Aliens are subject to U.S. income taxation on a limited basis. Unlike U.S. persons who are subject to U.S. taxation on their worldwide income, foreign investors generally are subject to U.S. taxation on two categories of income: 1) certain types of U.S. source income (e.g., interest, dividends, rents, annuities, and other types of “fixed or determinable annual or periodical income,” collectively known as FDAP income); and 2) income that is effectively connected with a U.S. trade or business (“ECI”). U.S. source FDAP is subject to a 30 percent withholding tax imposed on a gross basis (this rate may be reduced by treaties) and ECI is subject to tax on a net basis at the graduated tax rates generally applicable to U.S. taxpayers.
Many aliens have invested in the U.S. real estate market. There are special U.S. tax consequences that must be carefully considered. Investing in the U.S. real estate market often requires a balancing of U.S. federal income tax considerations on one hand, and U.S. federal gift and estate tax on the other. While U.S. federal income tax rates on the taxable income of an individual foreign investor are the same as those applicable to a U.S. citizen or resident, the federal estate and gift tax as applied to foreign investors can result in a dramatically higher burden on a taxable U.S. estate or gift transfer than for a U.S. citizen or resident.
The gross estate (all the U.S. property which the decedent had an interest in at the time of death) of a non-resident foreign investor is taxed from 18 percent to 40 percent of the value of the estate in excess of a $60,000 exemption. As a result, for many foreign investors, the most important U.S. federal tax consideration is U.S. federal estate and gift taxation. At Diosdi Ching & Liu, LLP, we carefully analyze each client’s situation to determine the best plan to mitigate the investor’s situation to determine the best plan to mitigate the individual’s exposure to U.S. taxes. We begin with how the foreign investor intends to hold the U.S. real property.
The foreign investor has a number of choices regarding the entity with which to invest in the U.S. They include:
1. Direct investment in the investor’s name.
2. The investor may incorporate a domestic corporation and invest through it.
3. The investor may incorporate in a foreign jurisdiction and cause the foreign corporation to make the investment.
4. The investor may form a partnership or limited liability company which in turn makes the investment.
5. The investor may make investment through a trust, either foreign or domestic.
A non-resident alien is perfectly free to own U.S. real estate. From a tax standpoint, there are no income tax prohibitions to ownership of U.S. real estate by a foreign individual. Most sophisticated foreign investors, however, have not held property in their own names because that approach does not allow anonymity and, more importantly, subjects the foreigner’s estate to U.S. estate tax and probate upon the owner’s death. Individual ownership also does not allow much in the way of effective tax planning.
Corporate ownership of real estate by a foreign investor continues to be the most preferred (but not necessarily the best) method of holding title to real estate. Once the determination has been made to invest through a corporation, the question arises as to whether the corporation should be domestic or foreign. If the corporation is foreign, the investor can potentially avoid U.S. estate tax, but the corporation may be subject to U.S. branch profits taxes, which may be steep.
Limited Liability Company Investment
All states and a number of foreign jurisdictions have adopted legislation authorizing limited liability companies. Limited liability companies present a combination of both corporate and partnership law. While a limited liability company may have appealing business characteristics, for tax purposes, limited liability companies are typically treated as disregarded entities. This means that for tax purposes, real estate held by a foreign investor through a limited liability company will be treated as if it were directly held by the investor. Even though holding real estate through a single limited liability company is not advisable for tax purposes, utilizing multi-tier limited liability structures can be very attractive as an investment vehicle.
Investing Through a Trust
A foreign grantor trust is usually not a good choice to own U.S. real estate because it exposes the real estate asset to the estate tax in the event of the foreign investor’s death. A grantor trust exists when a foreign investor either has the sole right to revoke a trust which holds real estate, or the income from the trust is distributable only to the foreign investor or the foreign investor’s spouse. When the trust that holds the real estate is a foreign grantor trust, it is deemed part of the foreign investor’s estate. On the other hand, a foreign trust that is not taxed as a grantor trust is taxed as an irrevocable trust. A foreign investor may find the use of an irrevocable trust valuable for estate tax purposes since one of the main drawbacks for an individual investing in U.S. real estate is the estate tax risk.
At Diosdi Ching & Liu, LLP, we carefully consider the best vehicle to real property to mitigate U.S. income tax and estate and gift tax. We not only advise foreign investors of their options to holding title to real property, we also assist foreign investors in establishing these vehicles.
U.S. Tax Planning to Minimize Income Tax Gains for Foreigner’s Investing in U.S. Real Property
Foreign investors considering investing in the U.S. real estate market should understand that appreciation of the property is subject to U.S. capital gains taxes. At Diosdi Ching & Liu, LLP, we advise foreign investors of their options to mitigate U.S. capital gains on U.S. real property. Foreign investors may reduce their exposure to U.S. capital gains through the contingent interest rules. Foreign persons typically are not subject to U.S. source capital gains unless those gains are effectively connected to a U.S. trade or business. Internal Revenue Code Section 897, however, treats any gains recognized by a foreign person on the disposition of U.S. real property interest (“USRPI”) as if it were effectively connected to a U.S. trade or business. A USRPI is broadly defined as: 1) a direct interest in real property located in the U.S.; and 2) an interest (other than an interest solely as a creditor) in any U.S. corporation holding real property (i.e., a corporation whose USRPIs make up at least 50 percent of the total value of the corporation’s real property interests and business assets).
The Income Tax Regulations under Section 897 elaborate on the phrase “an interest other than an interest solely as a creditor” by stating it includes “any direct or indirect right to share in the appreciation in the value, or in the gross or net proceeds or profits generated by, the real property.” The regulations go on to state that a “loan to an individual or entity under the terms of which a holder of the indebtedness has any direct or indirect right to share in appreciation in value of, or in gross or net proceeds or profits generated by, an interest in real property of the debtor is, in its entirety, an interest in real property other than solely as a credit.”
This principal is illustrated by an example in Income Tax Regulation Section 1.897-1(d)(2)(i): A non-U.S. taxpayer lends money to a U.S. resident to use in purchasing a condominium. The non-resident lender is entitled to receive 13 percent annual interest for the first ten years of the loan and 35 percent of any appreciation in the fair market value of the condominium at the end of the ten-year period. The example concludes that, because the lender has a right to share in the appreciation of the value of the condominium, he has an interest other than solely as a creditor in the condominium (i.e., a USRPI). Accordingly, a debt instrument with contingent interest that is tied to U.S. real estate (otherwise known as a shared appreciation mortgage) is a USRPI for purposes of Internal Revenue Code Section 897.
Income Tax Regulation Section 1.897-1(h) Example 2 illustrates a significant planning opportunity for non-U.S. investors investing in U.S. real estate. In the example, a foreign corporation lends $1 million to a domestic individual, secured by a mortgage on residential real property purchased with the loans proceeds. Under the loan agreement, the foreign corporate lender will receive fixed monthly payments from the domestic borrower, constituting repayment of principal plus interest at a fixed rate, and a percentage of the appreciation in the value of the real property at the time the loan is retired.
The example states that, because of the foreign lender’s right to share in the appreciation in the value of the real property, the debt obligation given the foreign lender is an interest in the real property “other than solely as a creditor.” Nevertheless, the example concludes that Section 897 will not apply to a foreign lender on receipt of either the monthly or the final payments because these payments are considered solely of principal and interest for U.S. income tax purposes.
By characterizing the contingent payment on a debt instrument as interest for U.S. income tax purposes, the Section 897 regulations potentially allow foreign investors to ability to avoid U.S. income tax on gains arising from the sale of U.S. real estate. If you are a citizen of a country other than the United States and are considering investing in U.S. real estate or holding U.S. real estate as an investment, call the international tax attorneys at Diosdi Ching & Liu, LLP to determine if a strategy can be developed on your behalf to reduce your exposure to U.S. capital gains associated with the increase in value of the real property that you are either considering acquiring or that you have already acquired.
U.S. Tax Planning for Direct Non-Real Estate Investment for Foreigners
Foreigners investing in U.S. businesses and other investments, must be mindful of the tax consequences of investing in the U.S. For example, foreigners investing in the United States can be subject to U.S. estate and gift taxes and branch profits taxes. Foreigners investing in the United States typically utilize a U.S. corporation as a base vehicle of choice for investing in the United States. The objective is to maximize the value of the interest deduction, which requires an analysis of the effective tax rates in both U.S. and the effective tax rates in both the U.S. and the country where the investment originates.
At Diosdi Ching & Liu, LLP, we understand the complex rules governing utilizing financing to acquire a U.S. business or start-up a U.S. business. If you are foreign investor looking to acquire a U.S. business or start a U.S. business, contact the international tax attorneys at Diosdi Ching & Liu, LLP.