When planning to acquire U.S. real estate, foreign individuals have a number of ownership alternatives to consider, each of which offers its own advantages and disadvantages. Following is a brief summary of the most common options, along with other items a foreign investor should consider when evaluating the most advantageous method for holding U.S. property title.
Foreign individuals considering an investment in U.S. real estate should assess a number of important factors including risk, economic impacts, and the income tax consequences in both the United States and their own home country. Here we will briefly examine the four most common ownership options for those acquiring U.S. real estate:
- Direct ownership by foreign individual
- Investment in U.S. real estate via U.S LLC (limited liability company)
- Investment in U.S. real estate via foreign corporation
- Investment in U.S. real estate via foreign corporation and U.S. corporation or LLC
Direct Ownership by Foreign Individual
There are several U.S. tax considerations for a foreign investor who owns rental property in the United States:
- If the foreign owner uses that property for personal purposes for more than the greater of 14 days or 10 percent of the annual number of days rented (at fair rental value), the deductions allowed for income tax purposes are substantially limited. When the owner of U.S. rental property (e.g., rental of vacation home) uses that property in excess of these prescribed limits, the general rule is that tax deductions to be claimed will be substantially limited — generally no more than the income from the property. In other words, the owner cannot write off tax losses for U.S. income tax purposes.
- One of the major benefits gained from owning the real estate directly: the foreign person is generally entitled to the more favorable U.S. federal capital gains tax rates at the time of sale. For 2010, the U.S. federal capital gains rate is 15 percent. Depending on the length of time the property is held, a portion of the capital gain may be taxed at a higher rate in connection with gains realized that are related to depreciation deductions. Each U.S. state will impose its own rates on capital gains. Of course, in evaluating the U.S. taxes on capital gains, the foreign investor must also consider the impact of the income taxes in his or her home country.
- The foreign individual will be required to file U.S. federal and state individual income tax returns for each year of ownership, whether or not he actually has an income tax liability. In order to preserve any deductions for which the owner is entitled (including loss carryforwards), a U.S. income tax return filing is required each year. Alternatively, that individual could lose all deductions and be assessed income taxes based on the gross income received.
- Direct ownership of U.S. real estate generally results in that property being reportable and taxable for U.S. estate tax purposes. Furthermore, a foreign individual is not eligible for the more generous estate tax filing exemptions available to U.S. residents. In general, the foreign person’s exempt amount is significantly lower than what is permitted for U.S. residents. In the case of a foreign decedent, all of the U.S. estate is subject to regular estate tax rates unless there is a tax treaty between the U.S and the home country of the foreign owner that effectively lowers the estate tax.
Transfers of U.S.-owned real estate will frequently result in U.S. withholding tax on the transfer price.
Investment in U.S. real estate via U.S LLC
Most of the issues associated with direct ownership also apply when a foreign individual owns U.S. real estate through a U.S. LLC. Following are some additional issues to consider:
- Ownership through a U.S. LLC gives the individual “limited liability” on the same general basis as a corporation. This is one of the main advantages of using the U.S. LLC.
- The U.S. income tax treatment of a U.S. LLC is as a partnership (if there is more than one owner) or disregarded entity (if there is only one owner). The foreign individual’s home country income tax treatment of the U.S. LLC, however, varies from country to country. Many foreign countries treat the U.S. LLC as a corporation, which often results in a mismatch of income taxation between that foreign country and the United States in any given year.
- The same U.S. income tax reporting and U.S. estate tax issues apply to the individual investor.
- A transfer of the ownership interest in the U.S. LLC will result in the same U.S. withholding tax under U.S. FIRPTA rules as a transfer of a direct interest.
- Both the individual and the U.S. LLC must file annual U.S. income tax returns.
Investment in U.S. real estate via foreign corporation
In this case, the U.S. income tax filing responsibilities fall to the foreign corporate entity. Following are some important considerations when using the foreign corporation as the vehicle for investment:
- The foreign corporation will not be entitled to the favorable U.S. capital gain rates (one of the principal disadvantages of this option).
- The foreign corporation will prevent the foreign individual from being liable for the U.S. estate tax (one of the principal advantages).
- The foreign corporation provides the owner with limited liability (another significant advantage).
- A sale of the foreign corporation’s shares will generally be taxable in the United States due to its classification as a U.S. Real Property Holding Company (USRPHC). A sale of shares in a USRPHC will also be subject to U.S. withholding tax. Furthermore, a sale of the foreign corporation to a U.S. buyer would not likely be an alternative and the foreign corporation would first need to sell the real estate and then liquidate the corporation.
The foreign corporation, in most cases, should be incorporated in the same country as the owner/investor.
Investment in U.S. real estate via foreign corporation and U.S. corporation or LLC
Why might one consider a double-entity approach to the U.S. investment? Frequently, when a foreign person is planning to invest in a large U.S. real estate fund, the fund has already decided that the U.S. structure is going to be the U.S. LLC. In that case, the foreign investor might decide to avoid risks associated with the U.S. estate tax compliance and/or the personal income tax filing requirements. In such cases, foreign investors often establish their own foreign corporation to own the U.S. real estate — thus giving up the potentially favorable U.S. capital gain rates in order to eliminate the U.S. estate tax issues.
A withholding tax is imposed on the transfer of U.S. real estate by a non-resident alien generally equal to 10 percent of the fair market value at the time of transfer, regardless of the amount of gain. Although the tax is referred to as a “withholding tax” the non-resident must still file a U.S. income tax return and determine the correct amount of income tax on the gain, if any. If the withholding exceeds the actual tax, a refund is paid to the taxpayer. A reduced rate withholding certificate can be obtained when the 10 percent withholding is expected to substantially exceed the actual tax liability; however, this certificate should be requested well in advance of the closing of the transaction.
In general, this withholding tax applies to any foreign individual or corporation that transfers an ownership interest in U.S. real estate. In some cases, this can also include an indirect transfer where it involves the transfer of a U.S. corporation that holds 50 percent or more of its assets as U.S. real estate interests.
There are numerous options for structuring an investment in U.S. real estate. Determining the appropriate structure is very specific and depends on the goals, objectives and income tax situation of the particular foreign investor. To choose the most appropriate alternative, the foreign investor must consider a variety of factors, including:
- The filing of personal annual income tax returns;
- The U.S. capital gain tax rate;
- U.S. estate tax; and
- Administrative costs of multiple entities.