Nongrantor trusts offer excellent tax performance for nonresident investors in U.S. real estate:
- Estate tax risk is eliminated; and
- Long term capital gains tax treatment applies to capital gains.
But everything has its price. These excellent tax results come at the expense of:
- Significant set-up costs.
- Significant operating costs.
- Loss of control.
- Capital — and capital gain — no longer belong to the investor.
Shameless Promotion: More on July 8, 2016
This episode of the Friday Edition gives you an overview of the benefits and risks. If you want more detail, you might consider an upcoming webcast/phone presentation on the topic.
For the next International Tax Lunch on July 8, 2016 (noon Pacific Time) I will be giving an hour presentation on the topic. Free. Sign up! You can listen to voice over slides, webcast. https://hodgen.com/newsletters
Measuring the Tax Benefits
The U.S. taxes a nonresident investor on rental income and capital gain. I will talk about those taxes in the International Tax Lunch presentation and perhaps in a future Friday Edition. But let’s keep this week’s newsletter short.1
The bigger problem an individual investor faces? The U.S. estate tax. This is a wealth tax imposed on assets owned by the individual at the moment of death. The tax rate can be as high as 40%.
The estate tax will be the topic of discussion this week.
Compared to What?
When we talk about tax benefits for using a trust structure, we should really ask “Compared to What?
We can only say “better than” or “worse than” when comparing one thing against another.
The alternatives (to a trust) for a nonresident investor to own U.S. real estate are are:
- Direct ownership;
- Corporations; or
Two weeks ago I wrote an overview to compare different methods for groups of foreign individuals to pool capital to make U.S. real estate investments. Read that for an introduction into the difference between the various choices.
The Prize: Lower Tax on Capital Gain
The attribute that is desirable for a trust structure is that capital gain can be taxed at the long term capital gain tax rate of 20% (Federal) while achieving estate tax protection.
A corporation structure will expose capital gains to tax at 34% (Federal) while achieving estate tax protection.
That’s what you are shooting for: a much-reduced capital gain tax rate when you sell the property
Estate Tax Strategy
A nonresident investor should first look at — and neutralize — the U.S. estate tax. The tax, if imposed, is as high as 40% of the value of the asset owned by the investor, measured at the time of death.3
Concepts: “Owned” and “Located”
Estate tax is imposed because someone dies. To use tax jargon, there is a “decedent” — someone who has died.
For people who are (a) not U.S. citizens and (b) not domiciled in the United States, U.S. tax law looks at assets “located in the United States” that they “owned” at the moment of death.
To put this into tax law language (and so you can start to do your own legal research), the nonresident investor does not want to have “U.S. situs” assets included in his/her “gross estate”.4
- Estate tax is only imposed on humans that own things. Estate tax cannot be imposed on legal entities (like trusts) that own things. Idea: entities own things, not humans — because entities never die.
- Estate tax is only imposed on things located in the United States that nonresident humans own. Idea: if a nonresident individual must own an asset, it should be an asset that is not “located in the United States”.
How Do You Own But Not “Own” U.S. Real Estate?
There is no question about U.S. real estate: it is located in the United States.
If a nonresident investor wants to buy U.S. real estate and avoid the estate tax, then, the strategy revolves around the idea of ownership. How can someone simultaneously:
- own (in the common meaning of the word) U.S. real estate; and
- not own (in the technical tax sense of the word) U.S. real estate?
If this can be done, then the nonresident investor faces no risk of having the estate tax imposed on the U.S. real estate investment.
Strategy: Defeat “Ownership”
We now turn to using a trust as a way to defeat the “ownership” idea, thereby preventing U.S. estate tax on the investment in U.S. real estate by a nonresident investor.
Or, to put it into technical terms, we are going to use a trust to prevent the real estate investment from being included in anyone’s gross estate. The real estate will be owned by a non-human thing (carefully constructed). Only humans die, and estate tax is triggered only by human death.
There are two ways that U.S. real estate can be a part of a nonresident’s “gross estate” (making the estate tax apply):
No Direct Ownership
Direct ownership of real estate means that an individual’s name is on the grant deed. This is something we will not allow — by design. We are going to use a trust to own the real estate. The grant deed will show the trust as the owner of the real estate.
Therefore, the individual nonresident investor does not have a risk of estate tax if he dies because of direct ownership of the U.S. real property. His name is not on the grant deed.
To put it in technical language, the gross estate of a nonresident noncitizen decedent will not include the U.S. real estate.
Or, to put it in technical + paperwork language, the nonresident noncitizen decedent’s executor, if filing Form 706-NA
(PDF), will not include the real estate asset on Schedule A as “the decedent owned this piece of real estate in his own name”.
No Indirect Ownership
Indirect ownership is subtle. Here we come to the difference between the tax law concept of “own” and everyday understanding of the same word. For tax purposes, if you have enough control over an asset — even if it is not yours, technically, you can be treated as the owner of the asset and be taxed accordingly.
Let us look at this from the point of view of two different people: the person who creates the trust (I will call this person the Settlor) and the person who is entitled to receive money from the trust (I will call this person the Beneficiary).
I am going to flag the major tax pitfalls for you to avoid when designing the trust. If you do these things successfully, the U.S. real estate asset will never be subjected to the estate tax — no matter who dies.
The Settlor: Avoid “With Strings Attached”
The idea of a retained interest is pretty simple to understand. When a Settlor creates a trust (and puts assets into it), does the Settlor let go entirely? Or does the Settlor create the trust but keep some control or economic benefits over the trust assets?
In other words, is this like an outright gift? Or is it like a gift “with strings attached”?
If the Settlor creates a trust, puts property into it, and has these strings attached, then the estate tax will apply as if the Settlor owns the trust assets directly.
The “strings attached” rules to watch for are in Sections 2036, 2037, and 2038 of the Internal Revenue Code. Here are some things that create “strings attached” and cause estate taxation for the Settlor:
- Transferring property to a trust but keeping an economic interest in the trust assets — in other words, you cannot make yourself a beneficiary of a trust you create.5
- You cannot keep the power to decide who can be a beneficiary of the trust or which beneficiaries receive distributions and which ones do not.6
- You cannot keep the power to revoke the trust and transfer property back to yourself.7 This is a key point — all real estate holding trusts should be irrevocable.
There are other retained interests, but let’s not make this an encyclopedia.
All of these powers can be exercised by someone else — they are only toxic when held by the Settlor. This means that if the Settlor wants to retain control over the trust’s assets, careful drafting of the trust will be required. The classic methods for retaining control over the trust assets will be:
- Appoint a special person other than the Trustee who holds the essential powers to do what the Settlor cannot do. This person is typically called a Protector, and has the power to order to Trustee to do things, including add the Settlor to the trust as a beneficiary.
- Use carefully-created “investment advisor” or “investment management” arrangements so investment advisory decisions are held by the Settlor, even if the Settlor has no other rights to control the trust and its assets.
The lesson here? Mr. Big did not become Mr. Big by voluntarily giving up control over his assets. He can achieve his desired results by using a trust. But it will be complicated — and therefore expensive — to set it up right.
The question will be whether the additional expense and annoyance of the trust structure is worth the capital gains savings that will be achieved.
The Beneficiary: Avoid General Powers of Appointment
There is a second way that trust assets can be treated as owned by an individual and become taxed at death. If the person has the power to distribute trust assets to himself without limits, then the reality is that the trust assets are his at any time. All he has to do is take them.
This is a general power of appointment, and causes the trust assets to be subjected to estate tax when the person holding the power dies.8
powers of appointment are . . . uhhh . . . powerful flexibility tools. This is when the person who has that power can send the trust assets anywhere — except to the power holder himself, or the creditors or estate of the power holder.
Mr. Big creates a trust for the benefit of Mrs. Big and the little Big children. Mrs. Big has a limited power of appointment. She can direct distribution of the trust assets to anyone except herself. She can set up a new trust using the assets of the trust that Mr. Big set up. What if Mrs. Big uses her power to set up a new trust where Mr. Big is a beneficiary?
Losing Control Over the Cash
Remember that if the Settlor transfers assets to the trust and can get assets back, this is a retained interest and the Settlor’s death causes an estate tax problem.
The first solution we look for is a simple one. Rather than make an outright gift of cash to a trust, the Settlor should gives some money and lend some money to the trust. Eventually the loan will be repaid with interest, so the Settlor will retrieve the bulk of the trust’s capital. No machinations with a Protector or other indirect methods of achieving distributions is necessary.
The second solution — in the right circumstances — is even easier. If Mr. Big creates a trust and Mrs. Big and the little Bigs are the beneficiaries, the trust — when it sells the U.S. real estate investment — can simply distribute the cash to Mrs. Big. Once the money has left the trust and the U.S. tax system, Mrs. Big can do whatever she wants with the money.
What the Trust Looks Like
If we take these principles, here is the type of trust we end up with:
- Irrevocable. The trust is irrevocable because the Settlor’s power to revoke or amend the trust creates an asset located in the United States that is subject to estate tax when the Settlor dies. The asset is a “retained interest” in the trust’s assets, which consist of U.S. real estate.
- No Retained Interests. The trust carefully eliminates all possible retained interests. This means that the nonresident investor has essentially no direct control over the trust or its investments. This is offset by indirect control — careful selection of friendly though nominally independent trustees, and the use of Protectors.
- Careful use of powers of appointment. Use limited powers of appointment to allow the trust’s assets to be distributed to people other than the named beneficiaries of the trust.
- Protectors. This is still not commonly used in the United States. Learn to use this as a tool to cause results that the Settlor cannot, directly, achieve.
- Debt. Loan money to the trust so the Settlor can pull money out later, even if he is not a beneficiary of the Trust. (He is a creditor, so repayment of principal with interest is a legal obligation of the trust).
- Management Companies. The trust can hire a management company to advise on real estate acquisitions and handle property management. This management company, hired at arm’s length compensation, might be owned by the Settlor.
There you have it:
- You want to use trusts because they provide estate tax protection and give you lower capital gains tax rates when you sell the real estate investments.
- Trusts introduce complexity by forcing you to use indirect methods to keep control over your investments — direct control cannot be kept without causing an estate tax risk (by way of retained interests or general powers of appointment). So you use complex workarounds to avoid
- Trusts cause you to permanently lose ownership of capital — because the transfer of funds to a trust means that now the trust owns the money, not you. Simple workarounds include lending money to the trust (rather than giving the trust money); complex workarounds include having third parties add you (the Settlor) as a beneficiary later.
- All of this is expensive to set up and operate. If the expected capital gains tax savings are big enough, you do it. Otherwise, you do not.
Disclaimer and Invitation
As usual, the disclaimer: this is not legal advice. Don’t rely on it.
And once again, the invitation: I am going to be giving an online one hour presentation at noon Pacific time on July 8, 2016 on this topic, with more detail on how these structures operate. Sign up for the International Tax Lunch mailing list at https://hodgen.com/newsletters
to get more information.
See you in a couple of weeks.