Own nothing taxable

The key to preventing U.S. estate taxation is to not own something that is taxable. The U.S. estate tax is imposed only on human beings, and only on what they own when they die. For nonresidents the only thing the U.S. taxes is “something” that is located in the United States.

The key to using a trust is that a human being doesn’t own the real estate, so the estate tax doesn’t get applied to it–remember that the estate tax is imposed on the assets of deceased people.

With a trust, the people involved own something–the right to use the trust’s assets. The key to this strategy is that everyone involved owns something that has a zero value when they die, so there is nothing to tax.

The people who can use the trust’s real estate (they are called “beneficiaries”) are really like tenants who don’t have to pay for using the real estate.

Example

Father sets up a trust and contributes cash to it. The trust buys a house, and Son lives in the house.

If Father is a nonresident, when he dies there will be no U.S. estate tax. Father made a cash gift to the trust and had no further control over the trust, the cash, or the real estate.

Whether Son is a resident or nonresident of the United States, when he dies there will be no estate tax imposed. Son’s right to use the trust’s real estate terminates when Son dies.

All of this assumes the trust is set up and operated correctly. And there is a universe of tax technicalities in that sentence.

Doing it right

It has to be an irrevocable trust. The person contributing the money to the trust can’t control the trust, directly or indirectly. Nor can the person contributing the money enjoy the benefits of the trust. (These are called “retained interests” in tax jargon).

The trust can be set up as a foreign trust or a U.S. domestic trust.

The typical situation for this strategy is where nonresident parents wants to provide a house in the U.S. for their child. It works best when the parents have no desire to eventually reclaim the money–they see the structure as an outright gift.

Remember that for U.S. estate taxation we are trying to identify exactly “where” something is–inside the United States (thus taxable) or outside the United States (thereby escaping estate taxation).

The view of the U.S. tax authorities is that a partnership interest will be U.S. situs property (subject to the U.S. estate tax on nonresident aliens) when the partnership is engaged in a U.S. trade or business.

The IRS says if death of the partner terminates the partnership, then the decedent’s pro rata share of partnership assets will be U.S. situs assets. If death does not terminate the partnership, then situs is where the partnership does business.

In summary, the taxpayer loses, no matter what:

If the partnership agreement says that the partnership terminates on the death of a partner, then the deceased nonresident is taxed on his or her pro-rata share of the underlying real estate will be subject to U.S. estate tax.

Example.

The nonresident is a 25% partner in a partnership that owns an office building in the United States. The partnership interest says that the partnership will terminate when one of the partners dies.

When the nonresident dies, he or she will be subject to estate tax just as if he or she owned a direct 25% interest in the office building.

If the partnership agreement says that the partnership continues after the death of a partner, then the deceased nonresident’s partnership interest is treated as located in the United States. Thus, it is subject to estate tax.

Example.

The nonresident is a 25% partner in a partnership that owns an office building in the United States. The partnership interest says that the partnership will continue in existence when one of the partners dies.

When the nonresident dies, he or she is treated as owning a asset–partnership interest located in the United States–that is subject to U.S. estate tax. The value of that partnership interest is calculated, and the nonresident’s heirs must pay estate on that partnership interest.

Direct ownership

Nothing says “U.S. situs asset” quite so much as direct ownership in U.S. real estate. If an individual dies while holding title to U.S. real estate, there will be U.S. estate taxation of that asset.

For U.S. law, real estate includes the land and all buildings and “fixtures.” If it is permanently attached to the land, it is real estate. A building is real estate. A sidewalk is real estate.

Stock of corporations

Look to the place of incorporation.

Stock of a corporation formed in the United States is situated in the United States. Stock of a corporation formed outside the United States is not situated in the United States.

Place of management, source of income, physical location of the stock certificate, etc. do not matter.

U.S. real estate inside foreign corporation

Stock of a foreign corporation is not a U.S. situs asset. Nonresident alien owns stock of a foreign corporation? Guess what—it does not matter what the foreign corporation owns.

Let’s say the nonresident alien owns the stock of a foreign corporation, which in turn owns U.S. real estate (clearly a U.S. situs asset). The nonresident falls over dead, owning a non-U.S. situs asset—stock of a foreign corporation. This passes to his heirs, free of estate tax.

California corporation owns real estate

Stock of a corporation formed under U.S. law is considered located inside the United States, making the stockholder vulnerable to estate tax when he or she dies.

A nonresident owns all of the stock of a California corporation. The California corporation owns U.S. real estate. The nonresident dies.
The decedent’s estate does not include ownership of real estate. His estate owns stock of a California corporation. The stock is a U.S. situs asset so the heirs will be estate tax on the fair market value of the stock.

Note the important distinction–the estate tax is not imposed on the real estate itself, but on the stock of the U.S. corporation (in this case I assumed California, but any other State will do).

So residence matters. A lot.

Assume no U.S. citizenship

Let’s assume that you are not a U.S. citizen and you never were.

If you were a citizen and you lost or gave up your U.S. citizenship, there are special rules that apply to you. The easiest thing to tell you is to Google “expatriation” and “877A” to learn more about this. (Section 877A is the reference in the U.S. tax law that governs this. Until mid-2008, it was Section 877).

Dual citizenship doesn’t matter. Many people hold two passports. We don’t care. All that matters is the question “Do you have U.S. citizenship?” It’s a Yes/No answer. A second citizenship doesn’t alter the tax result.

Residence for estate tax =! residence for income tax

Figuring out whether you are a resident for the purposes of estate tax is not the same as figuring out whether you are a resident for income tax purposes. The question for income tax is just a “count the days” exercise. Mostly.

Where do you live? Really?

For estate tax purposes, it is a common-sense question: where do you live? REALLY? Where’s home to you? Tax lawyers call this “domicile.” It is a combination of two things–you are there, and you have an intention to remain indefinitely.

That’s a pretty loose concept. How do we really know what’s going on in someone’s head? What are their intentions?

There are many, many Tax Court cases on domicile. The decisions are driven entirely by facts, and go in every direction.

Here are some of the factors considered in determining domicile in estate/gift tax cases.

• Duration of stay, frequency of travel. Even long presence in a country will not, alone, establish domicile.
• Comparison of housing: size, cost, owned or rented, etc. Your real home is likely to be that massive house, not the tiny little apartment.
• Where is the house? A house in a resort area looks less like a permanent residence than a house in a “normal” kind of place.
• Visa status is not relevant. Even a person present in the U.S. illegally can have U.S. domicile.
• Where are the your personal possessions?
• Where are your family and close friends?
• What about church and club memberships and participation in community affairs?
• The location of your business interests.
• Declarations of residence or intent made in visa applications, wills, deeds of gift, trust instruments, letters and oral statements. Watch out especially for declarations of intent that are contrary to the position you are attempting to push!

Controlling results with treaties

The United States has treaties with 16 countries deal with estate taxation matters. (There used to be 17, but the Swedish treaty lapsed at the beginning of 2008 because the Swedes no longer have an estate tax).

For Austria, Denmark, France, Germany, The Netherlands, and the United Kingdom there will be no problem—the treaties have tie-breaker provisions which can resolve potential situations where both countries wish to impose taxes on death.

For treaties with Australia, Finland, Greece, Ireland, Japan, Norway, South Africa, and Switzerland, there are no tie-breaker rules. Domicile questions are left to local law.

Summary

In many cases, a nonresident investor will clearly have his or her home in a country other than the United States: the visits to the United States and the business activities here are clearly those of an investor, but the person’s true home is elsewhere.

But as more ties are developed to the United States (children settle here, you buy a home and spend more time here) the question becomes less clear. If your situation is starting to look that way, you should take action to prevent estate taxation by other methods: assume the worst and plan accordingly. Set up ownership of your worldwide assets in a way that makes you untouchable for estate tax purposes, even if the U.S. government successfully claims you as a resident for estate tax purposes.

Estate tax–overview

Everything a deceased person owns is called his “estate.” The estate tax is a tax on the deceased person’s estate. The value of the property at the time of death is determined, and after various adjustments (certain exemptions and deductions for expenses and various other items) the tax is imposed. The tax rate can be as high as 45%.

Estate tax and nonresidents

The estate tax rules that apply to nonresidents are very different from the rules that apply to U.S. residents and citizens. A nonresident can easily pick up information that does not apply to him, and make bad decisions. This area is where cocktail party conversations can lead you astray.

Broadly, the heirs of a deceased U.S. citizen or resident will have to pay an estate tax on the deceased person’s worldwide assets before inheriting the remainder. By contrast, the United States will only impose the estate tax on assets owned by a nonresident which are located in the United States.

U.S. citizens and residents have a large exemption from the estate tax: the first $2,000,000 of assets will not be taxed. Nonresidents, by contrast, have a small exemption: only the first $60,000 of assets will escape tax.

There are a number of other differences, but these are the major ones.

Estate tax can wipe out real estate investment

The estate tax can wipe out a nonresident’s real estate investment, leaving nothing for his heirs. For example:

A nonresident owns an apartment building in his own name. The building is worth $5,000,000, and he has a $4,000,000 mortgage on the property. This means he has a $1,000,000 asset after paying off the mortgage.

If he dies, the estate tax will probably be above $2,000,000. The mortgage (of $4,000,000) and the tax liability (of $2,000,000) is greater than the value of the building. His heirs are left with nothing.

This example is a variation on the facts of a real Tax Court case involving a Hong Kong real estate investor. It shows the importance of properly planning for the estate tax.

The approach

In order to understand how this tax applies, we will follow this path:

Are you a resident or a nonresident for purposes of the estate tax?

If you are a resident, the first $2,000,000 of assets will be exempt from tax (good) but your worldwide assets will be taxable (bad). If you are a nonresident, only your U.S. assets will be taxable (good) but the exemption from tax is only $60,000 (bad).

Is the asset you own located in the United States?

A nonresident is at risk for the estate tax only for assets that are “located” in the United States.

Sometimes this is easy to understand. Land within the borders of the U.S. is classically “located” in the United States. But what about when you own the real estate via a corporation? Or a partnership? These are not so easy.

These are called “situs” rules. “Situs” is Latin for “where it’s at, y’all.” Lawyers love Latin. We will look at the various types of assets a nonresident real estate investor might own and discuss the risk of estate tax for each of them.

What about mortgages?

The example above shows that mortgages create problems for estate tax. But there are opportunities, too. If the terms of the mortgage are negotiated correctly, the mortgage can be used to reduce the value of the asset that is subject to estate tax.

In the example above, a mortgage that is fully nonrecourse (meaning that in the event of a default the lender can seize the property but not seek repayment from the borrower himself) would have the effect of reducing the taxable asset value from $5,000,000 to $1,000,000.

Ways to reduce or eliminate estate tax

Finally, we will talk about ways to reduce the estate tax risk through using different methods of ownership for the real estate.

Tax

The name on the deed means you have identified the taxpayer. Different types of taxpayers (corporations, partnerships, humans, trusts) are treated differently for tax calculations. Or if the tax rates are the same, the paperwork will be different, and less paperwork is always better.

Getting the answer right on “Who is the owner?” will mean the difference between no estate tax upon death of the owner, or a massive (as much as 45%) tax.

Getting the answer right will make a gift of the real estate a tax-free event. Or not.

Liability exposure

The United States has a reputation for litigation. Rightly or wrongly, the reputation is there. As the owner of real estate, you will have some business risk and it only makes sense to limit that risk if you can.

The owner of the real estate bears the risk. The wrong choice could mean the difference between losing everything, or not. Buy good liability insurance, of course. But build firewalls, too.

Inheritance

Who will inherit your assets when you die? Your spouse? Your children? Transfer of real estate to heirs after death of the owner can–with pre-planning–be simple, cheap, and fast (a few weeks and a few hundred dollars). Or it can be expensive and time-consuming (months leading into years, and thousands of dollars).

Your choice.

Don’t hold real estate in your own name!

Make a good decision now by knowing what happens later

The way you answer the question “Whose name will be on the deed?” is by knowing the tax and business factors, and balancing them so you come to a good solution for you.

That’s the purpose of this book.

(SECOND UPDATE) Yep I’ve rewritten this and expanded it. I was waiting for my daughter at rehearsal at the Sierra Madre Playhouse.

This book looks at the U.S. taxation of nonresidents and their U.S. investments in real estate – inbound investment.

It focuses on equity investments, rather than mortgage transactions. You’re a buyer, not a lender.

The three phases of real estate investment

When looking at a nonresident’s investment in U.S. real estate, we focus on three phases of that investment:

• The acquisition. The way in which title is acquired means everything to the investor’s future U.S. tax results. It is important to get things right. Fixing mistakes later can be expensive.
• The ownership phase. How is rental income taxed? What deductions may be taken against that income tax? What tax returns must be filed?
• The disposition. Eventually, the real estate is either sold, given away, exchanged, or transferred to heirs when the owner dies. All of these are dispositions. How will the United States tax that disposition?

Don’t assume anything

It is easy to pick up bad information. Not really bad, I guess, just wrong. The tax rules for nonresident investors are similar enough to the domestic rules to lead you to expensive problems.

Here’s an example, from real life:

A husband (nonresident and noncitizen) comes to the United States and buys a house for cash, and takes title in his own name. He then decides (prompted by his wife!) to add his wife, also a nonresident and noncitizen, as a tenant-in-common on the deed.

He records a quitclaim deed from himself to himself and his wife as tenants-in-common

This is probably a taxable gift from the husband to the wife.

Compare this to a husband and wife who are both U.S. citizens. The transfer just described would be a nonevent for U.S. gift tax purposes.

Objectives

This book is written for nonresidents of the United States. I hope to help my readers understand how their U.S. real estate investment will be taxed, so they can make good investment and tax decisions.

This is not an Encyclopedia of FIRPTA. We will follow the 80/20 rule and look at stuff you will see 80% of the time.

This book is also written with the intention that it will grow over time, because of reader suggestions, changes in laws, or just because I’m bored on a Wednesday night and need to do something so why not update the book?

This is a book about U.S. tax law — U.S. tax law as it applies to nonresidents who buy U.S. real estate.

Just because you read this book does not mean I am not your lawyer or your tax advisor. That only happens if you hire me. You will know that happens if you see a piece of paper with your signature on it. And mine.

Just because you read this book don’t think it is specific legal or tax advice for you. It isn’t. We’ve never met, we’ve never talked, we’ve never exchanged emails, I don’t know your situation and I don’t know about the real estate you’re buying.

This is general legal and tax information meant to help you understand how the U.S. tax system applies to nonresidents.

I suggest you hire someone competent to advise you specifically.

Inquiries and questions

I welcome questions, comments, and corrections. Really. Send them to philiphodgen at gmail dot com. I will do my best to answer them.

Don’t send me confidential information

The internet is not secure, so don’t send me emails with your private information. I’m not your lawyer, so whatever you tell me is NOT protected and confidential information.

Things change

The laws change. This book might change. I might get things wrong, and maybe I’ll fix it and maybe I won’t even know I got it wrong. Watch for edits, but the older the information the more likely it is to be unreliable.

I reserve the right to rewrite things at any time.

If you’re a California CPA, check me out in Orange County in December 10 and 11. One day is foreign investment in U.S. real estate, the other day is foreign trusts. And I’ll reprise both of these in San Jose in January.

Anyway, good to be back. Also, it’s good to be back in WordPress. The site languished while it was a Drupal-driven site. I just got overwhelmed with it. Nodes and modules ‘n stuff. Too much.

Check me out on hodgen.com/phil also. I’m noisier there. On other related topics, not just real estate investments.