João Pedro Volz – July 9th, 2022
It is difficult to underestimate the appeal US real estate has for many international investors. Real estate investments can serve a multitude of attractive purposes. It can be a source of US dollar income, providing a steady flow of return on investment. It can be a storage of wealth for those who wish to secure their wealth against local currency risk and inflation. It may even serve for personal use as a summer home. It is no wonder that an estimated 20% of Florida real estate was purchased by foreign investors prior to 2020. While the socioeconomic consequences of the COVID-19 epidemic did lead to a drop in foreign inbound investment, we are starting to see a strong resurgence of interest in US brick and mortar investments among international investors.
While attractive to many internationally, US real estate investment can be expensive to people who engage in it unprepared. Careful preparation and using the right structure to conduct your investment is the key to avoiding some of the more costly pitfalls of investment.
There is no single structure that can fit the needs of every investor. Structures can prioritize privacy, asset protection, cost efficiency, or practicability. In finding the right fit a diligent investor should take into account, reporting requirements, exchange of information agreements, asset protection laws, tax costs, structure costs, and how easy the structure might make opening bank accounts or obtaining mortgages. This kind of analysis should and often does get outsourced to professionals who far too
often rely on industry standard instead of taking the time to study what will best fit their client’s needs. I hope in the following pages to help those who wish to affect a plan for themselves or their clients to get an overview of some topics they might need to consider. Covering all these topics in their entirety is the subject of volumes of books and beyond the scope of this article. My hope is to elucidate on the key concepts which investors should be made aware of and examine against these concepts the five most used and useful structures for international investors looking to invest in US real estate.
“Who is investing” is the first and most important question when dealing with real property investment. There is no general bar on who may purchase real property in the United States. The holder of the real property can be anyone from individuals, corporations, partnerships disregarded entities, grantor, and non- grantor trusts. The treatment of these potential investors is also heavily based on if they are foreign or domestic.
Generally, a corporation partnership or disregarded entity is considered domestic based on its place of incorporation. If they are registered in a us state they are considered domestic, if not they are generally considered foreign. Treatment as a corporation, partnership or disregarded entity is determined at the time of incorporation, or by subsequent election. Without election, Corps are taxed as C-Corporations, single member LLCs are taxed as disregarded entities, multi-member LLCs are taxed as partnerships, and almost all foreign entities are taxed as foreign corporations. The United States offers some flexibility in the tax treatment of entities through form IRS form 8832. This form allows certain domestic and foreign companies to elect their United States tax treatment. US corporations can elect to be treated as S corporations. US LLC’s can elect to be treated as C-Corporations or S-Corporations, and some foreign corporations can generally elect to be treated as partnerships or a disregarded entity. In the case of foreign corporations, it will depend on weather the foreign corporation is not on the list of pre-se corporation’s ineligible for election. Electing to change the tax status of your company usually only affects the IRS treatment of that entity and normally will have no effect on how other jurisdictions will view the company.
Trusts are a little bit more nuanced in this regard. For a trust to be considered domestic it must be governed by a US jurisdiction, the “court test”, and substantially controlled by a United States individual, the “control test”. Failing either test will result in the trust being considered a foreign trust. Some US states have passed “directed trust” statutes which allows grantors flexibility in determining the tax status of their trusts by placing substantial control of a trust’s assets in a foreign third party and not the professional trustee. When these third parties are nonresident aliens to the United States, these trusts fail the control test. In essence a trust can enjoy the benefits of the laws of Wyoming, Nevada, or South Dakota, and be considered a foreign trust for income tax purposes. We will explore the importance of these kinds of trusts below.
There are five primary tax types we need to analyze when dealing with real estate investment structures. These are the Income and Capital Gains Tax, Gift and Estate Tax, Corporate dividend and branch profit tax, FIRPTA Withholding, and Partnership Withholding. If you are a tax professional you can probably point out that FIRPTA Withholding and Partnership Withholding are not really taxes, and that corporate dividend withholding is not the same as a Branch profit tax. I have decided to include them together, as regulation on all of these issues stems from the IRS, and they will in some way impact determinations on which structures to use when
investing. If you did not see your favorite tax on the list, its not because I find it unimportant. I have chosen this list because I feel they are the most important for examining structures used for US real estate investment by foreign persons.
Income and capital gains taxes are the two most important when considering what structure to use. This is mainly because they will vary profoundly depending on the structure. With real- estate investments, most investors can expect their primary sources of income to stem from rental income, and the sale of a property. Rental income is generally taxed at the progressive income tax rates for individuals, 10%-37% of net profits, and at the corporate tax rate 21% for foreign and domestic corporations. Capital Gains taxes can be broken down into long-term and short term. Long term capital gains occurs when real property is sold after three years of being purchased. Short term is considered any period less than three years for real estate transactions. For individual level this difference is marked by a sharp difference in tax rates. Long term capital rates are taxed at the reduced 0%-23% brackets while short term capital gains are taxed at the same rates as regular income. Corporations do not have a different regime based on type of income and all capital gains will be taxed at the same fixed 21% rate.
Out of all considerations foreign individuals should make when investing in united states real property, none are arguably as consequential as planning for gift and estate tax. This is mostly because gifts and estates can be taxed at high levels in the US and non-domiciled individuals have a relatively small exception from its application. While gift and estate taxes are two separate taxes, they have the same rates and apply similarly to foreign individuals investing in the United States. The gift and estate taxes range from 10% – 40% of the value of an asset being transfer or bequeathed. While the rates look comparable to those of for the income tax, it is important to consider that they are not calculated on income, but rather the gross value of the transferred property. It applies generally to all US situs property held by foreign individuals. US situs property includes real-estate, and real property holding companies. While US domiciliary have an 11.5-million-dollar lifetime exemption from this tax, rendering it a non-issue for many, foreign investors have a much smaller US $60,000 exemption to count on. Due to high value of real estate and the fact that this tax is not tied to any generation of income, many foreign families who fail to plan around this tax find themselves having to sell the asset to pay the taxes. Planning around this tax is the primary reason we will be looking at two tiered structures in the next section. A foreign entity can many times serve as an estate tax blocker. These entities do not die, and as such generally fail to create a US estate tax event. When the owners of these structures gift or bequeath shares of the foreign structure, those events are generally considered exempt from US taxation or reporting. In this regard not all structures are equal, and we will look at potential flaws in estate tax protection when exploring structures.
wo levels of taxation. The first is the 21% flat rate income tax we discussed above. Dividends paid to shareholders of US corporations are also taxed to the recipient. This tax will many times be considered a qualified dividends when the individual is a US tax resident and will be reported in that individual’s 1040 tax return together with all the other income that person might have received during the year. When a foreign individual or entity shareholder receives dividends, the US corporation withholds 30% tax on the dividend paid out. This withholding, like all other withholdings we will discuss, happens to safeguard that taxes will be paid on income earned. Due to the difficulty in prosecuting foreign individuals who fail to pay taxes owed, the United States has in some cases opted to impose a duty to withhold on the payer on behalf of the foreign recipient. The foreign
recipient of that dividend does not need to also file a tax return declaring that dividend payment, since taxes on that income have already been paid on his behalf.
Branch profit tax seeks to put foreign corporations investing in the United States on equal footing with US corporations. The 30% branch profit tax applies whenever a foreign corporation income effectively connected to a US trade or business (ECI) which is not reinvested in the same year that is earned. In other words, the US government levies an additional 30% tax on top of the 21% tax because it assumes profit which was not reinvested is being distributed to the foreign partners. This additional tax shows up anytime a foreign corporation files an 1120F declaring income from US sources. It theoretically applies to any ECI earned by the foreign corporation. We will discuss below how best to reduce or eliminate the potential branch profit tax on structures subject to it.
FIRPTA withholding is one of the most pressing considerations on the forefront of every real-estate transaction. Also known as 1445 withholding, FIRPTA applies any time a non- resident alien sells real estate in the United States. The purchaser of the property is generally required to withhold 15% of the gross value of the property sold. This amount normally more than covers any potential tax which might be applicable to the transaction. That is to say, FIRPTA withholding, unlike the withholding done by us corporation on the payment of dividends to foreigners, is not actually a tax. Its intended purpose is to guarantee that a foreign person will meet the filing requirements and pay adequately on the sale of their US real property interest. In transactions involving FIRPTA, investors will be given a copy of a 8288-A where the amount withheld will be detailed, and they will use it to file a tax return and generally request a refund.
While the process described above seems easy enough, in recent years the IRS has taken increasingly lengthy periods of time to issue large refunds. This was grossly exacerbated by COVID- 19 pandemic work from home policy, which left the few individuals staffing FIRPTA processing unable to meet the demand. The delay is often further compounded by individuals with multiple names and differences in how the name in the 8288-A is written compared to how the tax return is filed, a silly but far too common error. These inefficiencies make structures which do not require FIRPTA withholding look much more attractive to investors, but as we will discuss below, that benefit comes with a cost.
FIRPTA withholding can be avoided by requesting a withholding certificate from the IRS. These certificates can be requested when no tax is due on the transaction, or when the taxes due are much less than the amount withheld, which is almost always the case. An attorney, title company, or accountant will usually serve as withholding agent for the transaction and hold the funds until the IRS either releases the certificate or rejects the petition. These petitions must be submitted before the closing date on the property, together with required supporting documentation. Until recently these certificates were granted when the application was done in a timely and complete manner. Post COVID-19, the IRS has begun delaying their response to requests. The headache this process might cause versus the increase tax burden in having a structure which avoids the need for it, is something every investor must consider.
Like FIRPTA partnership withholding is not a tax, but rather a guarantee a foreign partner will meet with his duty to file tax returns on US source income. Simply put the Internal Revenue code section 1446 requires that partnerships withhold the maximum applicable tax rate on income related to a foreign partner. In other words, 1446 requires individuals and foreign trusts to be withheld on the 37% rate, and foreign corporations to be withheld at the 21% rate. Unlike FIRPTA, this withholding is on the net income and not on gross value of a
transaction. Withholding is done by the paying corporation directly when filing form 1065. A copy of how much was withheld is sent to the partner who can file its own tax return to request a refund. Since withholding is done at the maximum rate, there generally will be a refund due to foreign partners. The notable exception to this principal are foreign corporations which do not have a graduated tax rate but rather a fix 21% rate on all income.
The double Corp structure is the structure the most used by accountants and attorneys for their international clients, and with good reason. The double Corp structure involves a foreign corporation directly owning 100% of the membership interest or shares of a US corporation or US LLC which has elected to be treated as a corporation. This structure requires that the US corporation file form 1120 annually, and the foreign corporation file form 1120F whenever it receives profits from the liquidation of its United States holding.
It is so widely popular because it simplifies many of the issues discussed above. The foreign corporation serves an estate tax blocker to avoid any potential estate tax liability. The US corporation serves as a barrier to FIRPTA considerations. This stems from US corporations being US persons who can sign non-foreign affidavit during real estate closings. The Double Corp structure is also generally exempt from branch profit tax on their real property transactions. The foreign corporation would ideally only need to declare an income tax return in the eventual liquidation of its subsidiary, and that activity is not generally subject to the BPT.
Despite these advantages, this structure suffers from potentially high tax liability. The cost of having two levels of tax is not easy to ignore. At the US Corp level the structure is subject to the flat 21% income tax as well as a 30% dividend tax whenever a dividend payment is made. Dividends are optional, so many who hold real estate in this structure avoid making them altogether. While the US Corp does not need to distribute income to its shareholder, this structure will be generally subject to two levels of taxation whenever profits are remitted to its owner. Liquidation of the underlying corporate entity might alleviate this additional tax in some cases. Investors who value privacy should also know that US corporations are required to inform 25% or direct or indirect beneficial owners of the structure on form 5472. This information is not generally exchanged with other governments.
While I am not professionally opposed to use of this structure, I generally would not recommend it to anyone who is expecting to make a decent profit on their real estate investments through rental. From personal experience it can be risky to assume you will not earn profits. This structure has served many foreign investors in the Miami market the last 10 years, where prices were relatively stable and investors were for the most part getting the same or less out of selling their real estate, factoring in maintenance costs, interest payments, and property taxes. With the unexpected post pandemic boom in real estate values throughout south Florida, I have come by more than a few investors who were sadly surprised with their tax liability from this structure. While selling all real property assets and liquidating the holding company can alleviate some of the more onerous tax liabilities, these constraints can be limiting for some who wish to make use of company profits.
This is a much less common but not all together unseen structure. It involves a foreign corporation holding 100% of the membership interest in an LLC which did not make any elections. Tax wise the LLC makes no difference, and this analysis also applies to structures which involve a foreign corporation directly holding the US real property interest. This structure only reports 1120F every year, and a 5472 on the part of the LLC. The primary advantage offered by this
structure is it helps avoid estate taxes, and it theoretically could avoid the higher tax rates applicable to the double corp structure.
The disadvantage of this structure is dealing with both FIRPTA withholding and Branch Profit Tax. FIRPTA withholding is not a real tax and can be avoided as discussed in the sections above, but foresight to plan the appropriate documentation prior to a sale is fundamental in maintaining this structure. In other words, it makes more work for your accountant. Also, while BPT is an issue to consider in this structure, most entities holding real property will not see income for several years, since the value of real estate is depreciated, and this together with other expenses will generally bring tax liability to zero. Branch profit tax planning will also be required when the real property is sold. In order to potentially avoid having to pay an additional 30 percent in taxes, the underlying LLC should be liquidated in the same year the real property interest is sold.
This structure can be planned well into tax efficiency but requires a lot of work from attentive accountants or attorneys who need to keep track of both the FIRPTA and BPT issues which riddle this structure. For this reason, it is much more rarely used than the Double Corp Structure.
This structure is not for the ultra-conservative investor. It enjoys higher tax efficiency at the cost of asset protection. This structure involves using a foreign corporation which has elected to be treated as a disregarded entity, or partnership, owning 100 percent membership interest in a disregarded domestic LLC. Tax wise it gives the beneficial owner access to much lower individual tax rates discussed above while avoiding any questions of double taxation and branch profit tax. Individuals should also plan around FIRPTA.
The key debate with this structure is weather or not it will in fact insulate against the applicability of Gift or estate tax. Theoretically there is an argument to be made for both sides. Proponents of the point that it does not will argue that assets of domestic disregarded entities, and not the entities itself are considered when dealing with estate taxes, and treatment of foreign disregarded entities should not be different. Those that argue that this structure does protect against estate taxes will point out that the IRS as of yet does not regulate or keep track of changes in ownership between foreign individuals and shares of foreign entities. They will further argue that, in the decades since the development of these structures, there has yet to be a case dealing with this issue, or any communication from the IRS as to how they would treat these structures.
While I am of the opinion that investors shouldn’t be worried about the estate tax issues in these structures, there are more efficient ways to achieve efficient taxation while guaranteeing protection from estate taxes.
The foreign trust structure is potentially one of the most protective structures in existence for real estate investments. It involves a foreign non- grantor trust owning 100% of a domestic LLC. The foreign trust will need to file a 1040NR in the name of the trust whenever there is rent or capital gains. This structure is also subject to a single tier of taxation in individual income and capital gains rates. It has the best limitation on liability, as neither grantor or beneficiaries of the trust are generally treated as owning the real property. Depending on what laws govern the trust, this could have one of the highest levels of privacy protection. It absolutely protects against the imposition of Estate and Gift taxation, and Brach Profit Tax does not apply since there is no foreign Corp or 1120F filings. It is important to note that investors using this structure still need to plan around FIRPTA and take into account that trusts tend to be more expensive to set up and maintain than other entities.
This structure is highly flexible, and I have no issues recommending it to investors. With the development of favorable directed trust laws in
South Dakota, Nevada, and Wyoming, you can even have the flexibility of having a US based foreign trust. These trusts would keep the privacy and asset protection laws of those states while allowing foreign investors to keep the foreign tax treatment.
Replacing disregarded LLCs in the structures discussed above with Partnerships can offer more than a few benefits. Namely US partnerships are not subject to FIRPTA withholding. Partnership withholding is applicable, but that withholding is over net income, and more easily refunded when the foreign partner files a return. Using partnerships will add additional filing requirements, as the partnership will need to file a separate 1065, but it can help partners avoid some headaches without generating increase taxation.
Above I have attempted to do my best to simplify what is one of the most complex aspects of United States Law. The idea is to inform foreign practitioners and potential investors some of the considerations and options they have when investing in United States real property. I would highly recommend consulting with me or another US tax professional before investing. The items listed above are far from the only things which need to be reflected on when investing. As I stated above, being unprepared when investing can be a costly mistake.