Tax Considerations for Foreign Investors in U.S. Real EstateDecember 08, 2017
If you are thinking about investing in U.S. real estate, you must conduct careful legal and tax planning. One thing you need to review is the ownership structure that you’re using to hold your real estate.
According to the reports of several media outlets, the United States experienced a 49% increase in foreign investment in real estate in the past year. This includes purchases by foreign buyers and recent immigrants.
While interest in investment in U.S. is strong, U.S. taxation is quite complex especially when it comes to foreign investors and real estate. Hence, if you are considering investing in U.S. real estate or already an owner, ensure that this process is accompanied by initial careful legal and tax planning. While we cannot get into detailed overview of the entire lifecycle of real estate investment, we would like to touch upon several major considerations that will dramatically impact the outcome.
Step by step considerations
1. First, you should carefully consider the ownership structure. The common investment structures that are used to hold real estate include:
- Direct ownership by individual foreign investor;
- Ownership through a U.S. Corporation;
- Ownership through a foreign Corporation;
- Foreign Corporation owning a U.S. Corporation; or
- Utilization of Non-Grantor Foreign Trust.
Each of these models has its own nuances that present benefits and detriments to the investors. While some aspects might be appealing to one investor, they might be deterring to another. Thorough consideration of the investors’ overall objectives should be the starting point.
2. The next step in the process would be to determine whether this property is to be used by the investor for personal benefit, such as a vacation home, or to generate income. For example, if the choice of ownership is a corporation, and the property is to be used by the officer/shareholder, this may create taxable income to this officer/shareholder without any corresponding deduction.
If the property is to be used as income generating activity, it will be important to identify the type of business activity and income the company will be generating. It could be interest, rents, royalties, dividends or other income. The taxation of income generated could differ depending on the type and character.
The United States has two fundamentally different approaches of taxing income of foreign persons.
- On one hand, income can be effectively connected with the conduct of U.S. trade or business. In this case, foreign persons are taxed on the amount of effectively connected income net of deductions allocable to such income. It is then taxed using the regular tax rates that apply to U.S. persons.
- On the other hand, income can be Fixed, Determinable, Annual or Periodic (‘FDAP’). Generally, income from U.S. sources that constitute interest, dividends, rents, royalties are FDAP income, and are taxed at a flat rate of 30% on the gross amount of income with no deduction. Reduced withholding tax rates may apply under the applicable income tax treaty between the U.S. and the country of residency.
- In case of rental income; however, even if it is not considered effectively connected, the investor may elect to have it taxed on net basis, in order to offset this income with allocable expenses, such as interest, taxes, insurance, repairs, and so on.
Foreign taxpayers generally have to file a U.S. tax return with respect to income taxes related to U.S. real estate. They may also be required to pay quarterly estimated taxes on income and gains. There will also be a state/municipal filing requirement with the State where property is located. The tax return is required to be filed in order to make an election to be taxed on net basis.
3. Another step to consider when planning the ownership structure is disposition of the property or dissolution. It is important to understand what happens when the property is to be sold, or company to be dissolved. Prior to 1981, foreign persons were often exempt from U.S. tax on sale of U.S. real estate. However, in 1980, Congress passed what is called Foreign Investment in Real Property Tax Act of 1980 (‘FIRPTA’) to curb the preferential treatment and imposing income tax on foreign persons disposing of United State real property interests.
Thus, when you sell, the buyers of U.S. real property interests are required to withhold 15% (10% for personal residences valued under $1m) of the full sales price on any purchase of the U.S. real property interest from a foreign person. There are certain exemptions available to the seller. If the seller is (1) exempt from U.S. tax or non-recognition treatment applies, (2) seller’s maximum tax liability is less than the tax required to be withheld, or (3) special installment sales rules apply, the IRS can issue withholding certificate that allows for the reduced withholding rate.
In this article, we touched upon the inception/purchase, income generation, and disposition of U.S. real property. By no means, aspects of real estate taxation mentioned above are all inclusive. While there is no best answer for every situation, with thorough planning, you can find the ownership structure that best suits you. Reach out to us for more guidance.