Here is an article I wrote for publication in a local newspaper circulated amongst real estate brokers in Southern California.
Remember! This is not legal advice. An article for general publication by definition leaves out important clarifications and technicalities. In other words, read this for your amusement 🙂 but do not make any legal or tax decisions based on this. Or anything else in this website, for that matter.
TAX WRINKLES FACING THE FOREIGN BUYER OF U.S. REAL ESTATE
by Philip D. W. Hodgen
Foreigners buy real estate as one of the first investments they make in the U.S. They need special tax advice, because the tax rules they face are not the same as those facing U.S. residents. The normal transaction practices for real estate — escrow, title insurance, and so forth — are typically new to them as well. Finding mortgage financing can be troubling because these are people who have no credit profile at all in the United States.
REAL LIFE RISKS–ESTATE TAX
When dealing with a foreign buyer of U.S. real estate, the key tax decision lies in the answer to a seemingly simple question: of “How do I take title?” It is not an easy question to answer. The first choice people usually consider (when deciding how to take title) is “In my own name, of course!”
When the foreigner eventually sells the property, all capital gain will be taxed at the 15% long term rate (assuming he or she held the property for more than a year). However, foreigners are at a very substantial disadvantage for estate taxes–if a foreigner dies while owning U.S. real estate, the entire value above $60,000 is going to be taxable, at rates usually in the 45%-47% range. Compare that with the standard exemption for U.S. residents–the first $1,500,000 of their assets will not be subject to U.S. estate tax at all.
Thus, holding title directly is risky for U.S. estate tax purposes, unless immortality runs in the owner’s family.
REAL LIFE RISKS–RENTAL PROPERTY
Anyone owning rental property will want to take a tax deduction for depreciation, mortgage interest, property taxes, expenses of management and repair, and all of the other normal expenses associated with owning the real estate. That usually brings the net income for tax purposes close to zero. Then you apply the normal income tax rates to the net income to calculate your income tax.
Not so for foreign owners of rental property. Here’s the default rule that applies–they face a Federal income tax of 30% of the GROSS rent. No deduction for any business expenses is allowed. Fortunately, there is a way out, if the foreign investor takes affirmative action to get away from this “30% of gross rent is my income tax” to the “take every allowable deduction, then apply the normal income tax rates” system of taxation of NET income. And this must be done in a timely manner.
REAL LIFE RISKS–THE ACCIDENTAL GIFT TAX
Here is a real-life situation I have seen several times. A couple plans to buy a house in California for occasional use on visits. They will not live here full time. The husband comes to the United States, and buys a house for all cash, and takes title in his name. No thought is put into it; it just seems to be a sensible move. The wife arrives, and finds out. She wonders why she is not on title, and so the husband adds her as a co-owner (usually a joint tenant).
The IRS looks at this as a gift from the husband to the wife. For U.S. residents, this presents no problem. But for this couple, both nonresidents, this is a taxable gift. A gift tax return must be filed and gift tax will be due on the value transferred above $110,000.
Most countries do not have gift tax laws. And the default gift tax rules in the U.S. for its residents make this a simple, no brainer move in ordinary circumstances. But for this couple–both nonresidents–all of a sudden they may be facing a gift tax of hundreds of thousands of dollars even though the property remained in the family.
SO HOW SHOULD THE FOREIGNER TAKE TITLE?
With this litany of tax risks facing the foreign buyer of U.S. real estate, what IS the best way for that buyer to take title? There is no easy answer. In general, using direct ownership, a partnership, or a limited liability company will all expose the buyer to estate tax risk if there is death. On the other hand, capital gain on sale will be taxed at the favorable low long term capital gains tax rates.
On the other hand, if a foreign buyer takes title in the name of a foreign corporation, then dies, there will be no U.S. estate tax due. However, capital gains on sale will be taxed at corporate income tax rates (35%-36% typically).
In short, the solution that keeps capital gains taxes down (good) also exposes the buyer to estate tax risk (bad). And the solution that eliminates the estate tax risk (good) causes the tax on capital gain to more than double (bad).
The solution in each particular case needs to be examined with care, and with consultation with the buyer. There are some general rules that almost always apply, however:
1. Never buy the real estate in a U.S. corporation where the foreign individual is the shareholder. This causes the worst of both worlds–the capital gain is taxed at 35%-36% and if the buyer dies the U.S. will impose estate tax.
2. Never hold rental property directly in a foreign corporation. While this shelters the buyer from estate tax (good), it causes a double Federal income tax (bad). First, the corporation’s net profit from rent is taxed at normal tax rates. Then, the after-tax profit is taxed at 30%. It’s as if you paid an income tax on your salary, then paid a second income tax on your after-tax salary income. Horrible.
3. Don’t just consider the tax issues. California Probate Courts are dreadfully expensive and slow. Use living trusts, even if they give no tax benefits, to make sure that real estate passes to the right heirs quickly and cheaply.
Phil Hodgen is a Pasadena tax lawyer who specializes in international tax law. A large portion of his practice involves representation of foreign persons in real estate transactions.
Philip D. W. Hodgen
Hodgen Law Group, PC
140 South Lake Avenue, Suite 250
Pasadena, CA 91101
www.hodgen.com and www.firpta.com