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US real estate miniseries #1 - direct ownership
Phil Hodgen
Attorney, Principal
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Hi, it’s Phil Hodgen again. Welcome to the Friday Edition. If you want to stop getting this thing every Friday, just click the “unsubscribe” link at the bottom of this email. I won’t be offended. On the other hand, if you want more, you can sign up for one of our other mailing lists.
Real estate investor mini-series
Today is the start of a 4 week mini-series on real estate investment in the USA. The mini-series will cover federal estate tax and income tax on rent in four investment structures:- Direct ownership by a nonresident alien individual (this is the topic of this week's email);
- Direct ownership by a foreign corporation in a non-treaty country;
- A foreign corporation owns a U.S. corporation, which in turn owns the real estate; and
- Direct ownership by a foreign corporation in a treaty country.
Assumed scenario
You are a nonresident of the United States, and you want to invest in U.S. real property. You will collect rent from the real estate, and (you hope) sell the property in a few years with a nice capital gain.I will make assumptions to make the concepts easier to illustrate:- Ignore state income tax. The math gets much simpler and the ideas are easier to explain when we only think about Federal income tax.
- Rent paid by the tenants is $100,000 per month before expenses), or $1,200,000 per year. If the rent collected is lower, the tax calculations get more complicated because of graduated rates of income tax and the impact of higher income levels on reducing exemptions and deductions.
- Operating expenses. Assume $400,000 of operating expenses (maintenance, property tax, mortgage interest, etc) and $300,000 of depreciation every year.
- Property value. The value of the real property is $10,000,000, for making estate tax calculations.
- Home country income tax. I am ignoring income tax in your home country, in order to highlight the U.S. tax planning you need to do. Obviously, your home country income tax must be considered.
Estate tax: about 40% of value at death
The US imposes an estate tax on the taxable estate of nonresident aliens. IRC §2101. The taxable estate a nonresident alien is his US situs assets minus certain deductions and exclusions. IRC §§2103, 2106. US real property is a US situs asset. IRC §20.2104-1(a)(1). The nonresident alien’s real property investment is subject to US estate tax.A nonresident alien gets a credit of $13,000 against the US estate tax. IRC §2102(b)(1). This is about the same as excluding $60,000 of value from the taxable estate.If a debt can be enforced against the nonresident alien, then the debt must be pro-rated among the US situs assets and foreign situs assets. IRC §2106(a)(1). In the US, lenders typically secure the loan through the property, but they often have an option to collect the full debt against the borrower’s other assets. These loans can be enforced against the nonresident alien and therefore must be pro-rated.In effect, almost the entire value of the real property is taxable estate under US estate tax law. The US estate tax has a maximum rate of 40%. IRC §2001(c).The nonresident alien has an estate tax risk of almost 40% of the value of the real property at the time of death. For a $10,000,000 property, the estate tax risk is $4,000,000.Income tax on rent
Your U.S. rental income will be taxed in one of two ways, and you choose which method you want:- 30% of the rent you collect, with no deductions for your business expenses allowed in calculating your income tax. IRC §871(a)(1)(A). Income taxed at 30% of gross is called fixed, determinable, annual, or periodical income (FDAP).
- At graduated rates on taxable income (rent collected minus operating expenses. IRC §871(b). The tax rates go as high as 39.6%. Income taxed at graduated rates on net is called effectively connected income (ECI).
30% of gross rent = $360,000
If you choose to pay income tax using the "30% of gross income" method, your tax payable will be $360,000. You collect $1,200,000 of rent. Multiply that by 30%.This is easy, but look at the result: you collected $1,200,000 in rent, spent $400,000 for operating expenses, and paid $360,000 of income tax. You have $440,000 of cash left in your pocket.Pay tax on income after expenses
If you choose the "pay income tax on rent minus your business expenses" method, the tax you pay will be less.You collect $1,200,000 of gross income. §871(b)(2). From that, you deduct your expenses of $400,000 and depreciation of $300,000. IRC §§161-167.You have taxable income of $500,000. The highest individual tax rate is 39.6%. IRC §1. For simplicity, I assume the overall tax rate will be 35% of taxable income. (Some of the income will be taxed at lower tax rates.)Your income tax is $140,000.The cash in your pocket looks like this: $1,200,000 rent collected minus $400,000 of operating expenses and minus $140,000 of income tax = $660,000 in your pocket.Choosing how to be taxed on rent income
I said you can choose how to be taxed, and that is "somewhat" true. :-) The default method is the "30% of gross income with no deduction for expenses" method.The better way of being taxed is based on you being "engaged in business" in the United States. The numbers I just showed you demonstrate that you put more money in your pocket that way.You can claim this method of paying income tax on your rent in one of two ways:- Just start filing tax returns claiming that you are "engaged in business" and if you are challenged by the U.S. tax authorities, prove to them that you really are "engaged in business"; or
- File the same tax returns and add one piece of paper to the first tax return that you file, which guarantees you the result you want -- paying income tax on rent minus expenses, rather than paying income tax on rent without allowance for expenses
The impact of depreciation
The reason that the income tax liability is so much lower using the preferred method of being taxed like a U.S. resident taxpayer is that the income to be taxed is a much lower number. It is a much lower number because you get to deduct your expenses.Depreciation is usually one of the biggest tax deductions for a real estate investor. You do not spend real cash money to create this tax deduction. Instead, the tax law assumes that your building will get old and need replacing over its "useful life".As a result the law gives you a tax deduction every year to simulate the fact that your building is theoretically closer to the day when it must be demolished and replaced with something new.This is not a permanent tax deduction. When you sell the property you will pay tax on the amount of depreciation tax deductions you took. This is called "recapture".But for a real estate investor, you absolutely want to use the depreciation tax deduction. It makes a massively beneficial impact on your cash flow. Translation: more cash money in your pocket.Capital gain tax when you sell
Owning real estate directly means that when you sell your capital gains will be taxed at a low rate: 20%. In future episodes you will see that this is significantly better than the tax rate applied to capital gains if you use corporations to own your U.S. real estate.Summary: unacceptable risk; avoid direct ownership
By investing in U.S. real estate directly, you have an estate tax risk of about 40% of the value of the property -- about $4,000,000 of tax in this example. Your heirs would have to pay this tax, so your children will lose some of their inheritance to the U.S. government.This is an unacceptable investment risk. A successful investment strategy is one where you:- Limit your losses; and
- Collect your profits.