Tax Planning for Foreign Investors Acquiring Smaller ($500,000 and under) United States Real Estate Investments
By Richard S. Lehman, ATTORNEY AT LAW
This is principally an article about tax planning for the non resident alien individual and foreign corporate investor that is planning for smaller size investments in United States real estate (“Foreign Investor”).1
As a result of 40 years of Florida real estate experiences with foreign investors that purchase condominium units, smaller homes and many other forms of U.S. real estate investments, this article also has a few practical suggestions for the Foreign Investor.
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 $500,000 or less 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.
With all of this in mind we can review the various options of U.S. real estate ownership.
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 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. An investor’s individual name as an owner of 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 and will probably 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 will 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.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. This is often the best vehicle for a smaller investor in U.S. real estate. The limited liability company provides for the best income tax treatment and limited liability for the investor’s wealth.
3. 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, however, 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, the foreign investor has only transferred to his or her heirs’ shares in the foreign corporation and there is no direct interest in U.S. real estate.
4. 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 that earns the income as a tax on the gain for the sale of the real estate asset. Unlike the tax on an individual, which is limited to 20%, this tax can be as high as 35% when earned by a United States corporation. This can also lead to double taxation when dividends are paid to a foreign investor from the United States corporation.There are however, two situations in which investment in United States real estate by the ownership of a United States corporation does make sense. They are as follows:
Gift of Shares
First, if f the foreign investor intends to ultimately make a gift of his 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 gift tax may be avoided if shares in a United States corporation are transferred prior to the foreign investor’s death. By gifting the shares the original owner will avoid the estate tax.
5. Foreign Corporation and U.S. Corporation.
Another extremely important use of a United States corporation is when it is part of a chain of corporations 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.This method of ownership is often recommended for large investments in United States real estate where the estate tax can become a major issue. It does however involve potential double taxation and other traps and tax benefits that must be individually applied.
This double tax problem can be eliminated with careful tax planning.
Term Life Insurance
There is another alternative to having the best of both worlds, which is to 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. 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.
As an example, assume an investor invests one-half of One Million Dollars in United States real estate which doubles in value and is 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 value 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.3
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 and several property appraisers to rely on.
See article “Tax Planning for Foreign Investors Acquiring Larger ($1,000,000 and over) United States Real Estate Investments” for a companion article on Tax Planning for Foreign Investors Acquiring Larger 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.
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.