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Background
Direct
Ownership by Nonresident Individual
Indirect Ownership Through a U.S. Corporation
Ownership Through a Foreign Corporation
Ownership Through a U.S. or Foreign Partnership
Conclusion
It is important for foreign investors to plan their investment in U.S. real
estate carefully because U.S.
taxation varies significantly depending on the type of ownership structure.
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The following is a brief comparison of U.S. Federal
income, estate and gift tax consequences to foreigners owning U.S. real property
directly or through a legal entity.
Direct Ownership by Nonresident Individual
Two separate taxing regimes apply for nonresident
investors depending on whether their U.S. rental income is considered
to be passive or active. Passive rental
income is taxed at a flat 30% tax rate applied on a “gross income basis”
(without allowance for deductions). Active
rental income is subject to graduated tax rates up to 35% applied on a “net
income basis” (with allowance for deductions) if tax returns are timely filed.
Both categories of U.S.
rental income are subject to 30% U.S. Federal tax withholding at source. A passive investor may elect to be taxed
like an active investor under the net income regime provided the foreign
investor files U.S. tax
returns and pays taxes as a U.S.
person. However, there are many
important differences. For example, a
nonresident may not elect to capitalize carrying charges (such as real estate
tax and interest) if the property is not income producing. Also, as detailed
in a prior article, withholding tax of 10% is imposed on sales proceeds upon disposition
of a U.S.
real property interest.
For U.S. estate and gift tax purposes, the $2 million
exemption (increasing to $3.5 million by the year 2009) available for U.S.
citizens and residents is limited to only $60,000 for nonresidents (although
some tax treaties provide a larger exemption based on the ratio of their U.S.
over worldwide values).
Indirect Ownership Through a U.S. Corporation
A savvy foreign investor may choose to own U.S. real estate through a U.S. corporation. In this situation, the corporation is
taxable on U.S.
rental income (and capital gains) at graduated rates up to 39% on a net
income basis. Flow-through treatment afforded
Subchapter S corporation shareholders is not available to a nonresident shareholder;
in fact, the existence of a nonresident shareholder will invalidate “S”
status for all shareholders.
Profits distributed to a foreign investor as dividends are
subject to a flat 30% tax (unless the rate is reduced under an applicable
income tax treaty). This additional level of tax raises the maximum effective
corporate tax rate from 39% to 57.3%.
Because profits repatriated as dividends are not tax-deductible to the
corporation, it is preferable to use debt financing which results in interest
deductions in computing the corporation’s taxable income. However, the U.S.
imposes special rules that limit the deductibility of interest expense where
the interest recipient is not subject to full-rate U.S. tax and a related person
either makes or guarantees the loan.
Such interest is fully deductible if the corporation maintains a
debt-to-equity ratio no greater than 1.5-to-1.
Sale of shares in a U.S. corporation is subject to U.S. capital gains tax, with 10% source
withholding, if at least 50% of the U.S.
corporation’s assets consist of U.S. real property interests any
time during 5 prior years.
Transfer of a nonresident’s U.S.
corporate shares at death is taxable for U.S. estate tax purposes (subject
to any available tax treaty exemption), although an intervivos
gift of such shares may be exempt.
Ownership Through a Foreign Corporation
A foreign corporation’s U.S. real property income is
taxed according to rules essentially the same as those applied to nonresident
individuals, except capital gains and rental income are taxed at graduated
rates up to 38% plus an additional “branch profits tax” (BPT).
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Ownership
Through a Foreign Corporation (cont’d)
The BPT is a flat 30% (or lower treaty rate) tax applied
to the foreign corporation’s after-tax U.S. earnings not reinvested in
acceptable U.S. business assets, thus raising the maximum effective corporate
tax rate from 39% to 57.3%. The
legislative purpose of this tax is to equalize treatment of foreign
corporations with U.S.
corporations; however, the important difference is that the branch profits tax
applies whether or not profits are actually distributed. Special anti-avoidance rules impose the
requirement that interest attributable to the U.S.
activity paid to a foreign lender is subject to 30% U.S. tax. Because the branch profits tax is based on
a different measure of earnings, the tax can apply in situations where the
entity is operating at a taxable loss.
Many U.S. income
tax treaties modify application of the branch profits tax, but not for
foreign investors engaging in “treaty shopping” (i.e., taking advantage of a
third-country treaty with the U.S.). In situations where the branch profits tax
is prohibited by an applicable treaty, the U.S. imposes a flat 30% (or lower
treaty rate) tax on dividends paid by the foreign corporation.
A nonresident’s sale of shares in a foreign corporation is
not subject to U.S.
capital gains tax. Similarly, U.S.
estate or gift tax does not apply for transfer of shares in a foreign
corporation at death or by gift.
Ownership Through a U.S. or Foreign Partnership (including LLC’s treated as partnerships)
A foreign partner’s share of U.S.
real property income or gain earned through a U.S. or foreign partnership is
generally taxed as if earned directly by the partner. For example, a foreign partner’s share of
passive U.S. income is taxed at a flat 30% rate (or lower treaty rate based
on the partner’s country of residence) on a gross income basis, and his or
her share of active U.S. rental income or real property gain is taxed at
graduated rates on a net basis provided the foreign partner makes a net basis
election on a timely filed U.S. tax return.
The U.S.
seeks to enforce this result by requiring the partnership to withhold the
required tax. The required withholding
is generally computed at the highest applicable rate (35% for individual, and
35% for corporate, foreign partners) and must be paid by the partnership (in
quarterly installments) whether or not profits are actually distributed.
Sale of an interest in a partnership owning U.S. real
property is treated as sale of the U.S. real property itself and thus subject
to U.S. at-source withholding and capital gains tax.
Although there is uncertainty concerning the U.S. estate and gift taxation upon transfer of
a partnership interest, it is likely that U.S.
tax authorities will seek to tax the value of U.S. real estate held through the
partnership.
Ownership through a corporation (U.S. or foreign) generally incurs
a double tax on remitted earnings not imposed on an individual investor
owning real estate directly or through a partnership. However, for foreign investors the income
tax disadvantage of corporate ownership must be compared with the estate and
gift tax advantage of U.S.
tax-free transferability associated with that form of ownership.
Foreign investors are best advised to carefully consider
the significantly different tax consequences of owning U.S. real estate directly or
through a legal entity prior to making the acquisition.
Not discussed in this article are equally important foreign
country and U.S.
state and local tax considerations, nor is there a discussion of the various
U.S. Federal tax deferral techniques available to foreign investors (such as
like-kind exchanges and installment sales).
Foreign investors are typically concerned with U.S. information reporting rules
not discussed in this article, and planning in this area should also consider
the relative costs associated with forming and maintaining legal entities.
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