Article Category: US Tax Filings

Updated June 13, 2023Posted August 14, 2015

Why you, nonresident real estate investor, need another trust

Phil Hodgen

Attorney, Principal

Hi it's Phil and welcome to the Friday Edition. If you want to stop getting these emails, click on the "unsubscribe" link at the bottom of this email. On the other hand, if you want more international tax reading, sign up for our other email newsletters.

New schedule: bi-weekly

The Friday edition (like all of our email newsletters) is switching to a bi-weekly schedule. The next edition will arrive on August 28, 2015.

International Tax Lunch today

Today, August 14, 2015, we are doing our monthly International Tax Lunch at noon Pacific time. You can dial in and listen for free.

The topic is Using foreign corporations to invest in US real estate without a US subsidiary, so somewhat related to today's topic.

Special invitation/free food: if you are in Southern California, please come to our offices and sit in our conference room for the session. Ask questions, meet us and the other people attending (I think we have 9 guests this month), and if you call us early enough we will have a delicious sandwich and cookie for you. Call Kirsten Frank at +1-626-689-0060 to attend.

This week: why you need a different trust

This week I want to answer a quick question about U.S. real estate investment by nonresidents.

When a nonresident is thinking about buying U.S. real estate, we will talk about trusts as a method of ownership. Quite often, the nonresident investor already has set up a trust to hold investment assets, as part of investment and banking services from a private bank.

These trusts can be called many things, but frequently they are described as "self-directed trusts". The settlor has the power to tell the trustee what to do, and when you examine the trust deed you will see that the settlor effectively has the power to amend or revoke the trust.

When we talk about trusts as holding structures for U.S. real estate investment, their eyes light up. "I already have a trust!" I tell them that their trust is worthless for their U.S. real estate investments.

Let's talk about why.

The problem: estate tax

The U.S. imposes a tax on nonresidents at the time of their death. The tax is -- vastly simplified -- 40% of the value of the deceased person's assets that are located in the United States.

Note that the tax problem exists only when two conditions are present:

Someone died; and
That person had assets in the United States at the time of death.

We cannot control the first factor, but we can control the second factor. A successful estate tax prevention strategy for a nonresident will design investment strategies so that the individual does not "own" assets "in the United States".

I put those two ideas -- "own" and "in the United States" -- in scare quotes because these are concepts that have arcane definitions for tax purposes that are different from common sense.

You own it (for tax) even though you don't own it (for realz)

Consider a simple situation. You are a nonresident and noncitizen of the United States.

You create a trust;
You have the power to change the terms of the trust at any time, and you are a beneficiary of the trust;
You put money into that trust, and the trust buys U.S. real estate.

Remember the rule for estate tax: you (well, not you, technically) will only pay estate tax if you own something in the U.S. when you die. You don't own the U.S. real estate -- the trust does. So, no estate tax, right?

Nope.

You have an asset in the United States. The asset is called a "retained interest". There will be estate tax imposed on the value of that "retained interest".

Retained interests

Whenever you make a transfer of property but keep some rights, you have a "retained interest". You gave something away, but not completely -- you kept ("retained") some rights in that asset.

Retained interests are defined in gruesome detail in the Internal Revenue Code. Look at the trust you set up with $VERY_BIG_FOREIGN_BANK and see if you have one or both of these situations:

You created the trust and put money into it, and are also a beneficiary of the trust. This is a "retained life estate". You gave money to the trust but you kept the right to get distributions of the trust. You have a retained interest in the trust assets. IRC §2036.
You created the trust and have the power to instruct the trustee to transfer money back to you, or even revoke the trust and transfer all of the assets back to you. You have made a "revocable transfer" and you have a retained interest in the trust assets. IRC §2038.

There are other ways to find retained interests in trusts. These two will suffice for now.

Bottom line: you are treated (for U.S. estate tax law purposes) as having an ownership interest in the trust assets, so that if you die there will be an estate tax imposed.

Retained interest + U.S. assets

As long as the trust holds no assets in the United States, there is no problem at all.

If you create one of these trusts, contribute money to the trust, and use the money to buy Nestle stock, there is no U.S. estate tax problem. Yes, you have a retained interest in the Nestle stock (from the perspective of the U.S. tax system).
But the Nestle stock is not "in the United States" (for arcane reasons that don't matter right now) so even though you are treated as owning the Nestle stock, the estate tax will not be imposed.

But as soon as this trust owns a U.S. asset, you are treated as owning something in the United States that will cause an estate tax.

So that is the problem. A revocable trust, or more precisely a trust in which you hold one of a number of identified rights, can cause the existence of an asset not known in nature to normal humans -- an asset that exists only in the Internal Revenue Code, a "retained interest".

Conclusion

Buying U.S. real estate as a nonresident exposes you to estate tax risks if you die. Holding that real estate in the name of a revocable trust does not solve that risk. It merely renames the risk: instead of having a tax on "real estate" there is a tax on a "retained interest".

If you use a trust to hold U.S. real estate (and it is a fine idea) you need a trust that does not create a retained interest for you. In general, this means:

the trust is irrevocable (once it is created, you have no power to change it);
you have no control rights whatsoever over the trust and who receives distributions from the trust; and
you are not a beneficiary of the trust.

The standard "off the shelf" trust that your $VERY_BIG_FOREIGN_BANK gave you to hold your investment assets will fail on these three points.

This means that you will need to create a new trust to hold the U.S. real estate in order to prevent the existence of a retained interest and consequently the existence of estate tax.

Or you will need to not die.

(This is oddly James Bond-esque. "Do you expect me to talk?" "No, Mr. Bond. I expect you to die.")

Disclaimer

This is not legal advice. It is me having fun, sitting on the couch at midnight writing this thing because I get strange pleasure out of doing so. Go hire someone competent to help you with your U.S. real estate investment strategies. (Hint hint that would be us. We love doing real estate deals for nonresident investors.)

See you in two weeks (remember, this is becoming a bi-weekly rather than weekly newsletter).

And don't you love how many parentheses I used this week? Shameless, I am.

Phil.