Nonresidents, Real Estate, and Managing Tax Risks like an Investment Analyst
This is part of the Real Estate Series–episodes focused at helping nonresidents buy, hold, and sell U.S. investment properties–profitably.
We All Die
Our clients are wealthy individuals and families. People. People die. Even people who own U.S. real estate. This episode of the Friday Edition is about an investment risk that pretends to be a tax problem. Sometimes this investment risk is best managed with ideas from a tax lawyer. But not always.Estate Tax and Nonresident Real Estate Investors
The United States has a wealth tax at the time of death. It is called the estate tax. A nonresident/noncitizen of the United States who owns U.S. assets will have this tax imposed on those assets when he dies. You might think of this as an inheritance tax. In the United States, an inheritance tax is paid by someone who inherits money from a dead person. The estate tax is imposed on the property of the dead person (the dead person’s “estate”), so we call it an estate tax. One is a tax on the recipient of an inheritance, the other is a tax on the source of the inheritance. The U.S. system places the tax on the source. This Friday Edition tells you how to buy and own U.S. real estate and eliminate the estate tax. Your heirs will thank you. But more important, this Friday Edition shows you why treating the estate tax as a tax problem to be solved will lead you to make wrong decisions. I want you to think about estate tax as a mathematical exercise in investment risk management and investment operating cost management.TL;DR
Look at the U.S. estate tax as an investment risk you manage, just like the risk of a fire burning down your building. Find the lowest-cost risk management strategy and buy it. Sometimes you will buy your risk management strategy from an insurance company. Other times you will buy it from a lawyer. Your tax lawyer should speak to you with spreadsheets.Successful Real Estate Investors
Successful real estate investors have two special skills.They See Risks
Real estate investment rewards people who can identify risks and solve them. Tenant mix risk. Demographic risk. Location risk. All sorts of risks. If you can see the risks, you are less likely to lose money. If you know what to do with the risks that you see, you will make money.They Can Do Mental Math
Every successful real estate investor I have ever met has an odd skill: the ability to do sophisticated mental mathematics while simultaneously doing something else. A couple of weeks ago I was in a car with two friends who are planning an extremely interesting project in Las Vegas. Five minutes of mental math–construction costs, tenant improvements, land, the impact of time delays on the rate of return, and how much the project would sell for when finished. Back and forth they went, like a tennis match. Bang. Equation solved. “We’ll make $4 million dollars. Let’s do it.” (Hint: they are looking for investors.)Risk and Math For Nonresident Investors
Look at the owner’s death as an investment risk, not an unwanted interaction with the U.S. government. Manage that risk to avoid losing money. The magic number for your mental arithmetic is 40%. The estate tax will be approximately 40% of property value at the time of death.Solving Risks The Right Way
Remember we are managing the financial consequences of a death. If the owner dies, you receive a big tax bill from the U.S. government. It is like fire. If someone lights a match in the right place, then things happen with your building and it burns to the ground. We cannot eliminate death. We live, we die. So we manage the financial consequences of death. Here are the steps I take to do that.Step One: The Benchmark
The first thing I look at is a tool designed specifically to solve the mortality risk. Life insurance. If you have a nail, you reach for a hammer. If you have a financial calamity that will occur if someone dies, you look at life insurance. A real estate investment has a time horizon. There is a date in the future when the property will be sold, if conditions follow what is expected. (If you don’t have a date in mind for when you are going to sell, then you do not have an investment strategy.) Go get a price on life insurance. Make your expectations on value appreciation over the holding period you have selected. Buy life insurance with a death benefit of 40% of the highest property value in your projections. Maybe buy a little bit more for good luck. 🙂 The present value of the future stream of life insurance premiums payable is the cost of managing the investment risk of death. This is the measuring stick. The benchmark.Step 2: Get Alternatives, Get Numbers
Next, find alternatives to life insurance. These alternatives will all do the same thing as life insurance–make sure your heirs do not get hit with a big tax bill. For this, you will be talking to a tax lawyer. That is where you buy alternatives to life insurance. The tax lawyer’s strategies fall into two categories:- There is no estate tax because the dead person did not own anything taxable; or
- There is no estate tax because the dead person owned something taxable but the value is zero, so the tax is zero.
- Does it work? “Please confirm that if I die there will be no U.S. estate tax imposed on the U.S. real estate I own.”
- What does it cost? What will it cost to build and operate this thing you are telling me to do?
Step 3: Low Cost Wins
Now you have numbers. I hope they are all reduced to a lump sum present value, because that (for me) is the easiest way to compare the choices that you have. Low cost wins. That might be insurance, or that might be a Clever Lawyer Trick.Lawyer Solutions (Three I Like, One I Don’t)
There are two methods I use to solve the estate tax risk. Probably everyone else uses these, too. There is no magic.- Corporation structures (you own the shares of a non-U.S. corporation that owns a U.S. corporation that owns the real estate).
- Trust structures (a carefully constructed irrevocable trust owns the U.S. real estate).
Phil,
Interesting post on a very interesting topic. There’s a huge amount one could say, but I’ll just toss out a handful of observations:
1. The corporate structure (whereby the foreign investor forms a foreign corporate holding company and possibly a US corporate holding company subsidiary to hold the property) is, of course, very effective for preventing imposition of the US estate tax, but inefficient from an income tax perspective, since long-term capital gains rate are not available on exit and there may be a second level of tax (either a dividend withholding tax or a branch profits tax) on operating income.
2. The irrevocable trust structure is an absolute home run, in the right circumstances. If the client is willing to accept the terms that make it work, there is a clear defense against estate tax inclusion and the income tax consequences are the same as with individual ownership. The only problem (and it’s a big one) is that clients seem very rarely willing to accept the terms that are needed to make it work. Even if they accept that can’t have any of the trust value, they still want control (which they can’t have) over who enjoys that value, or when they enjoy it. Any control whatsoever results in estate tax inclusion.
3. I like (and have recommended) the approach of using term insurance to mitigate the risk of the estate tax. If the property is expected to appreciate significantly, the cost of the term insurance may be substantially less than the hoped-for income tax savings. Of course, this depends on the age, health, etc of the particular investor.
4. I absolutely agree about the uncertainty of using one or more partnerships to hold the property. We simply don’t have clear rules for when, or whether, we “look through” a partnership for estate tax purposes. (We have the same problem for income tax purposes as well, see e.g., RR 91-32, which is currently in litigation, but that’s a topic for another day.) Having said that, there’s nothing wrong with some uncertainty if the client understands the risks. For example, suppose the client is unwilling to do what’s needed to implement the trust structure, and prefers the estate tax risk to the income tax disadvantages of holding the property through a corporate structure. I would urge the client to purchase term insurance, as suggested in your post, but I don’t see why he couldn’t hold through a partnership (or two) as well. In the event of an untimely demise, I’d still like to have an argument against imposition of the estate tax. I’d also like the client to be able to give away interests in the partnership during his lifetime. It should be possible to do so with no gift tax.
5. I like the idea of using debt (nonrecourse debt, specificially) to reduce the value of the property that may potentially be subject to the estate tax (potentially along with other approaches, such as insurance and perhaps a partnership or two). For example, if I’m buying a $10 million property (I should be so lucky!) and don’t need bank financing, I might supply $6,000,000 with nonrecourse financing from, say, my BVI company to reduce the value to $4,000,000. But if I get greedy and try to finance the entire $10 million with NR debt, I’d have trouble defending the “debt” as real debt for tax purposes.
Thanks for such an interesting post! Would love to hear your thoughts on the above, if you have the time.
Couldn’t someone abroad simply get all the assets in other people’s names as per the legal process in a foreign country, don’t tell the US embassy, and give their SS check to charity until the Social Security Administration finally sends out someone to see if that person is still alive in (London etc.). I know the procedure because I know a guy who works for the SSA and he told me.
So someone dies at 85, send off their SS check to the Isaac Brock Society or some other use, and when they get to around 100, the SSA starts to question if the person is still alive? Not sure about FATCA data, but a dead person’s bank account wouldn’t be unheard of.
So the IRS catches wind about this situation 15 years later, what are they really able to do about it in today’s world? I believe as foreign banks start sending out 1099s and generate their own negative publicity, FATCA blowback will become more apparent.
Are they going to try to charge people abroad with Defrauding the US Government because they didn’t want to pay US tax only their local taxes?
Or is the US government going to hire a obituary specialist to track deaths etc.?