Land speculators and tax deduction hacks

Welcome again to the Friday Edition. This week I will look at tax deductions for nonresidents who buy and hold land in the United States.It's easy to get off the mailing list: just click the “unsubscribe” link at the bottom of this email. I won't be offended. On the other hand, if you want even more of this stuff, you can sign up for one of our other mailing lists – on expatriation, announcing our free monthly International Tax Lunches, or our “PFICS Only”.

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This week: land speculators and tax deductions

If you buy empty land and simply hold it, you will have some operating expenses. There will be annual property taxes. Maybe you will have some liability insurance to protect you from risk. If you borrowed money to buy the land, you will be paying interest on that loan.These are direct expenses associated with your investment. Is it possible to reduce your U.S. tax bill when you sell the land by claiming these expenses as tax deductions?Short answer: no.

Why ownership expenses cannot be tax deductible

Expenses on ownership of raw land cannot be deducted by nonresident investors, and the reason why is found in the basic metaphysics of U.S. tax law.

Two ways nonresidents are taxed

Nonresidents are taxed in the United States in one of two ways:

• If a nonresident is “engaged in business” in the United States, then all business expenses can be used to reduce taxable income, and therefore reduce income tax.
• If a nonresident is NOT “engaged in business” in the United States, then income earned in the United States is taxed at a flat 30% of the income received. Expenses do not reduce the amount of income that is taxed.

See IRC §871(a) (for the “30% tax without deduction of expenses” rule) and IRC §871(b) (for the “taxed on income minus expenses if you are doing business” rule). See IRC §881 and 882 for the same rules, restated for non-U.S. corporations. Those are the general concepts and of course there are exceptions and modifications galore.

This is an investment activity, not “doing business”

Someone who simply buys land and holds it … is that person “engaged in business”? No. To be engaged in business means that there are transactions. You are doing things. Buying an asset and sitting on it is investment activity, not operating a business.The expenses of owning raw land, and holding it with the hope of increase in value are real expenses. But they are investment expenses, not expenses associated with conducting business activities in the United States.

Expenses for investment activities are not deductible

Nonresidents cannot deduct their expenses for buying and holding investment assets (like land). It is a simple syllogism:

• If A, then B
• Not A
• Therefore, not B

Specifically applied to this situation:

• If a nonresident is engaged in business in the United States, then business expenses are deductible in computing U.S. income tax.
• A nonresident who passively holds land as an investment is not engaged in business in the United States.
• Therefore, the nonresident cannot deduct business expenses associated with holding the land for investment.

You cannot capitalize the expenses, either

There is another way that expenses are sometimes handled for tax purposes. Rather than take a tax deduction every year, you simply treat the expenses as part of the acquisition cost of the asset. If you bought an asset for $100 and you spent $15 in associated expenses, you treat your total investment in the asset (“basis” is the jargon used in U.S. tax law) as $115.Accountants call this “capitalizing” an expense.Sadly, the nonresident land investor cannot do that. In order to be able to capitalize an expense associated with an asset, the expense must be tax deductible. And we have seen that the expenses associated with a nonresident holding land as a long term investment cannot be taken as tax deductions.

Hacks and workarounds

This is not good. We want to get a tax deduction for these expenses. How do you do this? Here are your workarounds.

Be a domestic taxpayer

This limitation does not apply to domestic taxpayers. The solution: the nonresident investor forms a holding company that is a U.S. taxpayer. A common solution: the land is owned by a U.S. corporation. The nonresident investor is (usually indirectly rather than directly) the owner of the U.S. corporation.Now the expenses of owning the land prior to sale will be deductible. The corporation can take income tax deductions every year or can add the ownership expenses to the “basis” (total investment) that the owner has in the property. Later, when the land is sold, the taxable profit will be the difference between the sale price and the total investment in the property.

ExampleThe land is bought for $1,000 and held by a U.S. corporation. Over the years, various expenses (property taxes, insurance) of $300 are incurred. These costs are added to basis for the land, so the total investment by the owner is $1,300 in the land.The land is then sold for $1,500.The taxable profit (capital gain) is $200.

Compare this to direct ownership by the nonresident:

ExampleThe land is bought for $1,000 and held by the nonresident directly. Over the years, various expenses (property taxes, insurance) of $300 are incurred. These expenses cannot be deducted for tax purposes, so they cannot be added to the basis of the land. The nonresident's total investment in the land is $1,000.The land is then sold for $1,500.The taxable profit (capital gain) is $500.

Engage in business

This is not a workaround. This is a full frontal assault. The law says you can deduct expenses if you are engaged in business? Fine. Let's find a way to have you be treated as “engaged in business”.The way you “engage in business” for real estate is by doing business activities. That means you either behave like an land developer or your behave like a landlord.A land developer will do things like draw up plans to subdivide the land into multiple smaller parcels, then sell the smaller parcels of land. Or maybe build houses on the smaller parcels of land. In other words, you are behaving like a little factory, creating inventory for sale to customers.A landlord finds a tenant who will pay rent, and signs a lease. This is the more plausible option, and easier to achieve.The simplest thing to do is to find a tenant who will pay money for use of the land. Maybe someone will pay $100 per month to use the land as a parking area for trucks. Or maybe the land can be rented to a local farmer for grazing cattle. Do anything you can to find a third party who will pay you rent. If you do this, you are instantly “engaged in business”.Once you have that pure fact in existence, you file a U.S. income tax return (as a nonresident) reporting the income (and claiming your expenses as well). Crucially, you also make a special tax election called the “net election”. Find all the fun about this in Regs. §1.871-10.This tells the U.S. tax authorities that you, as a nonresident, elect to be taxed as a U.S. resident on all of your U.S. real estate investments. All of your other U.S. investments, and all of your other income outside the United States – these are unaffected by this special election.You can only make this election if you have actual income from the property. So if you do not find someone to pay you rent, you cannot make the election.Here is the “hack” part. Once you have someone who has paid you rent, the election is valid for all future years. Now you can continue to take tax deductions for the expenses of continuing to own the land. This means that you just have to establish yourself one year, collect rent, and then you are in good shape for taking tax deductions (or capitalizing expenses) for future years.

The backloading hack

The other hack is one of timing. U.S. tax law says that a nonresident is treated as engaged in business for a real estate sale – but just in the year of sale. This means that for the year of sale all related expenses can be deducted in computing tax.The game here is to backload your expenses: pay them in the year of sale when they are deductible, rather than in earlier years, when they are not.I will talk about the backloading hack sometime in the future.

Disclaimer

This is not legal or tax advice. It is being written after midnight in Toronto and I haven't eaten anything except for a manky California roll on the flight here from Los Angeles. I am tired, hungry, and sweaty from having gone for a late-night run along King Street to Spadina, up to Dundas, and then I got lost a bit but eventually got back to the hotel. So … excuses, excuses. (P.J. once said from the podium “There are no explanations, only excuses.” She might have heard it from somewhere, but I remember her saying that, even 20+ years later.)See you next week.Phil.