What’s the Best Way to Own Real Estate if you are not a US citizen?
In Part 1, entitled “Estate Planning for the Non-Citizen,” I discussed the differences between the terms “US Resident” (for income taxes) and “US domiciliary” (for estate taxes), which I will be referring to in this article repeatedly.
Given the various income tax and estate tax consequences that foreigners must be aware of when owning US assets, there are a number of different options available for a foreigner to own U.S. real property, each with its own set of pros and cons. Unfortunately, there is no one-size-fits-all approach and selecting the right strategy depends in large part on the owner’s objectives when it comes to who will be inheriting the property and whether the property will be rented, used for personal use, or sold.
The strategies outlined below apply to two different kinds of foreigners: (1) those who are both non-residents for US income tax purposes (and very likely also non-domiciliaries for US estate tax purposes) (who I will refer to here as a non-resident alien or “NRA”); and (2) those who are US residents for income tax purposes but who are non-domiciliaries for US estate tax purposes (who I will distinguish here as “Non-Domiciliaries”).
In determining the right approach, we must evaluate how each of the following are affected:
- Estate tax;
- Gift tax;
- Income taxation of rental income;
- Income taxation of capital gains of US real property;
- Presence of US beneficiaries;
- Tax filings; and
Although this is perhaps the worst form of ownership of US real property for an NRA as well as a Non-Domiciliary, I will still go through a brief analysis here simply to underscore the various issues presented. Direct ownership refers to an NRA or Non-Domiciliary owning US real estate directly in their name, regardless of whether any one else owns the property. In other words, direct ownership is ownership that does not involve a trust, LLC, corporation, or some other business entity.
There are a few limited advantages to note:
- Administrative simplicity
- Absolute control
- Eligible for long-term capital gain rate on sale of property at 20%
However, the disadvantages include the following:
- Greater Liability Risk: Generally, regardless of citizenship or residency status, US rental properties should be owned by a limited liability company (LLC) in order to prevent a creditor from enforcing a judgment against all of an owner’s properties, including their personal assets. An LLC, if properly structured, can shield your personal assets from liability and limit the exposure risk to only those assets owned by the LLC, namely one rental property. In this article, I discuss at length the need to create an LLC for asset protection.
- FIRPTA: When the property is sold by an NRA, or a foreign entity, there will be FIRPTA withholding, which I discussed briefly in Part 1.
- Estate tax applicable: This is perhaps the single greatest disadvantage to direct ownership of US real property by an NRA or Non-Domiciliary. The estate tax exemption for a Non-Domiciliary (which would include nearly all NRAs as well) is only $60,000; thus, when the individual passes away, any value greater than this will be taxed at 40%!
- Gift tax applicable: If the Non-Domiciliary/NRA attempts to transfer ownership of the home to anyone else or to a trust or entity, there will be a 40% gift tax on any amount above the exemption. In Part 1, I identified what those exemption amounts are; namely, $60,000 to any transfers other than a spouse, and $164,000 to a non-citizen spouse.
- Annual tax filings: There are a number of annual tax filings for an NRA that owns US real property.
- Lack of privacy: The County Recorder will make public any ownership of US real property; thus, with any kind of direct ownership, there is a lack of privacy.
While direct ownership is likely the worst method to hold US real estate by a foreigner, there are some solutions to solve for the estate tax exposure at death, including the purchase of a life insurance policy to be paid at death that can be used to pay for the estate tax (although I recommend the creation of an ILIT to do this), or placing a non-recourse debt on the property to reduce the taxable value of the property for purposes of estate taxes, or the creation of a Qualified Domestic Trust (QDOT) (discussed in Part 2) to defer any estate taxes at the death of the first spouse.
U.S. Limited Liability Company
Even with the creation of a US Limited Liability Company (LLC), the above analysis does not change much, other than the fact that there is asset protection with the use of an LLC as well as some privacy. However, there is still a substantial estate tax issue once the LLC owner (the US Domiciliary/NRA) dies and for that reason alone, the US LLC owned by the foreigner is not a recommended structure in and of itself.
While it is true that a foreigner can gift corporate shares without triggering a gift tax, the main drawback is that if a US corporation directly owns the US real estate, there will still be significant estate taxes due once the foreign shareholder dies, as stated above. Moreover, there would be additional disclosures if the U.S. corporation is owned by a foreigner, such as the filing of IRS Form 5472.
Foreign Corporation via U.S. corporation
This is a common setup sometimes, wherein the NRA/Non-Domiciliary owns shares of a foreign corporation which, in turn, own shares in a U.S. corporation, which then owns the real estate.
The advantages here are:
- Tax rate: The current lower corporate tax rate of 21% applies to all rental income as well as capital gains.
- No FIRPTA: The sale of shares in a foreign corporation is not subject to FIRPTA withholdings.
- No estate taxes: Because the NRA/Non-Domiciliary is owning the foreign corporation, the foreign corporation is not considered a US-situs asset and thus not subject to estate taxes at the death of the foreigner.
- No gift taxes: Gift tax is not applicable because ownership of shares are considered an “intangible asset” and not subject to gift taxes.
Some of the disadvantages here include the following:
- No estate/succession planning: Who inherits the foreign corporation after the death of the foreigner? This setup does not address this question. In fact, if a US beneficiary inherits a foreign corporation, there will be reporting required of this ownership structure, since the foreign corporation will be deemed a “Controlled Foreign Corporation” or “PFIC.” While a US beneficiary can do a “Check the Box” election to treat the foreign corporation as a disregarded entity, there may be some amount of phantom income still trapped, which presents some adverse tax consequences. Thus, if the ultimate successors of the foreign corporation are foreigners, this setup may be more suitable.
- Branch Profits Tax: One of the disadvantages in this structure is what is known as the “Branch Profits Tax,” which is when a foreign corporation is doing business in the United States and owns US real property directly or indirectly through a pass-through entity. Essentially, it is a second level of tax to mimic the two-tier tax system of a US corporation. Thus, there is an additional 30% “branch profits” tax in addition to any federal or state corporate income tax due. The tax, which is intended to approximate the 30% tax that would apply to dividends from a U.S. corporation, generally can be avoided if the foreign corporation is liquidated in the year of sale and certain other procedural requirements are satisfied.
- Tax Filings: Another disadvantage is by way of further tax filings, since IRS Form 1120 requires disclosure of identity of the beneficial owners with this type of setup.
In this structure, if the property will be rented out and the foreign corporation owns the property either directly or through a disregarded entity (such as a single member LLC), consideration should be given to making a “net rent” election and filing tax returns in the U.S. so that property taxes and maintenance costs may be deducted against rent (using ECI).
If there is no plan to sell the property, an LLC (taxed as a disregarded entity) can be used as the underlying US subsidiary instead of the U.S. corporation. If an LLC is preferred altogether and the property is to be sold, the LLC can be taxed as a corporation to avoid FIRPTA.
Domestic Irrevocable Trust via a US LLC
Trusts are the preferred way of gifting assets and bequeathing assets due to creditor protection. None of us have that beloved crystal ball and we don’t know what the future holds for a certain beneficiary, whether or not they will be in the middle of a divorce when they inherit an asset or whether they will be in bankruptcy, or whether they may have substance abuse issues, or whether they got into a car accident and now are being sued. Because of this uncertainty, the recommended vehicle to transfer assets is a trust.
One choice that must be made is selecting whether to create a domestic trust or a foreign trust. A domestic trust is taxed much like a US resident, on worldwide assets. A foreign trust, like an NRA, is taxed only on US-sourced income. (Read here to understand more the differences between a domestic trust and a foreign trust).
In this proposed structure, the foreigner will create an irrevocable US Domestic trust, which owns membership interests in a US LLC, which in turn owns the real property.
The advantages here are:
- Asset Protection: There is substantial asset protection.
- Estate Planning: There is succession planning.
- Tax rate: The trust is eligible for the 20% long-term capital gains rate.
- No US Filing Requirements: Since this is a domestic trust, there are no filing requirements as it relates to identifying foreign grantors or beneficiaries. (If this was a foreign trust, the US beneficiaries and foreign grantors will likely have US reporting and filing requirements for distributions from the trust).
- No estate taxes
- No gift taxes
- No Branch Profit Taxes
- No FIRPTA Withholding
Among the disadvantages of this structure, they are as follows:
- Rental Income: This will be taxed at ordinary income tax rates, which can be as high as 37%. Generally, foreigners are not subject to the 3.8% Net Investment Income Tax (NIIT), but here, because it is a US trust, the tax would apply. To combat this, the trustee would need to be actively involved in the management and rental of the property. Also, if there is no rental income, then the the long-term capital gains rate may apply instead.
- Control: To avoid estate tax inclusion, an irrevocable trust requires the grantor to part with ownership of the real property. Normally, a SLAT or hybrid-DAPT are good options here, especially in a state like Nevada, wherein the grantor can still be the investment trustee of the trust. However, in the case of an NRA, if the investment trustee power remains in the hands of a foreigner, it will cause the irrevocable trust to become a foreign non-grantor trust. However, the tax implications of having a foreign non-grantor trust may outweigh the need to control it, and thus a US domestic asset protection trust may be a better option; again, a SLAT can be used but where the investment control rests with a US resident so as to not cause the trust to be taxed as a foreign non-grantor trust.
- Rent-free Use of Property: Uncompensated use of a property of a foreign non-grantor trust by a U.S. beneficiary is reportable on IRS Form 3520 as a constructive distribution and can carry out income. If rent is paid by the beneficiary to the trust however, this is not an issue. In any case, US beneficiaries can use property owned by a US trust rent-free without a constructive distribution.
Generally, a trust should be established as a US trust if there is or will be US beneficiaries. If the trust will only have non-US beneficiaries, then structuring the trust as a foreign trust will prevent any gains from the sale of US real property from being subject to the 3.8% Medicare tax.
If the trust will hold US real property, it is very important that the non-US grantor fund the trust with cash from a non-US account, since a transfer from a US account could be subject to gift tax as I discussed in Part 1. The US property should be acquired by the trust (or an LLC created by the trust) and not the settlor.
Anonymity and Privacy
There are geographical targeting orders requiring identification of beneficial owners of shell companies by title issuers. For example, if an individual owns 25% or more of a purchasing entity, then these names must be reported on FinCEN Form 8300. However, this rule does not apply to trusts, or if a bank loan is procured.
A US disregarded entity with foreign owners must file IRS Form 5472 identifying their foreign owners. This requirement has nothing to do with income taxation.
This is a tremendously complex area of law, and the various structures outlined above have different permutations of strategies depending on each client’s unique goals when it comes to the real property. Moreover, there may be local tax issues in the home countries to the extent that the foreigner is not a US income tax resident, in which case local counsel and advisors will need to work together with your US tax advisors to create the most efficient structure possible.