The steep decline in US property prices has captured the interest of many investors. But Virginia La Torre Jeker, J.D. cautions that US property tax laws are complex and should be fully understood before investors decide to purchase US property.
The recent bargain basement prices in the US real estate market have attracted increased interest from foreign investors. But the US tax system is extremely complex, and the property acquisition structure will mean US tax consequences for foreign investors. Those interested in purchasing US property should be aware of some important tax considerations and strategies.
Operating income from the US property (e.g. rent) will be subject to US income tax. Investors must also be aware of the Foreign Investment in Real Property Tax Act (FIRPTA) designed to impose a tax on capital gains earned by foreign persons from their dispositions of US real properties. FIRPTA generally mandates that the buyer withhold 10 per cent on the gross proceeds paid upon purchase of the property from the foreign investor. This withholding tax is not the amount of tax actually due; it is an advance payment to the US tax authorities toward the foreign seller's ultimate income tax obligation arising from sale of the property.
FIRPTA rules apply to US Real Property Interests (USRPI), including apartments, farms, buildings and raw land, as well as shares in certain US corporations that primarily hold US real property (referred to in the tax law as a 'US real property holding company' or a 'USRPHC', the sale of which is taxed under FIRPTA).
What is the best ownership structure for a foreigner wishing to buy into the US property market, taking into account US tax ramifications? There is no bright line rule. The determination is subject to the facts of each case. For example, is the property being used as a personal residence, making it eligible for exclusion of certain amounts of gain on sale? Or is the property being rented? Are there any other properties owned in the US? Investors should be aware of the most frequently considered structures.
Direct ownership by foreigner
This structure is by far the simplest structure for an individual investor in US real property, having both advantages and disadvantages. A significant advantage of individual ownership, in addition to simplicity, is only one level of tax on repatriated earnings. Furthermore, favourable long-term capital gain (LTCG) tax rates apply on an individual's capital gain income from sale of the property if it has been held for over one year.
The current maximum LTCG rate is generally 15 per cent. If a foreign person owns more than one property, losses from unprofitable properties can generally offset rents from the profitable holdings. Moreover, a direct ownership structure is not subject to dividend withholding tax or Branch Profits Tax (BPT), since those taxes apply only to corporations. Filing of income tax returns by the individual would be required. Many foreigners are reluctant to do this, even if the alternative means paying higher US taxes. Even more troublesome is exposure to US gift and estate taxes when the foreign individual owns the property directly. For these purposes, an interest in US real property would be included in the foreign individual's US estate at the time of death. It would also be subject to US gift tax if gifted during the investor's lifetime.
The estate and gift taxes are imposed at a current 45 per cent maximum rate on the fair market value of the property (at death or at the time of the gift). Direct ownership also leaves an individual investor personally liable for creditors' claims (e.g. injuries to a tenant). While it is possible to mitigate this exposure by purchasing insurance, the risk can still be quite great.
Corporate ownership
There are two possibilities with corporate ownership of the real property: a non-US (foreign) corporation or a US (domestic) corporation. Let's look at foreign corporations first. Due to the potential for application of the so-called BPT, such a structure is generally unattractive. The BPT is a special tax imposed in addition to the corporate income tax on the US branch operations of a foreign corporation. It is generally imposed at a 30 per cent rate on the earnings of a foreign corporation that are not treated as having been reinvested in the US (i.e. repatriated earnings). Due to operation of the US tax rules, this means that the BPT can effectively result in double taxation of earnings from a rental business or on the sale of one of several properties owned by the corporation if the earnings are not treated under the law as reinvested in the US business.
On the positive side, use of a foreign corporation gives the foreign investor the shield of limited liability, as well as greater anonymity (e.g. the foreign shareholder will not have to file a US tax return, since this would be filed by the corporation if it is engaged in a US trade or business or upon its sale of the property). Furthermore, if a foreign corporation owns the property, neither the real property nor the foreign corporation stock will be subject to US estate tax at the death of the foreign individual owner.
Upon sale of the foreign corporation's stock by the foreign investor, any gain on the sale will not be subject to FIRPTA. However, finding a buyer for the foreign corporation's stock will be difficult. Most potential investors in US real estate owned by a foreign corporation will want to purchase the real estate itself, rather than the foreign corporation's stock. Sale by the foreign corporation of the property would result in tax under FIRPTA. Accordingly, a smart buyer will discount the price he is willing to pay for the shares by this inherent tax liability. In the case of a US domestic corporation owned by a foreign person, it will provide limited liability protection. If the foreign investor plans to purchase multiple properties, however, ownership through a single US corporation would not be very advisable, since holding all of the properties in a single corporation exposes each property to the claims of creditors of the other properties.
A single domestic corporation could be a very good structure, however, if the investment is to be made in a single property that has the potential for significant appreciation in value. Due to the interplay of certain tax rules, there would be only one level of FIRPTA tax at the corporate level when the property is sold and the corporation would be able to later distribute the sales proceeds tax-free to the investor in a liquidating distribution.
It should be noted that there would be a loss of the benefit of favourable capital gains rate with such a structure. If the US corporation sells the property, the maximum corporate tax rate is 35 per cent. Compare this rate to the more favourable individual LTCG rates. Another advantage with this structure is that the corporation will be treated as a separate taxpayer, eliminating the necessity for the individual to file annual tax returns. The BPT problem is also eliminated, since it applies only to a branch of a foreign corporation. The corporation, however, will likely be characterised as a USRPHC, and the sale of its stock will be taxable under FIRPTA.
Some significant disadvantages arise for the foreign investor using a domestic corporation as the investment vehicle of choice for making investments in US property. Stock of a US corporation held at the death of an individual investor would be subject to US estate tax, as discussed above. Furthermore, repatriation of operating income will result in double taxation. First, the US corporation, as a separate taxpayer, will pay regular US income tax on its income. Second, a 30 per cent withholding tax on items such as dividends or interest will be imposed when those earnings are repatriated to the foreign investor.
Ownership through US LLC
A limited liability company (LLC) is an unincorporated entity organised under the provisions of state law (usually formed in the state where the property is located). The LLC provides limited liability to its members in the same manner as a corporation does for its shareholders.
The LLC is a very popular investment vehicle because it offers both limited liability and the possibility for US income tax treatment as a 'flow through' entity, which means only one level of tax is assessed (unlike the corporate structure, where the corporation pays income tax and then tax is paid again by the shareholder upon receipt of a dividend). Generally, with an LLC, there is a pass-through of all items of income, deduction and loss from the entity directly to its owner(s), which means that there is only a single level of tax imposed at the member level. A foreign person deciding to invest in a single property can organise an LLC to hold the property, thereby avoiding some pitfalls such as unlimited liability and the potential double taxation of income. With multiple properties, the investor can create a US corporation to own various LLCs (one for each US real property to be purchased).
Under the flow-through taxation rules, the various LLCs are treated as divisions, rather than as separate taxpaying entities, and the losses from one property in an LLC can offset gains from the other more profitable properties in other LLCs. These single-member LLCs would not have to file US tax returns. Only one tax return would need to be filed by the top-level US corporation covering income, losses, etc. of all of the LLC divisions.
Nonetheless, each LLC has the advantage of limited liability any creditors of the particular LLC can attack only the assets in that particular LLC and not the assets in the other LLCs. When multiple properties are involved, this type of structure permits the foreign investor to enjoy the tax benefits available to an affiliated group without being subject to the complications of so-called consolidated tax return filings, thereby significantly diminishing administrative burdens. Again, however, direct ownership by the foreign investor of the US top-level entity raises US estate and gift tax concerns.
Foreign/domestic structure
A foreign person can create a foreign corporation that in turn holds as its only asset all of the stock of a US corporation (or multiple US corporations if more than one property is to be purchased). The US corporation would own the US real property. This structure provides limited liability against creditor claims, eliminates the need for the individual to file a US tax return, renders inapplicable the BPT (which will not apply because the real property operating assets are held in a domestic corporation) and renders inapplicable the US estate and gift taxes (which will not apply because the foreign investor owns the stock of a foreign corporation on which those taxes are not triggered).
Furthermore, once the domestic corporation sells all the property and pays tax, there is the possibility that the company can be liquidated tax-free, with the cash being paid out to the foreign parent corporation free of any US withholding tax. This dual structure is complex and expensive to create and maintain, but in the case of significant property holdings, it may be worth the costs given the overall benefits.
The tax implications of any holding structure must be carefully considered with a qualified tax professional. All of the facts must be taken into account. A change in fact patterns often dictates different structuring techniques.
© MONEYworks 2009
