US Real Estate Investment By Foreigners: Ownership Options

One advantage of a depressed US real estate market for wealthy individuals is the plethora of deals to be found.  For the real estate investor, or even for the wealthy individual looking for deals on a vacation home, both US federal income tax and US federal estate tax consequences of each form of ownership options should be considered.  This article assumes that the non-US persons discussed are non-residents for both US federal estate tax and for US federal income tax purposes. This article summarises some available structures for ownership of US real estate for the foreign investor.

Direct Ownership

Direct ownership is the least complicated form of ownership. It also avoids the cost of establishing other ownership structures as well as certain taxes associated with those structures, as discussed more fully below.  However, many non-US persons (‘NRAs’) walk headlong into a US federal estate tax liability by owning US real estate in their own name.  Most US people are unaware of the applicability of the US federal estate tax, so it is not surprising that NRAs often miss this tax consequence as well when purchasing US real estate. 

If an NRA dies owning property situated in the US, that property is subject to the US federal estate tax. US citizens and US residents receive an exemption amount of US$5,000,000 against the US federal estate tax,[1] however, NRAs are only afforded a US$13,000 unified credit against the tax.[2] This means that almost every NRA owning US real estate, regardless of the low value of said real estate, is exposed to the US federal estate tax.  The NRA can expect to pay a 35 per cent rate of US federal estate tax on US real estate, absent any tax treaty.[3]

The reality is that many NRAs purchase real estate in their own name without first obtaining any legal advice, so another way to offset the US federal estate tax is to obtain a life insurance policy that will cover the projected US federal estate tax burden. Life insurance proceeds are not considered to be part of the gross estate for US federal estate tax purposes for an NRA.[4]

If the property is a rental property, any rent the owner collects will be subject to a tax rate of 30 per cent.[5] If the owner uses a property management company or other entity to collect those rents, they must withhold that 30 per cent tax rate on the rents collected.[6]  

However, even if the property is not income-producing, there are still US income tax consequences for NRA owners.  The sale of the real estate, since it is considered a capital asset,[7] will trigger capital gains tax[8] at a long-term rate (for assets held longer than one year) of 15 per cent.[9] NRAs are also subject to the Foreign Investment in Real Property Tax Act (FIRPTA) upon the sale of the home. Under FIRPTA, the buyer of the home must withhold 10 per cent of the amount realised[10] by the sale.[11] FIRPTA serves a withholding in advanced on the taxes that will ultimately be due from the sale of the home. Therefore, if the owner owes more in taxes than the FIRPTA withholding, the 10 per cent will be credited to the total amount owed. Likewise, if the owner overpaid, a refund from the balance of the FIRPTA withholding is due.[12]

Foreign Corporation 

For those looking to avoid the US estate tax on real estate, an NRA could establish a foreign corporation and purchase the real estate through the corporation, rather than in the NRA’s individual name. Ownership through a foreign corporation has the advantage of avoiding the US federal estate tax. Shares of the foreign corporation are not considered to be situated in the US and only US situs property is subject to US federal estate tax for NRAs.[13]

From a US federal income tax perspective, however, foreign corporations are subject to US corporate income taxes on income generated in the US. This means that if the real estate produces rental income, the income is taxed at a rate between 15-35 per cent.[14] In addition to the regular corporate tax, the foreign corporation would be subject to the branch profits tax. The branch profits tax is an additional tax placed on all profits remaining after the expenses of a foreign corporation have been paid.  The rate of the branch profits tax is 30 per cent.[15] To illustrate, if after all rental expenses were paid, there was US$100 dollars in profit left, the profit would be taxable at a US federal income tax rate of 15 per cent. The US federal income tax owed would be US$15 leaving an US$85 profit. However, this US$85 profit would be subject to the 30 per cent branch profits tax. The additional tax owed totals US$25.50, leaving the owner with a total profit of US$59.50.

For the NRA real estate investor who is looking for a vacation property only, the use of a foreign corporation can provide excellent benefits.  A foreign corporation will avoid the US estate tax.  US income tax and branch profits tax will be avoided, since the property will not produce any rental income.  However, the trigger of capital gain upon the sale of the property is still a consideration.  A foreign corporation is subject to FIRPTA withholding of 35 per cent of the gain it recognises on distribution to its shareholders.[16]

US Corporation

An NRA might consider the use of a US corporation to purchase US real estate.  However, shares of stock in a US corporation are considered situated in the US and therefore, subject to the US federal estate tax in a NRA’s estate.[17] Use of a US corporation, therefore will not provide any avoidance of the US estate tax upon the death of the NRA and the result is the same as in direct ownership.

From a US income tax perspective, a US corporation will be subject to regular corporate income tax rates ranging from 15-35 per cent on the property’s rental income, which is a similar result to real estate held in a foreign corporation.  However, one important difference between the US corporation and the foreign corporation holding US real estate, is that the US corporation is not subject to the branch profits tax.  The US corporation will be subject to FIRPTA withholding, which is similar to a foreign corporation as well, however, the US corporation is subject to a withholding rate of only 10 per cent, rather than the foreign corporation’s 35 per cent withholding rate.[18]

US Corporation owned by Foreign Corporation 

There is a way to combine the benefits of a foreign corporation and the benefits of a US corporation by using a foreign corporation to own the real estate and then using a US corporation to own the foreign corporation.  If an NRA uses this structure, the value of the real estate will escape US federal estate tax.  The NRA, upon death, will own shares of a foreign corporation, rather than the real estate directly, and since foreign shares are not US situs assets, no US federal estate tax applies.[19] 

From an income tax standpoint, the US corporation must pay US federal income taxes on any rental income.  As discussed above, these rates range from 15 per cent to 35 per cent.  However, the avoidance of the branch profits tax is maintained, since branch profits tax applies to foreign corporations only and the income generated by the real estate is produced within the US corporation.  This option provides the unique combination of avoiding both the US federal estate tax and the branch profits tax while maintaining the same income tax rates on any rental income. 

Partnership 

The use of a partnership to own a home can be problematic because of some legal uncertainties. There are two schools of thought when analysing the treatment of a partnership interest.  The first is the ‘entity theory’ where the partnership interest is treated as a distinct entity that is separate from the individuals forming the entity.  The second is the ‘aggregate theory’, which treats the partnership interest as a collection of underlying assets and businesses that are not separated from the individuals involved in their management.[20]

Under the entity theory, an NRA’s interest in the partnership would be viewed as owning intangible property.[21] However, under the aggregate theory, the nonresident alien will be viewed as owning a portion of all of the assets held by the partnership directly.[22]  The US federal estate tax implications of these divergent views make it unclear how a partnership interest would be treated at the death of an NRA. 

If a partnership is engaged in business in the US, then the partnership is liable for a withholding tax on the foreign partners' share of income effectively connected to that US business.[23] The partnership has to withhold US federal income tax at the highest rate allowed for the individual on the foreign partner’s portion of the effectively connected taxable income.[24] 

If a foreign partnership is not engaged in business in the US, it will be subject to withholding on any rents collected from the property at a rate of 30 per cent.[25]  If the owner uses a property management company or other entity to collect those rents, they must withhold that 30 per cent tax rate on the rents collected.[26] The foreign partnership will also be subject to FIRPTA, as discussed above.

Due to the uncertainty in the application of the law for partnerships that hold real estate in the US, use of a partnership should be given extra careful consideration to determine if the tax consequences can really be determined.

Conclusion

The ownership structures available to NRAs have varied tax advantages and disadvantages and the intended use of the real property will determine which option is best for a NRA.  Factors such as use of the real estate as a rental property versus a personal residence may be key in determining the best choice of ownership structure.  The time and expense of creating and maintaining a particular structure, the value of the property and any corresponding federal estate tax liability, as well as the extent of rental income and any resulting US income tax liability, are all factors to consider.  As a result, no one method is a standard option for a NRA considering the purchase of US real estate and all relevant factors must be considered in order to determine the best structure. 

[1] I.R.C. § 2010(c)(3)(A)

[2] I.R.C. § 2012(b)(1)

[3] I.R.C. § 2001(c)

[4] I.R.C. § 2042

[5] I.R.C. § 871

[6] I.R.C. § 1441

[7] I.R.C. §1221(a)

[8] I.R.C. § 897(a)

[9] I.R.C. §  1(h)(1)(C)

[10] The amount realised is the sum of:  (i) The cash paid, or to be paid, (ii) The fair market value of other property transferred, or to be transferred, and (iii) The outstanding amount of any liability assumed by the transferee. Treas. Reg. § 1.1445-1(g)(5)

[11] Treas. Reg. § 1.1445-1

[12] Treas. Reg. § 1.1445-1(f)(1)

[13] Treas. Reg. § 20.2105-1(f)

[14] I.R.C. § 11(b)

[15] I.R.C. § 884

[16] I.R.C. § 1445(e)

[17] I.R.C. § 2104

[18] I.R.C. § 1445(e)

[19] Treas. Reg. § 20.2105-1(f)

[20] See, Cassell, Karlin, McCaffrey, and Streng, US Estate Planning for Nonresident Aliens Who Own Partnership Interests, 99 Tax Notes 1683 (2003).

[21] See, Blodgett v. Silberman, 277 US 1, 11 (US 1928) (holding that a partnership interest for a deceased partner to be considered an intangible asset).

[22] Sanchez v. Bowers, 70 F.2d 715 (2d Cir. N.Y. 1934)

[23] I.R.C. § 1446

[24] I.R.C. § 1446(b)

[25] I.R.C. § 1441, I.R.C. § 871

[26] I.R.C. § 1441