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.

Rental income taxed at 30% of gross income

The default rule for nonresident owners of U.S. rental real estate is that rental income is taxed at 30% of gross rent collected. That’s the Federal income tax. State income tax varies from State to State and I will ignore it.

For Federal purposes you do not take a tax deduction for mortgage interest, property taxes, repairs, etc. You do not get a deduction for depreciation.

Sit with a piece of paper and a pencil and you will soon find that this can put you into negative cash flow.

Have rental income taxed on net income instead

It is much better to pay income tax on your net income — collect rent income, deduct your expenses, and pay tax on whatever is left.

The law

Nonresidents make a special election with the U.S. tax authorities to make the desirable “tax me on net income not gross income” result occur. Here’s the law, found at Section 871(d) of the Internal Revenue Code:

(d) Election to treat real property income as income connected with United States business

(1) In general

A nonresident alien individual who during the taxable year derives any income–

(A) from real property held for the production of income and located in the United States, or from any interest in such real property, including

(i) gains from the sale or exchange of such real property or an interest therein,

(ii) rents or royalties from mines, wells, or other natural deposits, and

(iii) gains described in section 631(b) or (c), and

(B) which, but for this subsection, would not be treated as income which is effectively connected with the conduct of a trade or business within the United States,

may elect for such taxable year to treat all such income as income which is effectively connected with the conduct of a trade or business within the United States. In such case, such income shall be taxable as provided in subsection (b)(1) whether or not such individual is engaged in trade or business within the United States during the taxable year. An election under this paragraph for any taxable year shall remain in effect for all subsequent taxable years, except that it may be revoked with the consent of the Secretary with respect to any taxable year.

(2) Election after revocation

If an election has been made under paragraph (1) and such election has been revoked, a new election may not be made under such paragraph for any taxable year before the 5th taxable year which begins after the first taxable year for which such revocation is effective, unless the Secretary consents to such new election.

(3) Form and time of election and revocation

An election under paragraph (1), and any revocation of such an election, may be made only in such manner and at such time as the Secretary may by regulations prescribe.

How to do it–the Regulations

The Treasury Regulations give guidance on how to make the net election:

Regulations Section 1.871-10(d)(1)(ii) — Statement To Be Filed With Return

An election made under this section without the consent of the Commissioner shall be made for a taxable year by filing with the income tax return required under section 6012 and the regulations thereunder for such taxable year a statement to the effect that the election is being made. This statement shall include (a) a complete schedule of all real property, or any interest in real property, of which the taxpayer is titular or beneficial owner, which is located in the United States, (b) an indication of the extent to which the taxpayer has direct or beneficial ownership in each such item of real property, or interest in real property, (c) the location of the real property or interest therein, (d) a description of any substantial improvements on any such property, and (e) an identification of any taxable year or years in respect of which a revocation or new election under this section has previously occurred. This statement may not be filed with any return under section 6851 and the regulations thereunder.

Sample language

Here is a sample you can follow. Just attach this on a statement attached to the Federal income tax return filed (Form 1040-NR or Form 1120-F).

(Taxpayer Name)
(Taxpayer Identification Number)
Attachment to Form (1040-NR or 1120-F)
Tax Year Ending December 31, 2008
This statement constitutes an election under Regs. §1.871-10(d)(1)(ii) to treat the income generated from the following properties in the United States owned by the taxpayer as income effectively connected with a U.S. business for taxable year ending December 31, 20__ and thereafter:

Property 1 -
Land and Improvements located at 123 Easy Street, Anytown, USA. The structure is a commercial office building. Taxpayer holds a fee interest in the land and all property improvements located thereon. No prior election has been made under Regs. §1.871-10(d)(1)(ii) with respect to the subject property.

Property 2 –
Identify other properties as appropriate.

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.

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.

The United States has a gift tax: You will pay a tax for the privilege of giving your money away. There are plenty of exceptions, but let’s stick to one typical scenario — a gift by one family member (a parent) to another family member (a child).

Let’s say a nonresident owns U.S. real estate. A vacation home, let’s say. He’s a father, and wants to give his property to his daughter. He signs a deed that says, “I, Father, transfer this property to Daughter.”

Tax result? Awful. The father has made a taxable gift to the daughter, and U.S. gift tax is owed on the value of the real estate above $60,000. The tax rate starts at 18 percent and increases to (at current law) 47 percent of the value of the real estate transferred.

Moral of the story: if you’re a nonresident of the U.S. and you want to give away your U.S. real estate, absolutely do not take the “Do It Yourself” approach. Don’t do a simple transfer deed. There are ways to achieve the same result without incurring a gift tax.

The biggest tax risk for these nonresidents is the U.S. estate tax. Leaving aside all of the technical mumbo-jumbo, if you’re a nonresident, you own U.S. real estate, and you fall over dead whilst owning that U.S. real estate, you’re in for a rude shock. (Actually, you are shock-proof because, after all, you’re dead. It’s your heirs who are in for a grim tax surprise.)

The U.S. Estate Tax

The U.S. has what’s called an “estate tax.” Other countries call it a death duty. It is a tax on the privilege (!) of passing property to your heirs when you die. The top tax rate is 47 percent as of 2005. It is a wealth tax — the heirs total up the deceased person’s wealth at the moment of death, and pay the tax on that amount.

The rude shock? While U.S. residents can pass $1,500,000 of assets tax-free to their heirs, nonresidents can only pass $60,000 tax-free. So if you have a $1,000,000 vacation home in the U.S., the first $60,000 is exempt from tax but the remaining $940,000 gets hammered. (Hammered is technical tax jargon for “heavily taxed.”) Your heirs might be forced to sell the property in order to pay the tax. The tax, incidentally, is due nine months after death.

Canadians lose a simple solution

There are plain vanilla solutions for this problem. One of those plain vanilla solutions has just been snatched out of the hands of our Canadian friends.

Bear with me, now. This gets a bit complex, but if you are going to buy a personal residence in the United States and you’re Canadian, you need to know this.

One favored solution for Canadians with U.S. residences was to form a Canadian corporation. That corporation would then become the owner of the U.S. real estate. Hey presto, the Canadian human (who owns the stock in the Canadian corporation) falls over dead. Tax result? No U.S. estate tax.

Why? Because the human who died didn’t own real estate in the U.S. A corporation did. A Canadian corporation. The human owned stock in that Canadian corporation. By the technical rules of what the U.S. can tax upon death of a nonresident human, the U.S. real estate was not taxable.

What’s happened — CRA has spoken

Here’s what they said. If you’re a Canadian and you have a personal residence inside a Canadian corporation, you are going to have “pretend” but very taxable income in Canada equal to the rental value of the house you own in the U.S.

Result under the new Canadian rules

Thus, you have a U.S. vacation home that would rent out at $5,000/month, and you hold it in a Canadian corporation, you have happy time when you file your Canadian income tax return: $60,000 of “income” to you on which you pay Canadian income tax, please.

The U.S. estate tax benefits remain in place, just as before. But now that benefit is outweighed by the Canadian income tax on the rental value of the property inside that Canadian corporation.

What to do?

There are grandfathering rules in place. If you have such a structure in place already, check the rules, but you’re probably going to be safe. New purchases of U.S. real estate, however, won’t be safe. You’ll have to think of a new way to protect against U.S. tax.

There are methods for dealing with this problem. Some are more complex and expensive than others. First things first. If you’re healthy, buy term life insurance to offset the U.S. estate tax.

If that won’t work, talk to someone like (modestly speaking) me. You face a need to keep the Canadian Revenue Agency happy while you pay zero income tax there, while at the same time keeping the Internal Revenue Service happy while your heirs pay zero U.S. estate tax. It ain’t easy, but it can be done.

Basic idea: you’re taxed like a resident

The tax laws are constructed so that a nonresident investor and a resident investor will be treated the same. If you’ve handled your tax returns properly over the years, you — as a nonresident of the U.S. — will be pay tax in the same way you would have, had you been a U.S. resident.

Concept: capital gain

Your tax is figured on what is called “capital gain.” Normal people would call it the profit on sale. Tax laws create confusion amongst the laity by renaming common concepts with cryptic jargon.

Here’s the equation for calculating capital gain:

Selling price — expenses of sale — “adjusted basis” (explained below) = capital gain.

Concept: what you paid for the property = “basis”

What you paid for the property originally is called “basis.”

Example

If you bought a piece of land for $100,000, your basis is $100,000.

Basis can go up. If you invest more money into the property for capital improvements, you increase basis.

Example

You bought a piece of land for $100,000. You spent another $300,000 to build a house on the land. Your basis is now $400,000.

Basis can go down. This is usually for depreciation.

Example

You bought a piece of land for $100,000. You spent another $400,000 to build a house on the land. Your basis is $400,000. Every year you take a depreciation deduction of $10,000. At the end of the first year, your basis is $390,000.

OK. Clear on that? This basis number, as moved up and down for your activities during ownership, is called “adjusted basis.”

Tax rate applied to capital gain

Once you’ve calculated your capital gain, you are in a position to calculate your tax liability.

If you own the real estate for more than one year, the Federal tax is 15 percent of the capital gain. (If you own the real estate for less than one year, the profit is taxed as ordinary income at Federal tax rates that approach 40 percent). I’m talking now of ownership structures that DON’T involve corporations. Those rules are different.

States (and sometimes cities) will impose a tax on the capital gain. The rates vary. California’s rate will top out at 9.3 percent. (Again, we’re talking about situations where we don’t have corporate ownership of the U.S. real estate).

Tax is unavoidable

There is not much that you can do to eliminate the tax on your profit when you sell. U.S. tax laws do not discriminate against nonresident investors in calculating the tax liability.

There is sometimes a thought that the sale can be made in the U.S. and cash repatriated to the investor’s home country. How will the U.S. ever collect its tax from you if you (and your money) are never coming back to the U.S.?

Well, the U.S. tax authorities thought of that. The answer they have: mandatory withholding of 10 percent of the gross sale price of the real estate. The implications and dynamics of tax withholding will be the subject of another topic in this series.