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Tax Planning for Foreign Individuals That Own U.S. Real Property

Tax Planning for Foreign Individuals That Own U.S. Real Property

By Anthony Diosdi

As I have discussed in previous articles, nonresident alien domiciliaries are generally subject to U.S. estate tax on his or her U.S. situs assets. The most common example of a U.S. situs asset is U.S. real estate. In this context, it is important to remember that a nonresident alien domiciliary does not benefit from the same “Unified Credit” as a U.S. citizen or resident alien domiciliary. Instead, a nonresident alien domiciliary is only entitled to a $60,000 deduction (equivalent to a $13,000 credit). Because the value of U.S. real estate owned by a nonresident alien domiciliary almost always exceeds this $60,000 “threshold,” the estate of a nonresident alien domiciliary can be subject to a U.S. estate tax on such real estate.

In this context, many nonresident alien domiciliary’s own U.S. real estate in his or her individual name. Upon learning of the above-discussed estate tax issue, we are often asked how they can avoid or minimize their U.S. estate tax exposure on their U.S. real estate. In this regard, there are various options available for a nonresident alien domiciliary who wants to minimize his or her potential U.S. estate tax.

The first thing that each nonresident alien domiciliary typically wants to do is to transfer U.S. real estate into a newly formed foreign corporation (because the stock of a properly maintained foreign corporation is generally a non-U.S. situs asset). The initial problem with this solution is that such a transfer is taxable under the Foreign Investment in U.S. Property Tax Act of 1980, as amended. Assuming that U.S. real estate has been held by a nonresident alien domiciliary for more than one year, the federal income tax should not exceed 23.8 percent of the appreciation of the property when sold by such an individual. Nonresident alien domiciliaries are, in many cases, not willing to incur this tax “immediately” to reduce or eliminate a future estate tax assessment. The second potential problem is that the Internal Revenue Service (“IRS”) could still assess an estate tax liability on the property transferred to a foreign corporation. This is because the IRS could take the position that the U.S. real estate is includible in a nonresident alien’s U.S. estate under an ambiguous rule involving transfers of U.S. situs property with a retained interest.

In light of the above, many nonresident alien domiciliaries will purchase life insurance on his or her own life and thereby cover their potential U.S. estate tax exposure. The utilization of life insurance allows the nonresident alien domiciliary to continue to own the U.S. real estate for purposes of obtaining the beneficial capital gains tax should he or she sell the property. Insurance also reduces the U.S. estate tax exposure by using a non-U.S. situs asset (life insurance proceeds are generally not U.S. situs) to cover the U.S. estate tax.

Nevertheless, insurance is sometimes not a viable option. In this regard, other techniques might be utilized in order to minimize a nonresident alien’s exposure to the U.S. estate tax. These options include: 1) borrowing against the value of the U.S. real estate on a non-recourse basis (i.e., the value of the U.S. real estate is the only security against the debt). This has the effect of reducing the value of the U.S. real estate for U.S. estate tax purposes; 2) utilizing a jurisdiction that has an income tax treaty with the United States to implement a complex corporate structure that results in the nonresident alien domiciliary  ultimately owning the stock of a foreign corporation; or 3) formation of a structure that is taxed as a partnership for U.S. income tax purposes (possible a multiple tier structure). Although far from clear, this structure arguably results in the ownership of a foreign situs asset for purposes of the U.S. estate tax.

Needless to say, the viability of these options may ultimately be determined by reviewing the nonresident alien’s specific facts (e.g., the laws of the country in which he or she resides, his or her marital status, etc.). As such, a nonresident alien who owns U.S. real property should discuss all of the above options in detail with competent U.S. tax counsel.

Anthony Diosdi concentrates his practice on tax controversies and tax planning. Diosdi Ching & Liu, LLP represents clients in federal tax disputes and provides tax advice throughout the United States. Anthony Diosdi may be reached at 415.318.3990 or by email: Anthony Diosdi – adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.