As we went through the day I took notes on a number of topics and questions that seemed blogworthy. I’ll post on them as time goes by. Here they are:

• Estate tax situs rules for airplanes and boats. (Question: nonresident flies his airplane to the United States and then dies. The nonresident has tangible personal property located in the United States–the airplane that landed in the U.S. Will there be estate tax?)
• Gift tax rules applicable to the gift of LLC membership interests by nonresidents. (Dad owns U.S. real estate in a single member LLC. Dad is a nonresident of the United States. Dad gives the membership interests in the LLC to his U.S.-resident daughter. Gift tax or not?)
• Cash gifts by nonresidents. (The eternal problem of “I’m a nonresident and I have a U.S. bank account. What are the gift tax ramifications if I (1) withdraw cash and hand over a stack of $100 bills as a gift to someone? (2) write a check on my U.S. bank account as a gift to someone? (3) other variations on that theme.)
• The “net election”. I promised to post the magic language you attach to the income tax return to make this election. (This is what you do so rental income is taxed after you deduct related business expenses–net income–rather than having tax on the gross rental income received, without deduction for business expenses).
• Mortgage situations involving foreign lenders. When interest is paid to the foreign lender there will be 30% withholding tax imposed. What can you do here to reduce/eliminate withholding?
• Basis step-up on assets held in a foreign grantor trust with a nonresident grantor. How does that work?

Thanks to the 33 people in the room today. If I missed a question, please let me know. You can comment below or shoot me an email. I’ll get to work on these and start writing. Be patient, though. I have a life.

I have cross-posted this to hodgen.com/phil.

I spoke yesterday at the 2007 International Tax and Business Conference in San Francisco. My topic was “Multinational Families: When a Border Runs Through Your Balance Sheet.” The conference was organized by the California CPA Education Foundation.

Here, in glorious PDF, is the conference brochure. (PDF)

It is remarkably easy to be a speaker at a large conference such as this. All you have to do is become a member of the organizing committee.

Remember! This is not legal advice. An article for general publication by definition leaves out important clarifications and technicalities. In other words, read this for your amusement but do not make any legal or tax decisions based on this. Or anything else in this website, for that matter.

TAX WRINKLES FACING THE FOREIGN BUYER OF U.S. REAL ESTATE

by Philip D. W. Hodgen

Foreigners buy real estate as one of the first investments they make in the U.S. They need special tax advice, because the tax rules they face are not the same as those facing U.S. residents. The normal transaction practices for real estate — escrow, title insurance, and so forth — are typically new to them as well. Finding mortgage financing can be troubling because these are people who have no credit profile at all in the United States.

REAL LIFE RISKS—ESTATE TAX

When dealing with a foreign buyer of U.S. real estate, the key tax decision lies in the answer to a seemingly simple question: of “How do I take title?” It is not an easy question to answer. The first choice people usually consider (when deciding how to take title) is “In my own name, of course!”

When the foreigner eventually sells the property, all capital gain will be taxed at the 15 percent long term rate (assuming he or she held the property for more than a year). However, foreigners are at a very substantial disadvantage for estate taxes—if a foreigner dies while owning U.S. real estate, the entire value above $60,000 is going to be taxable, at rates usually in the 45-47 percent range. Compare that with the standard exemption for U.S. residents—the first $1,500,000 of their assets will not be subject to U.S. estate tax at all.

Thus, holding title directly is risky for U.S. estate tax purposes, unless immortality runs in the owner’s family.

REAL LIFE RISKS—RENTAL PROPERTY

Anyone owning rental property will want to take a tax deduction for depreciation, mortgage interest, property taxes, expenses of management and repair, and all of the other normal expenses associated with owning the real estate. That usually brings the net income for tax purposes close to zero. Then you apply the normal income tax rates to the net income to calculate your income tax.

Not so for foreign owners of rental property. Here’s the default rule that applies—they face a Federal income tax of 30 percent of the GROSS rent. No deduction for any business expenses is allowed. Fortunately, there is a way out, if the foreign investor takes affirmative action to get away from this “30 percent of gross rent is my income tax” to the “take every allowable deduction, then apply the normal income tax rates” system of taxation of NET income. And this must be done in a timely manner.

REAL LIFE RISKS—THE ACCIDENTAL GIFT TAX

Here is a real-life situation I have seen several times. A couple plans to buy a house in California for occasional use on visits. They will not live here full time. The husband comes to the United States, and buys a house for all cash, and takes title in his name. No thought is put into it; it just seems to be a sensible move. The wife arrives, and finds out. She wonders why she is not on title, and so the husband adds her as a co-owner (usually a joint tenant).

The IRS looks at this as a gift from the husband to the wife. For U.S. residents, this presents no problem. But for this couple, both nonresidents, this is a taxable gift. A gift tax return must be filed and gift tax will be due on the value transferred above $110,000.

Most countries do not have gift tax laws. And the default gift tax rules in the U.S. for its residents make this a simple, no brainer move in ordinary circumstances. But for this couple—both nonresidents—all of a sudden they may be facing a gift tax of hundreds of thousands of dollars even though the property remained in the family.

SO HOW SHOULD THE FOREIGNER TAKE TITLE?

With this litany of tax risks facing the foreign buyer of U.S. real estate, what IS the best way for that buyer to take title? There is no easy answer. In general, using direct ownership, a partnership, or a limited liability company will all expose the buyer to estate tax risk if there is death. On the other hand, capital gain on sale will be taxed at the favorable low long term capital gains tax rates.

On the other hand, if a foreign buyer takes title in the name of a foreign corporation, then dies, there will be no U.S. estate tax due. However, capital gains on sale will be taxed at corporate income tax rates (35-36 percent typically).

In short, the solution that keeps capital gains taxes down (good) also exposes the buyer to estate tax risk (bad). And the solution that eliminates the estate tax risk (good) causes the tax on capital gain to more than double (bad).

The solution in each particular case needs to be examined with care, and with consultation with the buyer. There are some general rules that almost always apply, however:

• Never buy the real estate in a U.S. corporation where the foreign individual is the shareholder. This causes the worst of both worlds—the capital gain is taxed at 35-36 percent and if the buyer dies, the U.S. will impose estate tax.
• Never hold rental property directly in a foreign corporation. While this shelters the buyer from estate tax (good), it causes a double Federal income tax (bad). First, the corporation’s net profit from rent is taxed at normal tax rates. Then, the after-tax profit is taxed at 30 percent. It’s as if you paid an income tax on your salary, then paid a second income tax on your after-tax salary income. Horrible.
• Don’t just consider the tax issues. California Probate Courts are dreadfully expensive and slow. Use living trusts, even if they give no tax benefits, to make sure that real estate passes to the right heirs quickly and cheaply.

CONTACT INFORMATION

Phil Hodgen is a Pasadena tax lawyer who specializes in international tax law. A large portion of his practice involves representation of foreign persons in real estate transactions.

Philip D. W. Hodgen
Hodgen Law Group, PC
140 South Lake Avenue, Suite 250
Pasadena, CA 91101
Tel 626-689-0060
Fax 626-577-2230
email phil AT hodgen DOT com
Hodgen Law Group PC and FIRPTA

The BAD NEWS? Link rot. If you have Lexis, you can find it on Tax Notes Today at 2002 TNT 153-78, published August 8, 2002.