THE INTERNATIONAL TAX ADVISOR by: Douglas J. Kingston, CPA/MBA • Mailing Address: 16443 N 59^th Place; Scottsdale, AZ 85254 • Telephone: +1 (602) 595-5885 (GMT-7) • E-Mail: doug@iTaxCPA.com • URL: http://www.iTaxCPA.com/
2003 TAX CHANGES PRESENT OPPORTUNITIES FOR U.K. INVESTORS IN U.S. REAL ESTATE
Background Rental Income and Expense Gain on Disposition Estate, Gift and Inheritance Taxes How Does the Tax Treaty Affect You? It is important for U.K. investors in the U.S. to review their estate plans in order to take advantage of the U.K.-U.S. tax treaty.	Background In March 2003 the U.S. and U.K. governments ratified a new income tax treaty generally effective for tax periods beginning on or after 1 January 2004. In general, a tax treaty is a written agreement between two countries providing uniform bilateral tax rules intended to avoid double taxation. Tax treaty provisions override each signatory country’s own “domestic” tax laws and may be invoked by the taxpayer if the treaty rule provides a lesser tax than the law of the taxing country. Estate and gift taxes are not dealt with in the new treaty but are instead the subject of a separate treaty in force since 1979. Separately, in May 2003, the U.S. enacted sweeping legislation significantly lowering tax rates. While U.S. tax rules applicable to foreign investors in U.S. real estate remain generally less favorable than those applicable to U.S. citizens and residents, many of the changes apply to all taxpayers. This article focuses on some of the more common U.S. and U.K. tax benefits and issues encountered by U.K. resident investors in U.S. real property. Rental Income and Expense Under U.S. domestic tax law, a foreign owner’s rental income derived from U.S. real estate is subject to a 30% withholding tax imposed on gross rents unreduced by expenses or losses. However, U.S. law provides the option of timely filing U.S. tax returns and electing “net basis” taxation at regular rates up to 35% (or alternative minimum tax “AMT” rates up to 28%). Once the election is made, it can only be changed with IRS consent, and the election applies to all of the investor’s U.S. rental activities. Allowable tax deductions include expenses related to the rental activity and straight-line depreciation computed over 27.5 years for residential real property and 39 years for commercial real property. The new U.K.-U.S. income tax treaty provides no U.S. tax relief for real estate rental income. Under U.K. domestic tax law, overseas net rental income of an individual resident and domiciled in the U.K. is subject to graduated tax at rates up to 40% (with deduction or credit for U.S. income taxes paid, whichever is more advantageous). The U.K.-U.S. income tax treaty does not exempt U.S. real estate rental income from U.K. income tax as do several other countries’ treaties with the U.S. Gain on Disposition The new U.K.-U.S. income tax treaty does not override U.S. tax rules for gains derived from disposition of U.S. real property interests. Thus, a U.K. investor’s net U.S. real property gain is subject to U.S. capital gains taxation. Taxable gain is computed based on original cost without adjustment for inflation. For dispositions after May 5, 2003, U.S.	Gain on Disposition (continued) gains tax is limited to a maximum rate of 15% for property held more than 12 months (the maximum rate is 20% for dispositions on or before that date). Gain attributable to prior depreciation is taxed at a maximum rate of 25%. Under U.K. domestic tax law, net capital gain of a U.K. resident or domiciliary (reduced by “taper relief” percentage up to 40%) is generally subject to graduated tax at rates up to 40% with credit for U.S. income taxes paid (limited to U.K. capital gains tax on the gain). Taxable gain is computed taking into account the original cost of the property adjusted for inflation. The U.K.-U.S. income treaty does not include the favorable “exemption with progression rule” found in several other countries’ treaties with the U.S. Estate, Gift and Inheritance Taxes Under U.S. domestic tax law, the value of U.S. assets of a nonresident decedent or donor is subject to tax at graduated rates up to 55% after exemption of only $US60,000 (a U.S. citizen or U.S. domiciled decedent is currently entitled to much larger exemption of $US1 million increasing to $US3.5 million by the year 2006). Since the 1988 enactment of a harsh U.S. tax law change effecting both U.S. and foreign decedents, surviving spouses who are not U.S. citizens do not benefit from the unlimited marital deduction available to U.S. citizen surviving spouses (unless a special purpose “qualified domestic trust” is used). The U.K.-U.S. estate tax treaty provides an election to use the larger exemption available to U.S. residents (i.e., $US1 million instead of $US60,000) provided the worldwide estate (not only U.S. assets) are included in calculation of U.S. tax. Unfortunately, the treaty does not provide any marital deduction relief for non-U.S. citizen surviving spouses. Under its inheritance tax law, the U.K. taxes the value of the worldwide assets transferred at death or within the prior 7 years by decedents domiciled in the U.K. at a 40% rate after a £255,000 exemption (currently about $432,000). Transfers to a surviving spouse are exempt from tax provided both spouses are domiciled in the U.K. The U.K.-U.S. estate and gift treaty does not include the favorable “exemption with progression rule” found in several other countries’ treaties, but ensures that credit will be given for U.S. estate and gift taxes imposed on transfer of U.S. real property. How Does the Tax Treaty Affect You? This article considers U.S. Federal, but not U.S. state and local income and transfer taxes. Also not discussed are alternatives for avoiding U.S. estate and gift taxes and probate by using a separate legal entity or entities to own U.S. real estate. U.K. investors in U.S. real property should be aware of these issues and plan their investments accordingly in order to reap the maximum tax savings.
Douglas J. Kingston is an Arizona certified public accountant (CPA) specializing in international tax planning and compliance for U.S., Canadian, European, Latin American and Asian business and individual clients and may be reached by: • Telephone: (602) 595-5885 • E-Mail: doug@iTaxCPA.com • URL: http://www.iTaxCPA.com/