Tax Planning for Foreign Investors Acquiring Larger (One Million Dollars and over) United States Real Estate Investments
This is principally an article about tax planning for the non resident alien individual and foreign corporate investor that is planning for larger size investments in United States real estate (“Foreign Investor”). That is investments of One Million Dollars ($1,000,000) or more.1
Foreign Investors are now finding that they invest both in U.S. real estate and a strong dollar at the same time. Thus, making their investment even more valuable than ever when compared to their wealth in their own currencies. The United States real estate market is strong and growing.
However, it is important to use only a limited amount of borrowed funds. When an investor finances real state with large borrowings, the investor runs the risk of continuing to hold their real estate investments in hard times. Investment in U.S. real estate can provide significant short term profits but often will fare much better when they are viewed as long term investments.
One must seek good professionals in the United States who are also knowledgeable about the needs of the foreign investor. You must have an independent tax lawyer, real estate lawyer, an accountant a real estate broker and a property appraiser to rely on.
Tax planning for the foreign investor acquiring real estate with cash investments in the range of approximately $1,000,000 or more requires a look at both the U.S. income tax consequences and the U.S. estate and gift tax consequences.
Definitions of U.S. Taxes
The foreign investor will need to be concerned about three separate U.S. taxes. They are the income tax, the estate tax and the gift tax.2
There is a U.S. income tax that is applied on annual net income which starts at 15% and can be as high as 35% for both corporations and individuals. There is a tax on capital gains from the sale of assets which is only 15% to an individual taxpayer, but may be as high as 35% to a corporate taxpayer.
There is an estate tax when a non resident alien individual dies owning U.S. real estate or shares of certain types of entities that own U.S. real estate. The first $60,000 of value is excluded. Thereafter this estate tax can be as high as 45% of the equity value of the real estate.
There is also a gift tax if a non resident alien individual gifts U.S. real estate to a third party. This can be as high as the estate tax, depending upon the value of the gift.
The Individual Foreign Investor – The Problem of the Estate Tax
As a general rule, the individual foreign investor that invests in United States real estate in equity amounts of $1,000,000 or more is going to be forced to use a corporation formed outside of the United States (Foreign Corporations) somewhere in their investment structure if they are going to avoid the U.S. estate tax.
There are many exceptions to this general rule but it is still the general rule. The United States Estate tax is so onerous that the individual Foreign Investor will generally not want to assume the risk of his or her estate having to pay the United States a large tax on the death of the individual foreign owner.
The estate tax may not be a factor if one of the exceptions apply. For example, if the Foreign Investor is from a country with whom the United States has an Estate Tax Treaty, the U.S. estate tax may not apply to that foreign individual.
Furthermore, if the individual Foreign Investor is from a country that has its own high estate tax, then the U.S. estate tax may not be of concern because it can be credited against the Foreign Investor’s estate tax of his or her own country, so that there is no double estate tax.
However, for the most part, the individual Foreign Investor will have to rely on owning a Foreign Corporation as a holding company or as the direct owner of the U.S. real estate investment.
The problem with this solution to the U.S. estate tax by owning a Foreign Corporation is that in protecting the Foreign Investor from the U.S. estate tax, that Investor will generally have to pay a higher income tax from rental income that may be earned and on the ultimate sale of the assets because there is a higher tax on capital gains earned by corporations as opposed to individuals.
Term Life Insurance
Another alternative to having the best of both worlds from a U.S. tax standpoint is that an investor can pay United States income taxes as an individual investor or as a limited liability company while not being concerned with the effect of United States estate taxes in the event of a premature death by buying life insurance equal to the potential U.S. estate tax exposure. That alternative is for the Foreign Investor to acquire sufficient “term life insurance” that pays only a death benefit for the contemplated life of the investment. Depending upon the age of the investors, this may be an inexpensive solution.
As an example, assume an investor invests one-half of One Million Dollars in United States real estate which doubles in value and is still held by the Foreign Investor but worth One Million Dollars upon the foreign investor’s death. Assume a United States estate tax of $350,000 on the value of United States real estate. The annual cost of a $350,000 life insurance policy for say a ten year period only, of a relatively young man or woman, will not be at all prohibitive from a cost standpoint.
Income and Capital Gains Tax
With all of this in mind we can review the various options of U.S. real estate ownership by the larger Foreign Investor.
1. Individual Ownership of U.S. Real Estate.
An individual Foreign Investor may own U.S. real estate in his or her own individual name. This represents the simplest form of ownership with the least amount of paperwork involved. If it is rented out the individual owner will have to file a U.S. income tax return personally reporting the U.S. income.
This form of ownership is only chosen by a small percentage of Foreign Investors. This is for at least two reasons. The first reason is liability. The owner of U.S. real estate will be personally liable for any damages that result from that real estate. While often insurance is more than sufficient to cover such claims, most investors do not want to expose themselves personally to individual liability.
Furthermore, investors from many countries are fearful of revealing their wealth for security reasons, particularly if it is a large investment. An investor’s individual name as an owner of U.S. real estate will appear in the public records where that real estate is located.
This form of ownership does however provide the best income tax benefits. The individual investor will pay tax only on the investor’s U.S. income. Because of expenses and depreciation deductions, the Investor may only pay a tax from operations in a relatively small tax bracket.
The tax on the profit from the gain from the sale of the real estate will be only 15% to 20%.
If one does choose to own U.S. real state individually, the foreign individual investor may be subject to an estate tax in the event that investor was to die owning the U.S. real estate.
2. Limited Liability Company Ownership.
Foreign Investors may use an entity acceptable in every state in the U.S. known as a limited liability company. This type of company is treated as if it does not exist for U.S. tax purposes and therefore the tax consequences of owning a United States limited liability company that owns U.S. real estate is similar to the tax consequences described for the individual foreign investor above. A U.S. estate tax will apply to U.S. real estate owned by a limited liability company.
However, the big difference is that the limited liability company, as the name says, provides the investor with limited personal liability for losses related to the real estate investment.
What this means is that the individual foreign investor’s personal assets are not exposed to the liabilities of the investment. The limited liability company provides for the best income tax treatment and limited liability for the investor’s wealth.
3. U.S. Domestic Corporate Ownership.
The use of a United States corporation by an individual Foreign Investor who invests in the United States real estate is very limited by itself. That is because shares of stock in a United States corporation that owns U.S. real estate are also included in the foreign investor’s estate, if the foreign investor dies owning those shares. Thus ownership of a U.S. corporation to own U.S. real estate does not solve any U.S. estate tax problems. It does, however, create an extra tax burden for the foreign investor in United States real estate. That is because there will be an income tax on a United States corporation on the gain of the sale of the real estate asset that can be higher than the tax on the foreign individual investor. Unlike the tax on an individual, which is limited to 20%, the corporate tax can be as high as 35%.
There is however, one situation in which investment in United States real estate by the ownership of a United States corporation does make sense. It is as follows:
Gift of Shares
If the individual foreign investor intends to ultimately make a gift of his or her shares in a United States company that owns U.S. real estate to third parties, such as family members, etc., there will be no U.S. gift tax asserted on the gift of those shares. There would have been a U.S. gift tax had the real estate been given directly. Thus, the estate tax may be avoided with no gift tax payable if shares in a United States corporation that owns U.S. real estate are transferred prior to the foreign investor’s death.
4. The Foreign Corporation.
As a general rule, it is not a good idea for a foreign investor to use a foreign corporation that will then directly invest in U.S. real estate. This is because foreign corporations that invest in U.S. real estate can be subject not only to U.S. corporate income taxes but might also be subject to a branch tax equal to 30% of the foreign corporate investors’ undistributed U.S. profits.
A foreign corporation is, nevertheless, very often the investment vehicle of choice for a foreign investor that is investing significant amounts of money in U.S. real estate, such as $1 Million or more. This is because estate tax becomes a major potential liability for substantial fortunes invested in U.S. real estate and U.S. estate taxes may be completely avoided if the individual Foreign Investor owns a foreign corporation that may in turn own the U.S. real estate.
There are no estate taxes in this situation because when the Foreign Investor dies owning the U.S. real estate indirectly, the Foreign Investor only transfers to his or her beneficiaries, shares in the foreign corporation and there is no direct transfer of an interest in U.S. real estate.
This more complicated structure, in knowledgeable hands permits many tax planning opportunities.
U.S. estate taxes may be completely avoided if the individual Foreign Investor owns a foreign corporation that may in turn own the U.S. real estate.
5. Foreign Corporations and U.S. Corporations.
A more typical structure for a large investment in U.S. real estate is for the individual Foreign Investor to establish a 100% owned Foreign Corporation that becomes the 100% owner of a United States corporation that ultimately owns the U.S. real estate. For example, if the Foreign Investor were to establish a foreign corporation that became the 100% owner of a United States corporation that owned United States real estate, the Foreign Investor will be able to avoid any United States estate tax completely since nothing in the U.S. is transferred in the event of the death of the Foreign Investor.
The Tax Planning Opportunities
The more complicated structure of establishing a Foreign Corporation that owns a U.S. corporation that owns larger U.S. real estate investments provides several opportunities for income tax planning.
Liquidation of Company
The principal tax planning tool of the use of the Foreign Corporation that owns a U.S. corporation to own its U.S. real estate is to make sure that when the United States real estate is sold by the U.S. Corporation, that U.S. Corporation must be liquidated after the sale. In this fashion only one single U.S. tax is paid at the U.S. corporation level. The proceeds of sale may be transferred free of tax by the U.S. corporation after it has paid its U.S. tax if it is liquidated after the sale.3
Another often used tax planning tool is known as the “Portfolio Loan”. As a general rule a Foreign Corporation or a U.S. Corporation that owns U.S. real estate will be able to deduct as a business deduction all of the expenses of that ownership, which include the payment of interest on loans made to acquire the real estate. As a general rule, loans made by a Foreign Investor to his or her own Foreign Company, U.S. Company or Limited Liability Company will be deductible by the company. However, the payment of such interest to the Foreign Owner of the company may be subject to a tax as high as 30% on the gross interest paid to the investing company’s foreign shareholder.
There is, however, a major exception to this general rule provided in the Internal Revenue Code. That is that a Foreign Investor who owns less than 10% of the real estate investment will be able to receive the interest that is deductible by the Foreign Company free of any U.S. tax whatsoever. This rule does not work in the event the investor owns 10% or more of the real estate investment or the entity that owns that real estate investment.
However, it is a useful planning tool in many situations where more than one investor is involved. In those situations where a portfolio loan can be used, the U.S. taxes on the income earned from the real estate investment will be reduced for the interest expense payable to the Foreign Investor without the payment of tax on that interest.
“. . . the U.S. taxes on the income earned from the real estate investment will be reduced for the interest expense payable to the Foreign Investor…“
Portfolio Loan Sales
There is another way to take advantage of the Portfolio Loan exclusion for interest paid to Foreign Investors. This can be accomplished at the actual time of sale by a Foreign Investor of his or her U.S. investment. To understand this, it is important to keep in mind that the portfolio interest deduction and exclusion from income is only appropriate if the Foreign Investor no longer has a 10% or less interest in the property.
Therefore a Foreign Seller may wish to sell the property, not for all cash but rather for cash and the balance due in the form of a note payable by the U.S. Buyer to the Foreign Seller who no longer owns any part of the U.S. real estate. At that point the Foreign Seller will be receiving tax free interest from the note that the Foreign Seller holds as a result of the U.S. real estate and the property can be used to secure the note until its full payment. This method of converting what otherwise might be taxable sales proceeds into tax free interest income could be of significant tax value under the right circumstances.
Like Kind Exchanges
Another method used by both Foreigners and Americans alike to grow their U.S. real estate portfolios free of U.S. tax is to make use of the “Like Kind Exchange Rules”. Essentially these rules hold that an investor in U.S. real estate may exchange the U.S. real estate project that they own for a different U.S. real estate project without paying any immediate tax on any gain or profit that may be accrued in the first investment.
For example, assume a Brazilian investor owns a U.S. corporation which owns raw land that the investor purchased for $ 3 Million. Assume the raw land is now worth $6 Million and the investor wishes to terminate his investment in the raw land and instead own an income producing asset such as a shopping center. Assume the shopping center is worth $ 6 Million.
Even though the raw land has increased in the amount of $ 3 Million, none of that gain will be recognized or will it become taxable until the Corporation actually sells the real estate that it has acquired as part of the exchange. At that point the investor’s investment in the shopping center has its original cost of $3 Million and any gain over and above that would be taxable if the shopping center were later sold.
… selling shares of a foreign corporation would result in no tax whatsoever being paid by the foreign entity trust on the shares of these stock.
Sale of Stock in a Foreign Corporation
In addition, on rare occasions, it has been possible for foreign investors to sell their shares in the Foreign Corporation that owns U.S. real estate to a third party buyer. It is clearly understood that selling shares of a corporation that owns real estate, instead of the actual real estate is not typical. However, this transaction, of a foreign entity selling shares of a foreign corporation would result in no tax whatsoever being paid by the foreign entity trust on the shares of these stock. There is a market for such transaction in the U.S. in specialized cases.4
See article “Tax Planning for Foreign Investors Acquiring Smaller ($500,000 and under) United States Real Estate Investments” for a companion article on Tax Planning for Foreign Investors Acquiring Smaller United States Real Estate Investments.
In addition, several of the individual states in the U.S. charge their own separate income tax on income earned in that state.
Often one Foreign Corporation may be used as a holding company and will set up several U.S. corporations to own different projects. That way each U.S. Corporation may be liquidated on a deal by deal basis, leaving the Foreign Corporation in place.
Another estate planning tool that allows a non resident alien investor to invest in United States real estate without incurring U.S. estate tax is the use of a Non Grantor Trust. This is a devise whereby the investor purchases the U.S. real estate using a foreign trust and foreign beneficiaries, such as family members, so that trust will ultimately benefit others. This vehicle is specifically not being discussed in this article since it does involve the investor’s alienation of the property to a trust that is extremely restrictive of any powers that the investor can have over the real estate owned by the Non Grantor Trust.
Richard S, Lehman, Esq.
6018 S.W. 18th Street, Suite C-1
Boca Raton, FL 33433
Richard S. Lehman is a graduate of Georgetown Law School and obtained his Master’s degree in taxation from New York University. He has served as a law clerk to the Honorable William M. Fay, U.S. Tax Court and as Senior Attorney, Interpretative Division, Chief Counsel’s Office, Internal Revenue Service, Washington D.C. Mr. Lehman has been practicing in South Florida for more than 35 years. During Mr. Lehman’s career his tax practice has caused him to be involved in an extremely wide array of commercial transactions involving an international and domestic client base.