According to a recent survey conducted by the National Association of Realtors, for the 12-month period ending with March 2012, international buyers (“Foreign Nationals”) invested $82.5 billion in U.S. residential real estate, which equates to about 4.8% of total U.S. sales. The top-five international buyers were from the United Kingdom, India, Mexico, China and Canada for purchases in primarily Arizona, California, Florida and Texas. These homes are primarily purchased as vacation homes, for investment, or as temporary professional relocation.
This article serves as an overview for Foreign National seeking to purchase property, primarily residential real estate, in the U.S. and the structuring issues which may arise. This article is not a substitute for experienced legal counsel and Foreign Nationals should also seek tax advice both in their country of residence and in the US to address many of the issues highlighted herein. It is important for Foreign Nationals to understand both the process and unintended tax and estate planning considerations which may arise.
PURCHASING PROPERTY IN THE U.S.
Purchasing property in the U.S. can be a transparent and efficient process. Unlike in many countries where buyers must bounce from agent to agent to find a property, new listing for sale are generally required to be posted on a listing service within 24 hours so that active listings are available to all brokers and agents.
Sales commissions are always paid by the seller and are divided equally between the buyer’s and seller’s brokers. While some seller’s brokers may engage in dual representation, that is, representing both the seller and buyer in a transaction, it is always advisable for a buyer to work with an exclusive buyer’s agent who will better protect the interest of their client.
FOREIGN NATIONALS MUST CONSULT WITH A TAX SPECIALIST IN THEIR HOME COUNTRY
There are a number of differences between a Foreign National and U.S. National when Foreign Nationals purchase real estate in the U.S. A Foreign National should seek local tax advice in their primary residence, as overall tax liability may depend upon the Foreign National’s home country tax treaty with the US, if any exists. As an example, if the property was owned for more than one year, the capital gains tax rate in the U.S. is 20%, but a Foreign National could be required to pay a different rate depending on the home country’s tax treaty with the U.S. and structuring of the transaction.
ELECTION TO PAY U.S. INCOME TAXES ON NET RENTAL INCOME
The IRS requires Foreign National to elect to pay US income taxes on any net income (rental revenues less expenses) derived from a rental property. The penalty for this election not being made on a timely basis is an assessment of 30% tax on gross rental income. Moreover, an investor would not be able to deduct any expenses such as depreciation, interest, property taxes, or common area charges. Taxes must be filed even if the Foreign National is incurring tax losses in order to take advantage of the various tax deductions available.
RENTAL INCOME DEDUCTIONS
The IRS provides various opportunities for property expenses for an investment property to be deducted from rental income. Mortgage interest, common area charges, property taxes, depreciation of the asset over 27.5 years, insurance, and amortization of closing costs are all deductions against income, providing the opportunity for negative taxable income. In future years, when the investment is generating taxable income, such income may be offset by the prior year’s negative taxable income (a.k.a. tax loss carry forward), which can result in a tax-efficient investment for many years.
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.
Buying a property in the U.S. involves many competing objectives and requires responsive and effective guidance. For more information, please contact Evelyn Ginossi at 310.746.3837 or firstname.lastname@example.org.