02.02 – Who is a resident for U.S. estate tax purposes?

by Phil Hodgen on November 23, 2008

Residents and citizens of the United States will have their worldwide assets subjected to the estate tax when they die. Nonresidents are at risk for the U.S. estate tax only for assets they own which are located inside the United States.

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.

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02.01 – Estate tax and the nonresident investor

by Phil Hodgen on November 23, 2008

This chapter deals with the estate tax–what it is, how it works, and how to plan around it. I will only talk about the U.S. estate tax as it applies to a nonresident investing in U.S. real estate. There is much more to talk about beyond real estate, but that’s a topic for another website.

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.

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01 – Introduction (part 2) – Why the acquisition is so important

by Phil Hodgen on November 23, 2008

How you acquire title to your U.S. real estate is the most important decision you make. The name on the deed will drive your tax results, liability exposure, ease (or not) of inheritance, and other items

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.

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