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.
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.