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.)

One, two or three income taxes

Income tax is imposed by the Federal government.

In addition, most States have an income tax. (Some states do not have an income tax. Examples: Nevada, Texas, Florida, Washington, and some others).

Finally, a few cities impose an income tax. New York City, for instance, has one. Los Angeles does not.

Income taxes are calculated on a calendar year basis.

The default Federal income tax rule: 30 percent of gross income

For nonresident real estate investors, the income tax on rental income is simple and harsh: your tax is 30 percent of the gross rent collected. You are not entitled to a deduction for any of your business expenses.

Example

You own an apartment that you rent for US$2,000 per month for the entire calendar year. You collected $24,000 of rent. Your Federal tax — under the default rule — is 30 percent of that, or $8,000.

That is harsh because most real estate investors incur high out-of-pocket expenses to purchase their real estate. They borrow money for a mortgage and must make payments to the bank. They pay property taxes, management fees, maintenance and repair costs.

Often, the default rule for Federal income taxation would mean that the investor would be paying out more money for expenses and taxes than he or she would collect in rent. Negative cash flow is highly undesirable.

A better Federal tax solution

A nonresident real estate investor can elect to NOT pay Federal tax at 30 percent of gross income. Instead, he or she can elect to be taxed just like a U.S. resident.

You accomplish this by making a special election — using the required magic words — on a U.S. income tax return that you file in a timely manner. (The tax return you need to file is Form 1040-NR for humans. I’ll write about investing through partnerships, corporations, limited liability companies, and trusts another time).

Truth serum

You must file income tax returns and file your tax returns on time in order to do this. It is essential that you get an experienced income tax return preparer — lawyer or accountant — who knows how to prepare nonresident tax returns and make this election.

When you’re talking to a prospective lawyer or accountant about this, ask them whether you need to make the “net election.” That’s the jargon we use in the trade.

If they know what they’re doing, you’ll know it by their response. If they bumble and huff and don’t seem to recognize what this is, don’t work with them.

If you make this election, you are entitled to deduct all of your business expenses from your rental income. The NET income (all the rental income collected minus your business expenses) is then taxed at the same tax rates that apply to U.S. residents. This rate is likely to be lower than 30 percent.

In addition, by making this election, you will be able to take a tax deduction for depreciation of your property. In many real estate investments, the total of cash expenses for owning and operating the property PLUS depreciation will be more than your rental income. Thus, you will have zero taxable income, and therefore zero Federal income tax.

TINLAB (This is not legal advice, but…) I can’t think of any situation where you WOULDN’T want to make this election for Federal income tax purposes.

Warnings:

Warning for procrastinators: if you are “too” late in filing your Federal income tax returns, you will lose the ability to make this election.

Warning for the “How will the U.S. tax authorities ever find me?” brigade: You’re right. You might be able to avoid filing tax returns and paying tax while you own the property — at least for a while. But when you sell, all of the chickens come home to roost.

There is a large Federal withholding tax imposed on sale of U.S. real estate by nonresidents (10 percent of the sale price). Frequently the withholding tax is far more than the actual tax liability you owe. In that case, you won’t be able to get a refund of part of the withholding tax unless you’re up to date on all of your tax filings for all of the years you owned the property.

State income tax

Every State reserves the right to tax rental income derived from real estate located within the State.

You are going to pay income tax on the NET income from your property (total rent collected minus expenses, including depreciation deductions). Rates vary from State to State. California’s top rate is 9.3 percent, for instance.

City income tax

A few cities impose an income tax on rental real estate located within the city. New York City is the one with which I have the most experience, since it is a city where nonresidents are likely to buy a property. Again, the tax will be on NET rental income.

Best practices recommendations

Best tax practices for a nonresident investor in U.S. real estate, then, are:

• The overall tax burden will be higher in some States and cities than in other. While tax is not the only consideration, you should think about it when deciding where to purchase real estate.
• Hire an experienced U.S. tax advisor — someone who knows specifically about nonresident investors and how they are taxed — to advise your and prepare your U.S. income tax returns.
• Make the Federal “net election” on your very first U.S. tax return filed.
• File all income tax returns on time. (Typically, for a nonresident, the deadline will be the following June 15. Thus, income tax returns for 2004 are due on June 15, 2005).