Real estate holding structures for nonresidents – tax law changes coming

This is a distant early warning to nonresidents with U.S. real estate investments. The warning applies to multi-national corporations as well (businesses that operate in the United States and elsewhere in the world) but I am going to focus on real estate investors here.

RISK

An proposed change in U.S. tax law may double the tax you pay when you sell the real estate.

WHO MAY BE AT RISK

Anyone owning U.S. real estate through a holding structure that contains a corporation for which an election has been made to treat it as a disregarded entity.

SUGGESTED ACTION

Examine your holding structures (that wedding cake of trusts, corporations, partnerships, and limited liability companies that you pay for every year) and plan to change those structures before the end of 2010.

SITUATION

You may be using corporations as part of a holding structure for your U.S. real estate. If so, it is likely that one or more of these corporations made an election to be disregarded for U.S. income tax purposes. (You would do this because the income tax rate on capital gains earned by regular corporations is much higher than the capital gains tax rate for other holding structures. You’d pay less in tax when you sell the real estate.)

When you elect to treat a corporation as a disregarded entity (use Form 8832 [PDF] to do this), the company continues to exist and operate in every normal way, except that it doesn’t exist for U.S. income tax purposes. You ignore the corporation and the shareholder of that corporation will pay the tax instead.

Useful. Simple.

NEW TAX LAW

President Obama’s team has proposed changes that will (I expect) largely eliminate this strategy. The ability to make a simple election and treat a corporation as a disregarded entity will likely be eliminated for most people.

We don’t know the details of the proposal yet. Like all tax laws, this will have rules, exceptions to the rules, and exceptions to the exceptions.

I think it is likely that the new tax law will be enacted. It is aimed at stopping certain tax-saving strategies for multi-national corporations. The U.S. government needs money. Enough said.

The new tax law may well be clumsy enough to affect nonresidents with U.S. real estate investments who are not using the tax-saving strategies that are targeted by the U.S. government. And that’s why I am saying you should be prepared.

THE FEDERAL TAX IMPACT IF THE LAW IS CHANGED

If it is made, you will pay a much higher tax on your capital gain when you sell your real estate. Looking at today’s tax rates, this will change your tax rate from a Federal tax at 15% (if you owned the property for more than a year) to a Federal tax somewhere in the 34% or 35% range. That means your Federal tax on profit when you sell the real estate will more than double.

NEXT ACTION @ YOU

Here’s what to do:

1. Identify holding structures that contain corporations that are treated as disregarded entities.
2. Create a plan for what you will do if the law changes.
3. (Maybe there is a reason other than the threatened tax law to make a change to your holding structure. If so, do it.)
4. Watch the tax law proposals as they work through Congress.
5. Take action when you feel the time is right.

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