October 22, 2008 - Phil Hodgen

Estate of Fung – mortgage debt and estate tax

For all of the people who were in my “Foreign Investment in U.S. Real Estate” class yesterday in San Francisco (I taught a 1-day course sponsored by the California Society of CPAs Education Foundation), here is one of the things I promised to deliver.

Tax Court Opinion

The Estate of Fung attached (warning: PDF) are from the United States Tax Court, and the affirming opinion from the Ninth Circuit Court of Appeals.

The problem, with easy math

The idea here is to describe the pickle facing heirs of a nonresident alien who has the bad judgment to die while owning U.S. real estate.

Let’s say the nonresident owns real estate and there’s a mortgage on the property. Let’s make up some numbers. The property is worth $5,000,000, and the mortgage is $4,000,000. The nonresident dies. What’s the estate tax?

Example 1: nonrecourse debt

If the mortgage is truly nonrecourse (meaning the lender can ONLY go after the property in the event of a default, and can never go after the borrower personally), then the estate tax is calculated on the nonresident’s equity in the property, $1,000,000.

For the sake of our example, let’s say the applicable estate tax rate is 40%. The heirs sell the property, pay off the mortgage, give Uncle Sam $400,000 ($1,000,000 equity times 40% tax rate = $400,000 estate tax), and go home with $600,000.

Example 2: recourse debt

If the mortgage is recourse (meaning the lender has the option of going after the borrower for personal liability on the debt in the event of a default), then the estate tax is calculated on $5,000,000 — the gross value of the real estate, without deducting the mortgage.

The heir sell the property. Pay off the mortgage ($4,000,000). They have $1,000,000 of cash left over. Now they tote up the estate tax on a $5,000,000 asset at 40% = $2,000,000. Note the conundrum: the mortgage plus the estate tax liability adds up to a bigger number than the cash on hand. The heirs get nothing.

My God!? Is there no mercy?

Seems insane, doesn’t it?? Well, in fact there is a way to get that mortgage to help reduce the estate tax.

On the nonresident dead guy’s estate tax return (Form 706NA) (warning: PDF) the executor will report the nonresident dead guy’s worldwide balance sheet. (!) Then there is some higher math involved. The details of the higher math are unimportant for our purposes–we’re just talking concepts here. But if you’re looking for specifics, look at the instructions for Schedule B of Form 706NA.

The idea is that since the nonresident dead guy only has U.S. estate tax on his U.S. assets, you have to do a pro-rata allocation of debt based on a fraction that looks like U.S. assets (numerator) divided by worldwide assets (denominator).

The answer is usually pretty grim. Usually your nonresident dead guy has LOTS of assets outside the United States, and only a little bit in the United States. This means that when you pro-rate that $4,000,000 mortgage, it’s not going to end up being all that big of a deduction from the gross estate in order to arrive at the taxable estate.

Which means that the tax savings for going through this exercise are likely to be relatively small.

And the heirs aren’t going to want to tell the U.S. government all about nonresident dead guy’s worldwide assets. Maybe they don’t want to spend the money for accounting and legal fees to do this. Maybe they’re just not interested in doing all of the necessary work. But more likely it is because of a healthy desire for privacy.

Action plan

If you have a situation like this (nonresident owner of U.S. real estate, and mortgage on the real estate) first look at the loan documents very carefully, and come to a professional conclusion as to whether it is a recourse mortgage or a nonrecourse mortgage.

If you have a recourse mortgage, do a quickie spreadsheet to calculate out the value of reporting worldwide income in order to use the mortgage to reduce the size of the taxable estate. Tell your (alive) nonresident alien investor or the (dead) nonresident alien investor’s heirs that number. Let them tell you whether they’re willing to report worldwide assets on Form 706NA.

I’m guessing the answer is “Not!”


Thanks to all of you who came to the course. Please keep in touch. Subscribe to the RSS feed here so you’ll get updates of stuff we talked about.

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