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Background
Rental
Income and Expense
Gain on Disposition
Estate, Gift and Inheritance Taxes
How Does the Tax Treaty Affect You?
It is important for French investors in the U.S. to review their estate plans
in order to take advantage of the France-U.S. tax treaty.
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Both Australia and the U.S. impose
income and estate and gift taxes – the necessary ingredients for double
taxation of crossborder investment. In order to facilitate the significant
economic flows between the two countries, Australia and the U.S. have had
tax treaties in force for many years (income and succession tax treaties
since 1954). 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.
U.S. tax rules applicable to
foreign investors in U.S.
real estate are generally less favorable than those applicable to U.S. citizens
and residents. However, certain Australian investors are entitled to special U.S. (and
Australian) tax benefits under Australia-U.S. tax treaties. This article
focuses on some of the more common U.S. and Australian tax issues
encountered by Australia-resident individual investors in U.S. real
property. The following summary of U.S. tax rules assumes President
Bush will sign intact the tax-cut plan passed by Congress on 26-May-2001.
Rental Income and
Expense
Under U.S. domestic tax law, rental income derived
from U.S.
real property is
subject to a 30% withholding tax imposed on gross rents unreduced by expenses
or losses. However, U.S. law provides foreign investors the option of timely
filing U.S. tax returns and electing “net basis” taxation at regular rates up
to 39.6% decreasing to 37.6 % by 2004 and 35% by 2006 (or, if greater,
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 related expenses and
straight-line depreciation computed over 27.5 years for residential real
property and 39 years for commercial real property. The Australia-U.S. income
tax treaty provides no U.S.
tax relief for real property rental income.
Under Australian domestic tax
law, overseas net rental income of an individual resident and domiciled in Australia is
subject to graduated tax at rates up to 47% with credit for U.S. income
taxes paid. An Australian withholding tax liability of 10% may arise in
respect of interest paid by an Australian resident to a non-resident lender
(this includes mortgage interest paid to a U.S. lender). The Australia-U.S.
income tax treaty does not exempt U.S. real estate rental income
from Australian income tax as do several other countries’ treaties with the U.S.
Gain on Disposition
The Australia-U.S. income tax treaty does not override U.S. tax
rules for gains derived from disposition of U.S. real property interests.
Thus, an Australian investor’s net U.S. real property gain is
generally subject to U.S.
capital gains taxation under the regular tax or AMT rules. Taxable gain is
computed based on original cost without adjustment for inflation. U.S. gains
tax is limited to a maximum rate
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Gain on Disposition
(continued)
of 10%
or 20% for property held more than 12 months (gain attributable to prior
depreciation is taxed at a maximum rate of 25%). The 10% rate drops to 8% for
dispositions after 2000 for property held more than 5 years. The 20% rate
drops to 18% for dispositions after 2005 for property acquired after 2000 and
held more than 5 years (a special deemed-sale election is available for tax
year 2000 to qualify pre-2000 acquisitions for the 18% rate for post-2005
dispositions).
Under Australian domestic tax law,
capital gains tax (CGT) applies to property acquired after 19-September-1985. For assets held
at least 12 months, taxable gain is computed excluding 50% of the gain (or
taking into account the original cost of the property adjusted for inflation
to 30-September-1999
for property acquired before that date). Net gain is generally subject to a
maximum tax rate of 24.25% with credit for U.S. income taxes paid. The
Australia-U.S. income tax 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% (50% beginning 2002 gradually reduced to 45% in
2007) after exemption of only $US60,000 (by contrast
a U.S. citizen or U.S. domiciled decedent is entitled to much larger
exemption of $US675,000 increasing gradually from $US1 million in 2002 to
$US3.5 million in 2009). 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 formed). The Australia-U.S. estate tax treaty
increases the $US60,000 exemption by allowing a pro-rata portion of the
larger exemption applicable to U.S. citizens and domiciliaries
(the pro-rata portion is based on the value of the deceased Australian's U.S.
estate over his/her worldwide estate). Unfortunately, the treaty does not
provide any marital deduction relief for non-U.S. citizen surviving spouses.
For deaths after 2009, the U.S.
estate tax is repealed, a modified carryover basis applies to inherited
property for income tax purposes, and the top gift tax rate is reduced to
equal the top individual income tax rate.
Unlike the U.S., Australia
does not impose an estate tax - its “estate duty” was repealed many years
ago. Instead, Australia
imposes its CGT which applies to sales or gifts of taxable property (but
generally not to transfers at death). As a result, Australia’s estate and gift
treaties with the U.S.
are of dubious benefit with regard to directly-held U.S. real estate.
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. Australian 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.
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