By Anthony Diosdi
Individuals that are not domiciled in the United States are subject to an estate and gift tax on the transfers of real property physically located in the United States. U.S. estate and gift taxes are charged at high effective rates (up to 40%) in the case of nonresident aliens, because the unified credit provides an exemption amount equivalent to just $60,000, an amount that has not increased in decades. See IRC Section 2101. For U.S. federal estate and gift tax purposes, the term “residency” means “domicile.” While the U.S. federal income tax concept of residency relates only to physical presence in a place for more than a transitory period of time, domicile relates to a permanent place of abode. For U.S. federal estate tax purposes a person can only (and must have) one place of domicile.
One of the most straightforward ways to avoid exposure to estate and gift tax is to have real property held directly or indirectly through a corporation, partnership, or trust. In our experience, foreign investors rarely consider U.S. estate and gift tax consequences when acquiring U.S. real property. Once a foreign investor takes title to U.S. real estate, absent planning, a foreign investor cannot simply transfer title to real property to a corporation, partnership, or trust without triggering the wealth tax. This article will discuss one potential strategy that may be considered by foreign investors to transfer U.S. property to a corporate or partnership structure for wealth tax planning purposes.
For foreign investors or U.S. nonresidents that invest in U.S. property consideration must be given to the U.S. estate and gift tax. The U.S. estate and gift tax is assessed at a rate of 18 to 40 percent of the value of an estate or donative transfer. An individual foreign investor’s U.S. taxable estate or donative transfer is subject to the same estate tax rates and gift tax rates applicable to U.S. citizens or residents, but with a substantially lower unified credit. The current unified credit for individual foreign investors or nonresident aliens is equivalent to a $60,000 exemption, unless an applicable treaty allows a greater credit. U.S. citizens and resident individuals are provided with a far more generous unified credit from the estate and gift tax. U.S. citizens and resident individuals are permitted a unified credit of $11,700,000.
The U.S. federal estate tax applies to transfers of tangible property (real property and tangible personal property, including currency) that is situated in one of the U.S. states or District of Columbia that remains in a nonresident’s estate at the time of his or her death. The gross estate includes all U.S. situs property at either the time of the transfer or the time of death. On the other hand, U.S. federal gift tax applies only to transfers of tangible property (real property and tangible personal property, including currency) physically located in the United States at the time of the gift. It does not apply to intangible property such as stock in U.S. or foreign corporations even though such property is includible in the U.S. gross estate for federal estate tax purposes. However, a gift of money to enable a purchase of U.S. real property may be treated as a gift of realty. The gift tax rules can be confusing. So, we will provide a brief summary of the longstanding statutes, regulations, and case law that constitute the federal gift tax regime. Internal Revenue Code Section 2501(a) imposes a tax on the transfer of property by gift. The amount of a gift of property is the value of the property at the date of the gift. See IRC Section 2512(a). It is the value of the property passing from the donor that determines the amount of the gift. See Treas. Reg. Section 25.2511-2(a). “The value of the property is the price at which such property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of the relevant facts.” See Treas. Reg. Section 25.2512-1 Where property is transferred for less than adequate and full consideration in money or money’s worth, the amount of the gift is the amount by which the value of the property transferred exceeds the value of the consideration received. See IRC Section 2512. Thus, foreign investors cannot transfer their real property interest to a corporate, partnership, or trust structure (without fair market value being paid) to avoid the estate tax because of the situs rules discussed above.
Many foreign investors place their U.S. real property interests in domestic corporations because once U.S. real property is placed into a domestic corporation the interest can be freely transferred without incurring a gift tax liability. This is because shares of domestic corporate stocks are not U.S. situs for purposes of the gift tax. Domestic corporations are also often utilized as part of a larger estate tax avoidance plan. However, in most cases, once a foreign investor has taken title to U.S. real property in his or her name, absent planning, the property cannot be transferred into a corporate structure without incurring a gift tax. Below, we will discuss how a foreign investor may transfer U.S. property into a corporation.
Transferring U.S. property to a corporate structure for purposes of wealth transfer tax planning has two steps. First, the foreign investor’s interest in real estate must be valued. Valuation discounts may be available if the property is held jointly. If the property is jointly held, a “valuation discount” may be applied. For purposes of the wealth transfer tax system, a “valuation discount” is not really a discount in the sense that the foreign investor is receiving a bargain at the expense of the government. Rather, the valuation discount is an appropriate factor in determining the fair market value of an asset. In short, a valuation discount can be thought of as one or more factors that a hypothetical willing buyer would consider in determining a fair price to pay for an asset. That is, if certain factors exist that would affect the hypothetical buyer’s use and enjoyment of such an asset, the hypothetical willing buyer would demand some sort of discount to compensate him or her for purchasing such an asset. A valuation discount can be contrasted with a valuation “premium.”
This “discount” reflects the reality that a willing buyer of the property would expect some measure of price reduction for owning less than the whole property. Courts have consistently recognized fractional interest discounts, particularly with regard to real estate interests. The value of an undivided interest in property is not equivalent to the proportionate part of the value of the entire interest. Rather, the value of a fractional interest should be less than the value of the propionate part of the whole. To support such a discount with respect to real property, however, an appraisal by a qualified appraiser is necessary.
The following factors, which generally affect marketability and control of real property, are used by appraisers to support a fractional interest discount:
1. Banks generally will not lend money to the owner of a fractional interest in real property without the consent of the co-owners.
2. The historic difficulty of selling an undivided fractional interest in real property.
3. The holder of a fractional interest in real estate lacks control because he or she cannot unilaterally decide how to manage it
4. The forced sharing of control that concurrent ownership arrangements require.
Once the value of the U.S. property is valued (taking into consideration any above discussed discount rules), the foreign investor may move forward with the next step. The next step involves establishing a corporation structure. Once established, the corporation structure should be capitalized in an amount that equals or exceeds the fair market value of the foreign investor’s U.S. real property. This can be done through a capital contribution of cash, promissory notes, or both. Once the corporation is capitalized, the foreign investor may transfer his or her U.S. real property interest to the corporate structure in exchange for its corporate stock. Such a transfer may potentially avoid the gift tax. This is because the transfer of the foreign investor’s interest in real property given in exchange for corporate stock is not inconsistent with the fact that a real buyer (and, by extension, a donee) would receive an interest in a corporation.
Conclusion
Foreign investors generally have the same goals of minimizing their income tax liabilities from their U.S. real estate and business investments, as do their U.S. counterparts, although their objective is complicated by the very fact they are not U.S. persons. Foreign investors have a number of options when investing in the U.S. real estate market. As in many areas of international tax planning, one size does not fit all. A careful analysis must be done by a qualified international tax attorney to determine the best estate and gift planning for each individual foreign investor.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. As a domestic and international tax attorney, Anthony Diosdi advises both U.S. and international individuals in relation to a broad range of personal taxation and estate planning matters. He has extensive experience of advising on complex cross-border estate planning matters. Anthony Diosdi is a frequent speaker at international tax seminars. Anthony Diosdi is admitted to the California and Florida bars.
provides international tax advice to individuals, closely held entities, and publicly traded corporations. Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: 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.