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Often, a nonresident alien’s first entry into the U.S. economy is through the purchase of U.S. residential real estate, be it for personal, investment or rental purposes. In fact, from April 2017 through March 2018, foreign buyers purchased $121 billion of residential property in the United States.
For the cross-border investor, there is likely great value in doing this because, unlike U.S. tax residents, who are subject to U.S. income tax on a worldwide basis, nonresident aliens are subject to U.S. income tax only on two types of U.S. source income:
1. Fixed or determinable annual or periodical income (FDAP)
2. Effectively connected income (ECI)
Regardless of the motivation, gains from the disposition of U.S. real property interests by a nonresident alien are taxable as ECI. The Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) governs the tax consequences from the sale of U.S. real estate and requires that the transferee withhold 15 percent of the gross amount realized from the sale or exchange by a nonresident, whether a gain or loss is realized from the sale. Notwithstanding FIRPTA, the 1031 exchange is available to the nonresident alien taxpayer, allowing for no gain recognition.
For a nonresident alien who receives rent from a property, the default rule is that the rental income is FDAP subject to a 30 percent (or lower by treaty) withholding tax. Alternatively, the nonresident alien can elect to have the rental income taxed as if it were ECI.
The manner in which the title to the real estate is held will be dispositive as to other issues as well, including whether or not the nonresident alien’s estate is subject to the U.S. estate tax. A nonresident alien’s estate will be subject to the estate tax on U.S.-situs assets, including real estate. A nonresident decedent receives only a $60,000 exemption amount (or more depending on treaty), as opposed to the $11.4 million estate tax exclusion amount available for U.S. citizens and domiciles (in 2019). Additionally, the nonresident decedent estate tax credit is not adjusted for inflation.
As a result, many investors will hold title to the real estate in an entity, which of course brings its own set of unique tax issues. Clearly, careful structuring of ownership of U.S. real estate by a nonresident alien is paramount.
For many foreign individuals, the most important U.S. tax consideration when considering an investment in U.S. real estate is how to avoid being subjected to U.S. federal estate and gift taxes (up to 40 percent). While the income tax aspect is generally not the dispositive variable in the NRA ownership analysis, if capital gains treatment (generally, 20 percent) can be achieved (as opposed to regular income tax rates reaching 37 percent), that too should be a planning goal. With corporate income tax rates now at a fixed 21 percent, the corporate form of ownership is no longer an automatic negative. Consider these structuring options:
While the sale of the property by the foreign corporation would be subject to the lower U.S. federal corporate 21 percent tax rate, the sale of the property by the foreign corporation may trigger the branch profits tax. The branch profits tax is imposed at a flat rate of 30 percent on amounts deemed repatriated out of the United States.
Clearly, entering the U.S. tax system is a journey that should be undertaken with proper diligence. Careful income, gift and estate tax planning for the NRA will accumulate what were the many unknowns in the U.S. tax system for the NRA. The risks which remain are those familiar to the NRA investor, and the NRA can proceed to assess the viability of his foreign direct investment in U.S. real estate in a relatively comfortable environment.
Doeren Mayhew’s international tax advisors can help you navigate this complex process and help determine ownership options of U.S.-situs assets most appropriate for nonresident aliens. Contact us today for more information.
This publication is distributed for informational purposes only, with the understanding that Doeren Mayhew is not rendering legal, accounting, or other professional opinions on specific facts for matters, and, accordingly, assumes no liability whatsoever in connection with its use. Should the reader have any questions regarding any of the news articles, it is recommended that a Doeren Mayhew representative be contacted.
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