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/
U.S. TAXATION OF FOREIGN-OWNED REAL ESTATE VARIES BY OWNERSHIP STRUCTURE
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.	Background 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. Active rental income (otherwise known as “income effectively connected with a U.S. trade or business”) 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. Passive rental income (otherwise known as “fixed or determinable annual or periodic income”) is taxed at a flat 30% tax rate applied on a “gross income basis” (without allowance for deductions). 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 by a foreign investor. For U.S. estate tax purposes, the $5 million exemption (for deaths during 2010 through 2012) available for U.S. citizen and resident decedents is limited to only $60,000 for nonresident decedents (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 35% 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 35% to 54.5%. 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 on gross sales proceeds) 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 35% plus an additional “branch profits tax” (BPT).	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 35% to 54.5%. 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 (or withholding). 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 ordinary income and 15% of an individual partner’s share of any long term capital ) and must be paid by the partnership (in quarterly installments) whether or not profits are actually distributed to partners. 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. Conclusion 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.
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/