Is there a “best” way for a foreign individual to own U.S. real estate? When planning to acquire U.S. real estate, foreign individuals have a number of ownership alternatives to consider each of which offers its own advantages and disadvantages. There are other items a foreign investor should consider when evaluating the most advantageous method for holding U.S. property title.
When investing in U.S. real estate a number of important factors should be considered including risk, economic impacts and the income tax consequences in both the United States and the investor’s home country.
This article briefly examines the five ownership options for those acquiring U.S. real estate:
- Direct ownership by foreign individual
- Investment in U.S. real estate via U.S LLC (Limited Liability Company)
- Investment in U.S. real estate via foreign corporation
- Investment in U.S. real estate via foreign corporation and U.S. corporation or LLC
- Domestically-controlled REIT (Real Estate Investment Trust)
Direct ownership by foreign individual
Some of the tax considerations include:
- If the foreign owner uses the property for personal purposes for more than either the greater of 14 days or 10% of the annual number of days rented (at fair rental value), the deductions allowed for income tax purposes are substantially limited1. When the owner of U.S. rental property (e.g. rental of vacation home) uses that property in excess of these prescribed limits, the general rule is that tax deductions to be claimed will be substantially limited - generally no more than the income from the property. In other words, the owner usually cannot write off tax losses against other income for U.S. income tax purposes.
- One of the major benefits gained from owning the real estate directly is that the foreign person is generally entitled to the more favourable U.S. federal capital gains tax rates at the time of sale. For 2011, the U.S. federal capital gains rate is 15 percent2. Depending on the length of time the property is held, a portion of the capital gain may be taxed at a higher rate in connection with gains realised that are related to depreciation deductions. Each U.S. state will impose its own rates on capital gains. Of course, in evaluating the U.S. taxes on capital gains, the foreign investor must also consider the impact of the income taxes in their home country.
- The foreign individual will be required to file U.S. federal and state individual income tax returns for each year of ownership, whether or not he/she actually has an income tax liability, in order to preserve any deductions for which the owner is entitled (including loss carry forwards). Alternatively, that individual could lose all deductions and be assessed income taxes based on the gross income received, if tax returns are not filed timely.
- Direct ownership of U.S. real estate generally results in that property being reportable and taxable for U.S. estate tax purposes. Furthermore, a foreign individual is not eligible for the more generous estate tax filing exemptions available to U.S. residents. The foreign person’s exempt amount is significantly lower than what is permitted for U.S. residents3. In the case of a foreign decedent, all of the U.S. estate is subject to regular estate tax rates, less a credit of $13,0004, and less any foreign estate taxes.
Transfers of U.S.-owned real estate by a foreign person will frequently result in U.S. withholding tax on the transfer price. (See additional discussion below regarding the Foreign Investment in Real Property Tax Act (FIRPTA) rules).
Investment in U.S. real estate via U.S LLC
Most of the issues associated with direct ownership also apply when a foreign individual owns U.S. real estate through a U.S. Limited Liability Company (LLC). Additional issues to consider include:
Ownership through a U.S. LLC gives the individual “limited liability” on the same general basis as a corporation. This is one of the main advantages of using the U.S. LLC.
The U.S. income tax treatment of a U.S. LLC is as a partnership (if there is more than one owner) or disregarded entity (if there is only one owner). The foreign individual’s home country income tax treatment of the U.S. LLC, however, varies from country to country. Many foreign countries treat the U.S. LLC as a corporation, which often results in a mismatch of income taxation between that foreign country and the U.S. in any given year. Because of this difference in tax treatment, the use of a U.S. LLC is often not recommended for foreign investors.
The same U.S. income tax reporting and U.S. estate tax issues apply to the individual investor, i.e. the foreign person must file a U.S. federal and state return each year.
A transfer of the ownership interest in the U.S. LLC will result in the same U.S. withholding tax under U.S. FIRPTA rules as a transfer of a direct interest. (See additional discussion of withholding below).
Investment in U.S. real estate via foreign corporation
In this case, the U.S. income tax filing responsibilities fall to the foreign corporate entity. Following are some important considerations when using a foreign corporation as the vehicle for investment:
- The foreign corporation will not be entitled to the favourable U.S. capital gain rates (one of the principal disadvantages of this option).
- The foreign corporation will prevent the foreign individual from being liable for the U.S. estate tax (one of the principal advantages).
- The foreign corporation provides the owner with limited liability (another significant advantage).
- A sale of a foreign corporation’s shares is not taxable in the US. A sale of a US Corporation’s shares due to its classification as a US Real Property Holding Company (USRPHC) would generally be taxable under the US FIRPTA rules (more fully discussed below).
- Because of the limitation on benefits provisions in most treaties, the foreign corporation should generally be incorporated in the same country as the owner/investor.
Investment in U.S. real estate via foreign corporation and U.S. corporation or LLC
Why might one consider a double-entity approach to the U.S. investment? Frequently, when a foreign person is planning to invest in a large U.S. real estate fund, the fund has already decided that the U.S. structure is going to be the U.S. LLC. In that case, the foreign investor might decide to avoid risks associated with the U.S. estate tax compliance and/or the personal income tax filing requirements. In such cases, foreign investors often establish their own foreign corporation to own the U.S. real estate - thus giving up the potentially favourable U.S. capital gain rates in order to eliminate the U.S. estate tax issues.
Domestically controlled REIT
A REIT is essentially an entity that is otherwise taxed as a corporation unless it meets certain technical requirements and affirmatively elects REIT status. The principal difference between a U.S. corporation and a REIT is that the REIT is allowed a special tax deduction for dividends paid to its shareholders. As one of the qualifications for this special treatment, a REIT must distribute at least 90% of its net taxable income exclusive of capital gains to its shareholders annually.
Accordingly, this regime subjects investors to only one level of tax (as opposed to the general ‘double-tax’ U.S. tax regime that applies to corporations and their shareholders). This makes a REIT a unique holding vehicle designed specially to invest in real property assets.
REITs that invest into the U.S. are predominately investing in U.S. property. As a result, distributions from a REIT to non-U.S. investors, or gains such investors realise from the sale or exchange of REIT shares, are generally subject to FIRPTA taxation. However, there is an exception for domestically-controlled REITs.
A disposal of shares in a domestically-controlled REIT does not trigger FIRPTA tax or filing obligations. However, the disposal of the underlying REIT assets will likely trigger a FIRPTA tax and related filing obligation for the non-U.S. investors. Thus, it will be important for the non-U.S. investors to think carefully about the exit alternatives before moving forward with this REIT structure.
The REIT must be structured in a particular way to demonstrate domestic control. In general, as long as foreign investors own less than 50% of the value of the REIT for the lesser of five years or the time during which the REIT has been in existence, the REIT will qualify as a domestically-controlled REIT. Although no FIRPTA tax will be due upon the sale or exchange of domestically-controlled REIT shares, distributions to all investors are taxable.
A withholding tax is imposed on the transfer of U.S. real estate by a non-resident alien generally equal to 10% of the fair market value at the time of transfer, regardless of the amount of gain5. Although the tax is referred to as a ‘withholding tax’ the non-resident must still file a U.S. income tax return and determine the correct amount of income tax on the gain, if any. If the withholding exceeds the actual tax, a refund is paid to the taxpayer following the filing of the annual income tax return. A reduced rate withholding certificate can be obtained when the 10% withholding is expected to exceed substantially the actual tax liability; however, this certificate should be requested well in advance of the closing of the transaction.
In general, this withholding tax applies to any foreign individual or corporation that transfers an ownership interest in U.S. real estate. In some cases, this can also include an indirect transfer where it involves the transfer of a U.S. corporation that holds 50% or more of its assets as U.S. real estate interests.
There are numerous strategies for structuring an investment in U.S. real estate ranging from relatively simple to advanced. Determining the appropriate structure is very specific and depends on the goals, objectives and income tax situation of the particular foreign investor. To choose the most appropriate alternative, the foreign investor must consider a variety of factors, including:
- The filing of personal annual income tax returns
- The U.S. capital gain tax rate
- FIRPTA issues
- Tax treaty implications
- U.S. estate tax
- Administrative costs of multiple entities