In our last blog post, we provided many helpful tips for foreign investors. You can find that article here. Today, we’ll continue with additional information that all foreign investors must know before purchasing investment real estate in the United States.
FOREIGN INVESTMENT IN REAL ESTATE PROPERTY TAX ACT (FIRPTA)
When a Foreign National sells property in the U.S., the IRS must be paid capital gains taxes. Accordingly, the IRS will withhold 10% of the gross purchase price of the property. When a US tax return is submitted reporting the capital gains tax, if there is any refund due, the money will be refunded to seller.
CAPITAL GAINS TAX DEFERMENT VIA 1031 EXCHANGES
The US government allows Foreign National sellers to use Section 1031 of the IRS Code to defer capital gains taxes for as long as the capital gains of a property are used to purchase a subsequent investment property per Section 1031 of the IRS Code. Such a transaction requires the structuring of a “like kind exchange” as well as the use of a qualified intermediary. Rules for carrying out a 1031 Exchange are extensive and should be followed to the letter in order to benefit from this unique tax deferment opportunity.
U.S. ESTATE TAXATION
Many Foreign Nationals are not aware that ownership of a U.S. home triggers U.S. estate tax on death, and a gift of the property during lifetime triggers U.S. gift tax. U.S. estate and gift tax is imposed at a rate of 40% and an individual who is neither a U.S. citizen nor domiciled in the U.S. can shelter only $60,000 of U.S. situs assets on death (i.e. assets located or deemed to be located within the U.S.). In terms of gifting, an individual who is neither a U.S. citizen nor domiciled in the U.S. can make annual exclusion gifts of $14,000 per year to anyone and can currently pass $143,000 per year to a spouse who is not a U.S. citizen free of gift tax. This is in contrast to the $5,250,000 that a U.S. citizen or domiciliary can pass free of estate tax on death or by gift during lifetime as well as unlimited transfers to a U.S. citizen spouse.
STRUCTURING THE PURCHASE
Owner of investment real estate (foreign or US) should consider forming an LLC to hold the property (and no other assets), since using this structure limits the owner’s liability to the value of the LLC, thereby limiting the owner’s liability to the net value of the property. In addition, setting up a Foreign Corporation in which the Foreign National holds shares for the purpose of owning the LLC would provide protection to the Foreign Buyer against estate tax, since the property would be “owned” by the Foreign Corporation. This form of title has the added advantage of providing anonymity and liability protector to the shareholder. This structure would also permit the transfer of the property from one party to another by the selling of shares of the corporation rather than the sale of the property, which might otherwise trigger a taxable event.
However, owning a property in a foreign corporation triggers other more immediate tax concerns. Some of these concerns are: the application of the corporate tax rate (up to 35%) in lieu of the preferential long-term capital gains rates on sale (up to 20%); possible imputed rental income for use of corporate property by the shareholder; loss of the step-up in the income basis of the home upon the death of the owner (the basis of the stock in the corporation would be adjusted but the inside basis—the home itself would not receive a basis adjustment); and the loss of the ability to avoid a home from being reassessed for California real property tax purposes upon transfer from parent to a child.