Evaluating Ownership Options of U.S.-Situs Assets Following Tax Reform
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.
Structuring Options for Ownership of U.S. Real Estate
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:
- Direct Ownership in U.S. Real Estate: The most simplistic ownership structure is for a nonresident alien to acquire ownership in the real estate in an individual capacity. The biggest disadvantage of this ownership structure is the potential exposure to U.S. estate tax, which applies to U.S. situs assets, including U.S. real estate. Advantages of direct investment is the simplicity of formation and the (capital gain) tax treatment upon sale.
- Ownership Through a Single Non-U.S. Corporation: The NRA should not be considered to own a U.S.-situs asset for U.S. federal estate or gift tax purposes; therefore, a transfer of the foreign corporation by gift or bequest should not trigger U.S. federal estate or gift tax liability. While these factors are certainly beneficial, this scenario contains factors that may be detrimental.
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.
- Ownership Through a Two-Tier Corporate Structure (“Corporate Sandwich”): The corporate sandwich (U.S. corporation owned by a foreign corporation) also will be subject to FIRPTA withholding tax when the foreign corporation disposes of its shares in the domestic corporation because it is considered a United States Real Property Holding Company (“USRPHC”), but the sale of the underlying real estate (held by the U.S. corporation) will not involve FIRPTA. This scenario shares the two advantages with the ownership through a single non-U.S. corporation, namely no U.S. federal estate or gift tax exposures, but contains one additional advantage - it prevents the 30 percent branch profit tax because the property is held through a domestic corporation. Instead, a 30 percent tax (subject to reduction by treaty) will apply to FDAP income, such as dividends or interest paid by the domestic corporation to its foreign corporate parent, unless the domestic corporation is liquidated into the foreign parent.
- A New Option: Ownership in an S Corporation: Historically, an S corporation could not have an NRA as a shareholder, and the S corporation election was terminated if a foreign individual became an owner. Under tax reform, a foreign individual may now use an Electing Small Business Trust to obtain an interest in an S corporation. Similar to limited liability companies, S corporations are pass-through entities whose corporate income, losses, deductions and credits flow through to their shareholders for federal tax purposes.
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.