties, this often discourages direct ownership by the individual purchaser or purchasers. (It is unlikely that the Congress will rush to provide more favorable treatment.) There are a number of forms of ownership that can be used to avoid the tax that have varying degrees of complexity.
A common ownership structure that will avoid the tax is ownership of the property by a US corporation whose shares are owned by a home country corporation or other entity that is not transparent to the beneficial owners for US tax purposes. The advantage of this structure is simplicity. The disadvantage is the US corporate tax rate of 35 percent and possibly disadvantageous tax treatment in the home country. The second level of tax on the distribution of the sale proceeds by the selling corporation can be avoided in almost all circumstances if the distribution is made in liquidation of the US corporation.
Direct ownership of the property by a foreign corporation to avoid the US estate tax is not advisable. The US imposes a 30 percent branch profits tax on the distribution of proceeds from the sale of US real property by a foreign corporation unless made in connection with the termination of the existence of the corporation and in compliance with a number of requirements set forth in applicable Treasury regulations. The branch profits tax due would be in addition to the capital gains tax imposed on the corporation in connection with the sale for which the rate is presently 35%. Also, as described below, any rental income from the property would be subject to a withholding tax of 30 percent that does not allow deductions for expenses incurred to operate the property.
The US estate tax can also be avoided if the real property is owned by a trust that is not treated as a grantor trust, which requires that the trustee be independent of the settlor, and the settlor must not have reserved a reversionary interest in the trust assets or specified powers set forth in applicable Treasury regulations. This structure may be appropriate where the property is expected to remain in the family when the parents are no longer enjoying it. The trust may be foreign or domestic. Other alternatives are possible; the key is to ensure that there is a blocker between the US ownership entity and the foreign individual or individuals that are the ultimate beneficial owners of the property.
3. Rental Agreements.
If the title to US property is held by a US corporation, there should be a rental agreement, which requires the foreign owners who control the corporation to pay a fair market rent for their personal use. Otherwise, the rental value of their occupancy could be treated as taxable income to them. It is likely that the cost of maintaining the property will produce offsetting deductions that will eliminate all or most of the taxable income generated from the rent.
If US property that is directly owned by a foreigner will be rented to third parties, it will be necessary to determine whether the owner will be treated as conducting a US trade or business and must therefore obtain a US taxpayer identification number and file annual US tax returns. (Most foreign individuals do not wish to become US taxpayers.) If the owner will actively manage the property, the rental is likely to be treated as a US trade or business. The rental may also be treated as a US trade or business if a managing agent engaged by the owner is authorized to operate the property in a manner that would be treated as a trade or business if conducted directly by the owner.
4. Withholding Requirements
The US imposes a withholding tax at the rate of 30 percent on the distribution of rental income from US real property to foreign owners. The tenant must withhold the tax and transmit the funds to the Service. Where the tax imposed on rental income is withheld and paid in this manner an income tax return is not required.
The US also imposes a 10 percent withholding requirement against the amount realized from the sale of US real property by a foreign owner that holds title to the property directly. The withholding can be avoided by obtaining a withholding statement from the IRS, which requires the seller to enter into an agreement with the Service that provides for payment of the tax and security for payment. This effort is likely to be time consuming and expensive. For that reason, most sellers allow the withholding to take place. The purchaser must withhold and transmit the funds to the Service. The seller must file a US tax return and either claim a refund or pay any additional tax due.
5. Reporting Requirements
Reporting requirements include information returns as well as income tax returns, and the penalties for failure to file these returns can be substantial.
6. Tax Treaties
The effect of tax treaties between the US and the home country on the taxation of the owner must be taken into account. These treaties generally provide significantly more favorable treatment to owners who reside in a country with which the US has income and estate tax treaties. The US has income and estate tax treaties with most of the major countries of the world.
7. State and Local Taxes.
The manner in which the owner will be taxed by the state and community in which the property is located, including state income and death taxes and local property taxes, should be taken into account.