Tax Planning Considerations for the Purchase of a Residence in the U.S. by Foreign Buyers
Overview
In spite of its many problems as a nation, the quality of life and level of economic opportunity as well as the overall respect for the rule of law, places the United States in a very unique position when compared to the rest of the World. The proof of my thesis – how many people have come to the U.S. legally and illegally for the last 150 years versus the rest of the world? Central and South Americans and others are moving to the United States and not Beijing, Moscow or Outer Mongolia.
The combination of economic and political stability along with a stable currency and low inflation continue to make the United States a desirable final destination. These considerations – political and economic instability- are frequently short lived and uncertain in many parts of the world. Many non-Americans discovered this truth a long time ago. In many large metropolitan areas of the U.S., wealthy individuals and their families can live without personal scrutiny and threat to their personal freedom and security.
Many foreigners purchase a personal residence as an investment and a safe haven from their own countries in the pursuit of their own version of life, liberty and the pursuit of happiness on American soil. In many cases, foreigners send their children to college in the U.S. with the children frequently remaining in the U.S. after graduation for a number of years. As home financing is less available in many countries when compared to the U.S., many foreigners purchase the residence outright. As a result and by definition, these foreigners have substantial assets in the U.S. for tax purposes.
Traditionally, the tax structuring for wealthy foreigners in regard to the purchase of a U.S. personal residence has focused on federal estate tax planning considerations and not federal income taxation. As a practical matter, why would the homeowner worry about income taxation if there is no rental income associated with principal residence?
The 2012 Tax Court case of G.D. Parker, Inc. v. C.I.R. T.C. Memo 2012-327 (2012) is the proverbial "game changer" for this planning scenario and shifts the focus to income tax considerations. The case is a perfect example of what can go wrong.1
Genaro Delgado Parker is a very wealthy Peruvian who owned a large ocean front home in Key Biscayne. The taxpayer owned a Florida corporation which had a number of subsidiary companies including another Florida corporation which owned the Key Biscayne home. The shares of the holding company were owned by a Panamanian corporation. In this respect, the taxpayer did what a large number of foreign buyers have done when it comes to purchasing a personal residence.
The client and his family lived in the home rent-free for several years (2003-2005). The IRS disallowed deductions under IRC Sec 262 for repairs and maintenance and depreciation on the basis that these deductions were personal and family expenses and not business expenses. These expenses over a three year period averaged $125,000-$150,000 per year approximately. Further, the IRS treated the rent-free use of the house as a constructive dividend paid to the taxpayer through the corporate chain up to the taxpayer personally.
When a shareholder or his family is permitted to use corporate property for personal purposes, the fair rental value of the property is includable in his or her income as a constructive dividend to the extent of the corporation's earnings and profits.2 For a corporate benefit to be treated as a constructive dividend, the item must primarily benefit the taxpayer's personal interests as opposed to the business interests of the corporation.3
The IRS hired a local real estate expert to determine the fair market value rent that should be imputed as a constructive dividend and determined that the fair rental was $23,000 per month or $360,000 per year for each year over a three-year period.
IRC Sec 881(a) imposes a tax of 30% dividends received from U.S. sources by a foreign corporation except as provided under IRC Sec 881(c), to the extent the dividend received is not effectively connected with the conduct of a trade or business within the United States. A lower rate may apply where the taxpayer has the benefit of a lower rate under a tax treaty. IRC 1442(a) generally requires the payor of interest subject to the tax imposed by section 881(a) to deduct and withhold that tax at the source. If the payor does not do so, it becomes liable for such taxes under IRC Sec 1461. The IRS assessed substantial accuracy-related penalties and interest in the Parker case.
The amazing aspect of this case is the fact that the original tax audit was primarily focused on the taxpayer's other corporate transactions. Once you let the IRS into the tent, they have the ability to look under every stone! The last thing that the foreign taxpayer wants to do is end up on the flip side of the equation of the cliché – "Su casa es Mi Casa" (Your house is my house) as a result of poor tax planning.
The planning paradigm has shifted to a balance of planning for unexpected estate taxes and income tax considerations for use of the personal residence. A failure to acknowledge these considerations could result in Uncle Sam ending up with the foreigner's house as a result of tax liens.
Tax Planning Considerations in the Purchase of a U.S. Residence.
A. Federal Estate Taxes
The federal estate tax is imposed on the estate of every non-domiciliary decedent under IRC Sec 2101 based upon the value of gross estate situated in the United States at the time of death. The estate tax exemption threshold is very low - $60,000. Property is not ordinarily included in the taxpayer's estate for estate tax purposes unless the decedent owns the property at death. Real property physically located in the U.S. and owned outright has a U.S. situs as does U.S. stock owned by a non-resident at the time of death. Stock in a foreign corporation is defined as foreign situs property
Property that is considered U.S. situs property for estate tax purposes may be purchased directly by a foreign corporation as its parent or ultimate beneficial owner and treated as having a foreign situs for U.S. federal estate tax purposes. The entity must be classified as a corporation and corporate formalities must be observed and the corporation should be the real owner of the property in substance.
The writing was already on the wall for non-resident aliens purchasing a homestead in the U.S prior to the GD Parker case. Some older case law already existed which examined the business purpose of the corporation owning the U.S. real estate. If the corporation is disregarded, the shareholder can be treated as the direct owner of the property resulting in an unexpected estate tax. Specifically, raw land or a residence used by the shareholder poses some concern.
In Bigio v. C.I.R., a non-resident owned a condominium and other Miami properties on Miami Beach through a Panamanian corporation as a residence. Absent a lease or loan arrangement, the Tax Court determined that the non-resident was the beneficial owner of the condominiums.4
Bigio was principally an income tax case focused on the issue of U.S. residency based upon the taxpayer's substantial presence in Miami during the tax years of question. The Tax Court looked through the ownership by a Panamanian corporation and ruled that Bigio was the beneficial owner, i.e. treated as if he owned the property personally. The structuring in Bigio did not use a separate U.S. entity to own the real estate coupled with the ownership of the U.S. entity by a foreign corporation. The federal estate tax laws for non-residents treat shares in a foreign corporation as non-U.S. situs property.
Many existing transactions for non-resident aliens owning homes have used a LLC treated as a disregarded entity to own the U.S. real estate. This structuring poses a potential estate tax risk with respect to a LLC that is treated as a pass-through entity, i.e. treated as a sole proprietorship or partnership. The IRS will not generally issue an advance ruling on whether or not a partnership (LLC) interest is treated as intangible property when owned by a LLC that is taxed as a partnership or sole proprietorship in the case of a single member LLC. As a result, a LLC that is treated as a disregarded entity, partnership or sole proprietorship, may be considered a U.S. situs asset for federal estate tax purposes.
In that respect, making an election to be treated as a regular corporation is essential for estate tax planning purposes otherwise a single member LLC will be treated as a disregarded entity potentially subjecting the residence owned by the non-resident alien to federal estate taxes. Under the aggregate theory of partnerships (LLC), the owner of a partnership interest may be treated as owning a proportionate interest of the underlying property of the partnership (LLC).
B. How Ugly Can it Get?
The revelation that the ownership of the U.S. homestead is improperly structured is likely to result during an audit and will be a big surprise to the taxpayer. The initial estate tax bracket under the progressive rate structure is 26 percent. The threshold for the non-resident alien is $60,000 of assets in the U.S. estate. Absent an arms-length lease between the corporation and the non-resident alien, a deemed dividend will be assessed based upon a fair market rental of the property to the taxpayer. Corporate level deductions for repairs and maintenance along with depreciation will be disallowed. The U.S. corporation is the withholding agent and is personally liable for the withholding on the dividend deemed payable to the foreign corporation that owns the shares of the U.S. corporation. Based upon the personal use of the residence, the withholding tax rate on the deemed dividend is 30 percent absent a lower rate under a tax, treaty.
Example
Frukko, a resident and citizen of Colombia, purchased a three bedroom condo on Brickell Key in Miami for $750,000 in January 2010. Based on rentals within the same condominium, a fair market rental is $4,500 per month or $54,000 per year. The condo is owned within a Florida corporation. The Florida LLC is treated as a corporation for federal tax purposes. The LLC is wholly owned by a Cayman corporation which is owned by Frukko.
Frukko's children have lived in the property on a full time basis since the purchase while they attend the University of Miami. Frukko and his wife have lived in the property when they are in the U.S. which is approximately half of the year.
The IRS audits Frukko's returns for the following tax years – 2010-2013. They determine that he should have declared income based upon the value of the deemed dividend of $54,000 each year. The withholding liability amount is $16,200 per year in 2010-2013, four years. An estimate of the taxes, interest and penalties for the four years is $60,080.
C. Federal Tax and Compliance Requirements of Electing to be Taxed as a Corporation
LLCs are entities created by state statute. A single member LLC is treated as a disregarded entity for tax purposes absent an election to be treated as a corporation through the filing of Form 8832. A domestic LLC with two members is treated as a partnership for tax purposes unless it files Form 8832 and elects to be treated as a corporation. A single member LLC is treated as a sole proprietorship absent an election to be treated as a corporation.
An election must be filed within 75 days of the formation of the company. Alternatively, the IRS allows Form 8832 to be filed within the first 75 days of the fiscal year which is the calendar tax year for our foreign buyer. Rev. Proc. 2009-41 permits business entities to file a classification election with an effective date retroactive up to 3 years and 75 days prior to the date that the request is filed.
Normally an entity may not change its corporate status within a 60-month period unless there is a change of ownership of more than fifty percent. The 60-month rule does not apply to a LLC that was a newly formed entity that made its initial election upon formation. Most entities formed by non-resident aliens should be able to fall under this rule in regard to making an election for the LLC to be treated as a corporation for federal tax purposes.
As previously stated in the discussion of federal estate taxes, the corporate election is critical to avoid U.S. federal estate taxation. The LLC will require a tax identification number and file a Form 1120 each year.
D. LLC Taxed as a Partnership
Historically, foreign buyers have structured their real purchases using LLCs taxed as a partnership for federal tax purposes. As previously discussed, this structure has some estate tax uncertainties due the Internal Revenue Service's lack of clarity on whether it subscribes to the entity theory or the aggregate theory of partnerships.
In the entity theory, the LLC is treated as a distinct entity separate from its owners. In the aggregate theory, the LLC is treated as a collection of assets owned by the members on a pro rata basis. If the aggregate theory applies, the member under the U.S-situs rules would be subject to transfer taxes on his pro rata ownership. Under the entity theory, the LLC interest would be treated as intangible property.
E. Where Do We Go From Here?
The scale of the potential tax adversity as demonstrated in GD Parker for foreigners purchasing a personal residence is significant. It is always alarming when you find out that you may be sleeping in a minefield.
Moving forward, taxpayers and their advisors would be well advised to revisit their existing structures and make revisions. The decision in GD Parker suggests that corporate ownership of personal real estate with the shares being owned by a foreign corporation in order to eliminate U.S. transfer taxes is still a functional solution. However, taxpayers would be well advised to structure an arms-length lease based upon a fair market rent based on comparable rentals in the jurisdiction where the property is located. Oddly enough, in many instances, the tax rate at the corporate level may end up being lower than the marginal tax rate of the individual if the LLC were taxed as a partnership.
Summary
The amount of real estate purchased within the U.S. either for personal or rental purposes is very significant and shows no signs of slowing down. The amount of home purchases in the Border States – Florida, California, Texas and Arizona – by foreign buyers is significant. First, foreign buyers like hard assets. The recession in home prices in general presents a buying opportunity. Second, the absence of political and economic uncertainty still presents the U.S. as the favorite safe haven. Many foreigners have purchased a residence in addition to commercial real estate.
The common thinking about how to restructure the purchase of a home in the U.S. needs to be reviewed and reconsidered. The tax minefield has new land mines based upon the result in GD Parker. My legal instinct suggests that a large majority of foreign owners are not properly structured based upon the result in GD Parker. As a result, the tax structuring of each and every foreign buyer should be reviewed to avoid any unpleasant surprises.
1 G.D. Parker V. Commissioner, TC Memo 2012-312 (2012).
2 Commissioner v. Riss, 374 F.2d 161, 166-167, 170 (8th Cir. 1967), aff'g in part, rev'g in part T.C. Memo. 1964-190; Melvin v. Commissioner, 88 T.C. 63, 80-81 (1987), aff'd, 894 F.2d 1072 (9th Cir. 1990); Falsetti v. Commissioner, 85 T.C.332, 356 (1985).
3 Ireland v. United States, 621 F.2d 731 (5th Cir.1980); Palo Alto Town & Country Village, Inc. v. Commissioner, 565 F.2d 1388 (9th Cir.1977), remanding T.C. Memo. 1973-223; Commissioner v. Riss, 374 F.2d 161.
4 Bigio v. C.I.R., T.C. Memo, 1991-319.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
