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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 German investors in the U.S. to review their estate plans
in order to take advantage of the Germany-U.S. tax treaty.
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Tax rules applicable to foreign
investors in U.S.
real estate are often less favorable than those applicable to U.S. citizens
and residents. However, certain German
investors are entitled to special U.S. and German tax benefits
under the Germany-U.S. income and estate tax treaties.
In general, a tax treaty is a
written agreement between two countries providing uniform bilateral tax rules
intended to avoid double taxation of their crossborder
citizens and/or residents. Tax treaty
provisions override each signatory country’s own tax laws and may be invoked
by the taxpayer if the treaty rule provides a lesser tax than domestic law of
the taxing country.
This article focuses on some of the more common U.S. and
German tax issues encountered by German resident individual investors in U.S. real
estate (not U.S.
citizens or “greencard” holders).
Rental Income and
Expense
Under U.S. domestic
tax law, 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 foreign investors the option of timely filing U.S. tax
returns and electing “net basis” taxation at regular rates up to 39.6% and
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. In addition to
ordinary and necessary expenses, allowable tax deductions include
straight-line depreciation computed over 27.5 years for residential property
and 39 years for commercial property.
Under German domestic tax law, a German resident’s
overseas net rental income is subject to graduated tax at rates up to 53%
(with credit for foreign country income taxes paid). However, the Germany-U.S. income tax treaty
overrides domestic law with the result that U.S. real estate rental income is
exempt from German income tax. Though
not taxable, the exempt income is taken into account in determining the tax
rate on other German-taxable income (this is known as the exemption-with-progression
rule).
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Gain on Disposition
The Germany-U.S. income tax
treaty does not override U.S.
tax rules for gains derived from disposition of U.S. real estate. Thus, a German investor’s net U.S. real estate
gain is generally subject to graduated rate taxation under the regular tax or
AMT rules. For dispositions after May 7, 1997 U.S.
gains-taxation is generally limited to a maximum rate of 20% for property
held more than 12 months (except that gain attributable to prior depreciation
is taxed at a maximum rate of 25%).
Under German domestic tax law, a German resident’s
overseas real estate gain is subject to graduated tax at rates up to 53%
(with offset for any foreign country income taxes paid). However, the Germany-U.S. income tax treaty
overrides domestic law with the result that U.S. real estate gain is exempt
from German income tax under the exemption with progression rule. Some commentators are of the opinion that U.S. real
estate losses, especially those attributable to currency fluctuations, are
deductible in Germany
even though gains are tax exempt under the treaty.
Estate, Gift and
Inheritance Taxes
Under U.S. domestic tax law, the value of U.S. assets of a nonresident decedent who is
not U.S. citizen is
subject to tax at graduated rates up to 55% after exemption of only $US60,000 (a U.S.
citizen is entitled to an exemption of $US650,000 increasing to $US1 million
by the year 2006). The Germany-U.S.
estate tax treaty increases the exemption to one-half the value of U.S. assets
transferred to a surviving spouse.
Under its domestic tax law, Germany
taxes the value of the worldwide assets transferred (if either the decedent
or beneficiary is resident in Germany)
at graduated rates between 30% and 50% after exemption of between DM10,000 and DM600,000 (rates and the amount of exemption
depend on the degree of family relationship).
The Germany-U.S. estate tax treaty provides a credit against German
inheritance tax for U.S.
estate taxes paid on transfer of U.S. assets.
How Does the Tax Treaty
Affect You?
This article considers U.S. Federal, but not U.S. state
and local, income and transfer taxes.
German investors in U.S.
real estate should be aware of the benefits available under the Germany-U.S.
income and estate tax treaties, and plan their investments accordingly in
order to reap the maximum tax savings.
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