Nonresidents often show up and sign contracts to buy U.S. real estate in their own names. Then, before the sale is complete, they set up a holding structure. They transfer the purchase contract to the holding structure, and the purchase is complete.
As I wrote a few weeks ago, transferring a purchase contract from a nonresident individual to a holding structure is a “disposition” of U.S. real estate. The result?
- Paperwork. Until proven otherwise, the nonresident individual must file a U.S. tax return to report the “disposition” of a “U.S. real property interest”, even though self-evidently there is no capital gain.
- Withholding. When a nonresident disposes of U.S. real estate, the buyer must withhold 15% of the purchase price for tax, and send it to the IRS. That’s terrible. You don’t want to be sending real money to the tax authorities when nothing has really changed.
This time I am going to tell you why one restructuring technique avoids all of this. There is no tax return paperwork required. There is no tax withholding required.
This is what we want to do:
- The nonresident signs a contract to buy U.S. real estate.
- The nonresident creates a U.S. limited liability company.
- The nonresident, with the agreement of the seller (or by a right reserved in the contract), assigns the right to buy the real estate to the limited liability company.
- The limited liability company buys the real estate.
We like pretty pictures:
The Holding Structure
This is one of the simplest structures that a nonresident can use to own U.S. real estate. The nonresident owns a domestic limited liability company. The limited liability company owns the U.S. real estate.
This is not a spectacularly good holding structure, but it is useful.
- The limited liability company gives some risk protection.
- It is a little easier for the nonresident to get banking in the United States.
- If the nonresident dies, there will be U.S. estate tax imposed on the value of the U.S. real estate.
- Capital gain will be taxed (almost) like a resident would be taxed. (The nonresident actually pays slightly less tax on capital gain than a U.S. resident taxpayer).
- The U.S. probate courts will control the transfer of the asset to the nonresident investors heirs — if the nonresident commits a monumental error in judgment and dies while owning this real estate. This is a time and expense burden for the heirs.
Enhancing the Holding Structure #1
You don’t want your family to have the expense and delay of waiting for the U.S. courts to administer a will and transfer the real estate to your heirs if you die.
To control that risk, I usually add a simple revocable trust into the structure.
This makes no difference for tax purposes. It merely controls inheritance. It is an order of magnitude cheaper and faster to transfer property to heirs this way.
Enhancing the Holding Structure #2
If you die while owning U.S. real estate, you do not want your family to lose 40% of the value of the U.S. real estate investment you made. That is what the estate tax will do.
To mitigate the pain of the estate tax, I like the investor to buy term life insurance.
Now, if you die, there will be cash to pay the estate tax. Assuming you are young enough and healthy enough, this is an extremely cost-effective way of dealing with the estate tax risk.
Step One in the Process
OK. So you know where we are going with this super simple holding structure. Let’s talk about the first step in getting there: assigning the purchase contract to the limited liability company. We can add all the other stuff after the purchase is complete.
The key to understanding this is understanding the idea of a “disposition”. If a nonresident individual has a disposition of a U.S. real property interest, then the tax return filing requirements and the tax withholding requirements are imposed.1
A contract to buy U.S. real estate is a U.S. real property interest.2
We don’t want a “disposition”. No disposition = no tax. The government’s attempt at defining “disposition” is embarrassingly tautological:
For purposes of sections 897, 1445, and 6039C, the term “disposition” means any transfer that would constitute a disposition by the transferor for any purpose of the Internal Revenue Code and regulations thereunder.3
For the rest of us, think of it this way. You start the day as the owner of something. You end the day and it isn’t yours anymore. It doesn’t matter how that happened: gift or sale. It isn’t yours.
That’s a disposition.
Not a Disposition
At first glance, when the nonresident transfers the purchase contract (a U.S. real property interest, remember?) to a limited liability company, it sure looks like a disposition. A human owned the contract rights at the beginning of the day, and at the end of the day a limited liability company owned the contract rights.
But it’s not a disposition.
A U.S. limited liability company that is owned by one person is ignored for U.S. tax purposes. It is a disregarded entity.4
The individual owner of the limited liability company is treated as the owner of the limited liability company’s assets.
For Federal tax purposes, a disregarded entity owned by an individual is treated as a sole proprietorship.5
That means that the assets are treated as belonging to the owner, and all of the income is taxed directly to the owner.
In practical terms, transferring an asset to your own limited liability company is a nonevent for tax purposes. It is equivalent to reaching into your left pants pocket, pulling out your car keys, and putting them in your right pants pocket.
Nothing changes. You are still the owner of the asset.
And since you are still the owner of the asset — in the eyes of the U.S. tax system — there can be no disposition.
Withholding Rules Give Us a Clue
The withholding rules give us a clue.
The withholding rules (“buyer withholds 15% of the purchase price when buying from a nonresident”) have an exception: if the seller certifies that he/she/it is a domestic taxpayer, then no withholding is required.
What if the seller is a single member limited liability company? A “disregarded entity”, in other words.
The IRS tells you (the buyer) to ignore the limited liability company. The transferor (the person making the disposition of real estate upon which withholding might or might not be required) is not the limited liability company. It is the owner of the limited liability company:
A disregarded entity may not certify that it is the transferor of a U.S. real property interest, as the disregarded entity is not the transferor for U.S. tax purposes, including sections 897 and 1445. Rather, the owner of the disregarded entity is treated as the transferor of property and must provide a certificate of non-foreign status to avoid withholding under section 1445. A disregarded entity for these purposes means an entity that is disregarded as an entity separate from its owner under § 301.7701-3 of this chapter. . . . .6
If the rule is good enough for when the limited liability company is selling property, then the rule should also be good enough for when the limited liability is acquiring property. Ignore the limited liability company.
Paperwork and Withholding
Because there is no “disposition”, there is no capital gain event to report when the nonresident transfers the contract to a limited liability company. No U.S. income tax returns are required for the nonresident.
Similarly, because there is no disposition there will be no tax withholding requirement. No need to send 15% to the Internal Revenue Service.
This is a bit long already. The next step is to add a revocable trust to the holding structure.
I won’t deal with this step here. However, note well that this trust should be a “grantor” trust. If so, then the nonresident (who is the settlor and beneficiary of this trust) is treated as the owner of the trust’s assets for tax purposes.
You can see where this is going: the nonresident is treated as owning everything that the trust owns, which is a limited liability company. The trust is treated as owning everything that the limited liability company owns. Therefore, the nonresident is treated as owning the limited liability company’s assets.
Again, a disregarded entity, and again the transfer is a nonevent for U.S. tax purposes.
There are many other structures that nonresidents use to own U.S. real estate. There may well be a way for a nonresident to assign a contract to one of these other holding structures with trivial tax consequences. Maybe there is tax paperwork, but withholding tax can be avoided.
The temptation is always to skip over the fiddly bits. Assigning a contract from yourself to a holding structure entity (limited liability company, trust, partnership, or corporation) seems as though it should be a non-event — and it SHOULD be.
But deal with the paperwork anyway. Your future self will thank you. Don’t create potential wreckage in your future.
Not Advice, Not Nothing
This is not legal advice. I am not your lawyer. Insert your favorite battery-operated lawyer disclaimer here.