Foreign corporations to hold U.S. real estate

Nonresident investors frequently hold U.S. real estate using foreign corporation structures. (A “foreign corporation” for our purposes is a corporation formed in a country other than the United States.) There are two common variations of this theme:

• Nonresident owns all the shares of stock of a foreign corporation. The foreign corporation owns the U.S. real estate.
• Nonresident owns all of the shares of stock of a foreign corporation. The foreign corporation owns all of the shares of stock of a U.S. corporation. The U.S. corporation owns the U.S. real estate.

This is done primarily for estate tax protection.

Why it works

The United States will impose an estate tax (for our purposes let’s say it is 45% of the fair market value of the property) on U.S. real estate owned directly by a nonresident. That is because estate tax is imposed only on a nonresident’s property that is “located” in the United States. And nothing screams “I am located in the United States” quite as much as real estate within the national boundaries of the USA.

The United States will NOT impose an estate tax on shares of stock of a foreign corporation which are owned by a nonresident deceased individual.

That is because a foreign corporation is treated as being “located” in the country under whose laws the corporation was formed. Thus, because the corporation is “located” outside the United States under the estate tax definitions, there is nothing to be taxed because if you look at what the nonresident individual actually owns, which is stock, not real estate.

“But . . . .”

“Well,” you say. “The foreign corporation owns U.S. real estate. Shouldn’t you look through the foreign corporation at the assets owned by the corporation?” And the answer is . . . no, we don’t do that.

Yes, we (meaning the U.S. tax authorities) could do that. And maybe they will some day. But at the moment it doesn’t work that way.

Summary of where we are now

For now the conventional wisdom is that indirect ownership of U.S. real estate by a nonresident — using the foreign corporation as described — will isolate the nonresident individual from U.S. estate taxation when he or she dies. Well, it won’t isolate that individual, because after death he/she doesn’t really care all that much, right? It’s the heirs that care.

Storm clouds over the horizon–family limited partnership analogy

The Internal Revenue Service has been attacking family limited partnerships — as an estate tax planning device — for several years. I won’t go into the details of the technical and metaphysical arguments on this.

But many people feel that the same theories used by the IRS to attack family limited partnerships could be used to attack the foreign corporation ownership structures used by nonresidents to hold U.S. real estate.

Storm clouds over the horizon–personal use of corporate asset

There’s a second thing. Let’s say you are a U.S. resident and you own a business. The business buys a yacht as a corporate asset and you happily sail it up and down the coast and have fun on it. Will the Internal Revenue Service have a cow? You bet. Individual use of corporate assets by shareholders and officers triggers all sorts of imputed income attacks by the government.

So now take a look at this holding structure used by nonresidents. They buy a house or a ski condominium or a beach house, and hold title in the name of a foreign corporation. Then they proceed to use the house. Personal use. And they are the shareholders of the foreign corporation.

I can see this as a potential reason to either disregard the foreign corporation or to cause the shareholders to have some kind of imputed income from the trust. U.S. source imputed income. Probably FDAP. On which 30% withholding should be imposed, ‘n other bad stuff.

Fashion-forward Canada

A few years ago the Canadian tax authorities changed the tax rules for Canadian resident taxpayers, essentially saying that if a Canadian had a personal use residence inside a corporation like this, there would be an imputed dividend to the shareholder based on the fair market rental value of the house. So imagine having taxable income and paying tax just for the privilege of living in your own house.

<understatement> Suddenly, corporate structures became much less appealing to Canadian residents. </understatement>

I take that as an early warning sign. The Canadians had an exit tax far before we in the United States acquired the entirely execrable, useless, and utterly counter-productive Section 877A. (Ah, but I am a fairminded man. I do not judge.)

So I think it reasonable to assume that at some point the Internal Revenue Service will wake up and announce that they have an entirely original idea and while it won’t be an exact copy of the Canadian method, at least it will rhyme with what the Canadians suffer under.

Bottom line

Foreign corporations probably work for estate tax protection. For now. Might not later. Your mileage may vary, all bets are off, this is not legal advice to you, and you’d be a damned fool to believe anything you read on the internets unless of course it is posted on Slashdot.

(This is cross-posted to my main blog at hodgen.com/phil and thanks Brian for the question.)

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.

Here’s an article from Tax Notes Today (warning PDF) about Advice Memorandum 2008-003, written by a tax practitioner. It discusses the technical pushing and shoving on this topic. The article was published in March, 2008.

If you’re a tax law professor, go have fun. For the rest of us, let’s watch a while and see what happens. While you’d think that the IRS would win this fight (when in doubt, impose a tax) I would not underestimate the power of NAREIT.

Just so you have it, here’s the ruling that I think he was referring to. Notice 2007-55.

The IRS is telling the world that it is going to issue regulations to plug what it perceives to be a loophole. Because you don’t want to chase the rabbit’s trail through the Internal Revenue Code, here’s the gist of the problem.

Foreign government investments can be tax-free in many situations. (Section 892 for all of you True Believers who want to read the Holy Bible Internal Revenue Code). Sovereign wealth funds have been buying minority pieces of REITs. Distributions from the REITs are claimed to be tax-exempt because of the exemption for foreign government investments.

The IRS is saying this is bogus.

This is up in the air at the moment. Some commentators have said that the IRS lacks the authority to plug this loophole (if it is one) and the change must come from Congress, if at all.

I try to get my clients out of them and into better ways to own their real estate.

THE PROBLEM WITH CORPORATIONS

The problem with corporations is simple. When the property is sold, corporations will pay Federal tax on the capital gain at about 35 percent. Other holding structures can result in a Federal capital gain tax of 15 percent.

So what would you rather do? Pay $350 in tax for every $1,000 of profit? Or pay $150 for every $1,000 of profit? (This is a rhetorical question. Don’t raise your hands, class).

FIXING THE PROBLEM TRIGGERS TAX

If you take real estate out of a corporation, you are triggering a tax event. This is treated like a sale (and tax is due) even though the ultimate owner didn’t change at all. The change in ownership is approximately like taking your keys out of your left pocket and putting them in your right pocket, but the tax authorities still want to impose tax.

Pay a huge tax now because you’ll save some tax later? Not appealing.

BAD REAL ESTATE MARKET MEANS GOOD RESTRUCTURING OPPORTUNITY

Right now, the real estate market is suffering. Values are declining in many markets. This means that for many people, the property is worth about what they paid for it a few years ago.

And more to the point, it means that if they engineer a “sale” from their corporation to some other holding structure, the sale will generate zero taxable profit, thus no tax.

EXAMPLE

Imagine someone who bought a house for $2,000,000 a couple of years ago, put it in a corporation, and used it from time to time as a personal residence. The market went up — it was worth $3 million. Now the market came down again, and the appraisers say it would sell for $2,000,000 today.

We engineer a sale from the corporation that owns the house. The sale is for today’s fair market value: $2,000,000. The corporation files a tax return and declares zero profit, and pays zero tax. The new owner is a holding structure we have created—a holding structure that will give us a 15 percent tax rate on capital gains, not 35 percent.

COTTAGE INDUSTRY

We have a little pipeline of these deals right now. We picked up a couple more today, in fact. Smart move. Even if you assume modest appreciation (like 5 percent), over the long haul, this will save hundreds of thousands of dollars in capital gains tax.