Hello from Phil and welcome again to the Friday Edition. Every other Friday you get your dose of international tax news from me. If you want this email to stop, please click the “unsubscribe” link at the bottom of the email.
Many countries will not allow foreigners to own real estate. Mexico is a prominent partial example for Americans — direct real estate ownership is forbidden for property too close to the border or the coastline. Inland, no problem. Other countries flatly limit ownership of real estate to their citizens only.
I received a WhatsApp message from an American living in one such country. He is married to a woman from that country, has children born there, and has lived there for many, many years. He has been buying real estate, and this creates some possible U.S. tax compliance questions:
In $COUNTRY I cannot own property. My wife owns it and holds it for me, it is not a gift. In fact I am forced to put it in my wife’s name helps with the legitimate reason for being in her name – not a gift, as it is the only legal way for me to own property.
Let’s look at a simple set of facts. Property is for sale for $300,000, and our American husband abroad wants to buy it. The country prohibits him from owning property directly in his own name, so he will have his wife (a citizen of the country) buy the property in her name, using his cash.
He moves $300,000 from his bank account to his wife’s bank account. His wife buys the property and holds title to the real estate.
What has happened?
Here are the possible ways (that I can think of) that the U.S. tax system can look at the transaction that just occurred:
I will discuss the “nominee” scenario here.
But be aware that the IRS may have a different point of view based on the facts of your situation. Here are the other possibilities:
I am not telling you which conceptual model applies in real life — either for my friend in $COUNTRY, or for you (wherever you live and whoever you are). I am telling you that the facts matter, and your U.S. tax results (and the paperwork the IRS demands form you) will matter tremendously based on on the facts.
There is an additional factor: whose money is it?
In my example I have said that the $300,000 belonged to the American husband.
But many countries have some variation of a community property idea for assets acquired during marriage, so it is not always clear whether an asset (including money) is the sole property of one spouse, or is jointly owned property.
I am going to finesse that question by ignoring it completely. Let’s just assume that a bus full of bishops came along and all of them swore on a stack of Bibles that the $300,000 is the American husband’s sole and separate property, under all possible applicable matrimonial property laws of every country on Planet Earth.
I am ignoring the back end of this transaction.
Talking about that stuff will make this email too long, so I will cheerfully ignore those questions.
I am also ignoring the ownership phase. What happens if this property is rented? How is the rental income reported? What if there is tax paid by the wife (because she owns the property and collects the rent) in that country on the rental income? Does our American abroad take a foreign tax credit?
The U.S. tax problems that the American husband faces are:
Anytime there is a transfer of money from one person to another, you need to decide whether this is a taxable event. U.S. taxation of the funds transfer will occur if it is a gift (triggering gift tax) to the nonresident noncitizen wife, or if it is a “sale or exchange” (triggering ordinary income or capital gain that will be taxable).
E.g., a gift of $300,000 to a nonresident noncitizen spouse would trigger a gift tax liability.
Even if the transfer of funds from the American husband is not taxable, it might be reportable. E.g., contributions to a foreign trust must be reported on Form 3520. Transfers to a foreign partnership must be reported on Form 8865.
The U.S. tax system has a form for every situation, designed to force American taxpayers to report the existence of foreign assets and foreign investment vehicles to the IRS. E.g., if this is a trust, then Form 3520 and Form 3520-A will apply. As you will see below, this leads to an interesting metaphysical question: when is an individual an “account”?
Let’s take the most logical interpretation of facts. Our American friend abroad is the principal, and his wife is his agent. She owns the real property in $COUNTRY purely as a nominee title holder. He has the real economic interest in the property. When the property is sold, he will get all of the money. If he dies while owning the property, it will be listed as one of his assets for U.S. estate tax purposes.
A transfer of funds from a principal to an agent is not a gift. A gift is made when you transfer something to another person and receive nothing (or less than full value) in return.
For the principal/agent relationship, the principal has a legally enforceable right to require the agent (or nominee — I use these two words interchangeably here) to return the asset at any time. As a result, there has been no “transfer” of ownership (since the principal is still the true owner), and even if there is a transfer, the principal has received full value in return (a legally enforceable right to full return of all property held by the agent).
The transfer of funds from a principal to an agent is not a “sale or exchange”. From a legal point of view, the $300,000 still belongs to the American husband (principal) even after he transfers it to his noncitizen wife (agent). She then uses the money to buy the real estate.
The reporting requirements apply to contributions by U.S. taxpayers to foreign entities of various kinds: trusts, corporations, partnerships. Now we come to an interesting metaphysical question — in the context of principal/agent legal theory, is a human “agent” an “entity” for all of the reporting purposes of the Internal Revenue Code?
The definitions of the various types of entities all contain the seeds of the answer. A foreign corporation must be a corporation. A foreign partnership must be a partnership. Both of these necessarily generate some legal documentation to show that the entities exist, and humans do not generate those types of documents.
So the only risky possibility is that the arrangement will not be treated as a principal/agent relationship by the IRS, but that it will instead be treated as a foreign trust structure: the wife will be treated as the trustee of a trust. The settlor and beneficiary of the trust will be the American husband.
Class, I am assigning some homework. Read 26 CFR 301.7701-4. This is where the IRS defines what a trust is. Be prepared for a pop quiz next week.
For now, let’s assume that your friendly Revenue Agent agrees that the arrangement is not an “ordinary trust” as defined by the Treasury Regulations.
In that case, there is nothing to report for the mere transfer of funds from the American husband’s bank account to his wife’s bank account. (She then uses the funds to buy the property in her own name).
We are now into the land of FinCen Form 114 (Dread Pirate FBAR) and Form 8938.
FinCen Form 114 first. This is where a U.S. person discloses an ownership interest in or control over a “foreign financial account”. The Instructions to FinCen Form 114 (PDF) define a “financial account” as follows:
A financial account includes, but is not limited to, a securities, brokerage, savings, demand, checking, deposit, time deposit, or other account maintained with a financial institution (or other person performing the services of a financial institution). A financial account also includes a commodity futures or options account, an insurance policy with a cash value (such as a whole life insurance policy), an annuity policy with a cash value, and shares in a mutual fund or similar pooled fund (i.e., a fund that is available to the general public with a regular net asset value determination and regular redemptions).
Emphasis added by me.
The key factor here? There is some kind of relationship with a “financial institution”. The instructions explicitly suggest that there are many types of persons that could be financial institutions. Theoretically, a human could be a financial institution.
However, the Internal Revenue Manual solves the problem for us. I.R.M. 18.104.22.168.2, Paragraph 3(B) says that real estate or an account solely holding real estate will not be considered to be a “financial account” for FBAR purposes.
Form 8938 is the other disclosure form to worry about. The key to understanding Form 8938 is to understand that it wants you to tell the government about “specified foreign financial assets”. This means you need to decide whether having your non-U.S. citizen spouse hold real estate for you is a “specified foreign financial asset”.
Foreign real estate is not a specified foreign financial asset required to be reported on Form 8938. For example, a personal residence or a rental property does not have to be reported.
If the real estate is held through a foreign entity, such as a corporation, partnership, trust or estate, then the interest in the entity is a specified foreign financial asset that is reported on Form 8938, if the total value of all your specified foreign financial assets is greater than the reporting threshold that applies to you. The value of the real estate held by the entity is taken into account in determining the value of the interest in the entity to be reported on Form 8938, but the real estate itself is not separately reported on Form 8938.
If we take the heroic position that a wife is not a “foreign entity” LOL then the nominee arrangement does not get reported on Form 8938. However, IRS web pages (and even form instructions) are not valid and binding interpretations of the law, so rely on them at your peril.
A “financial account” is an account at a foreign financial institution which is a defined term found at T. Regs. § 1.471-5(e). Again, there will be a quiz later but if you read this, it will be blindingly obvious that a wife will not do any of the things listed there that would qualify her as a “financial institution”.
No matter how you define a “financial account”, then, if there is no “financial institution” there can be nothing required for Form 8938.
We are almost safe. There is a second category of things that are disclosed on Form 8938: interests in non-foreign financial entities: NFFEs for short. Tax law loves acronyms.
The key to safety is that last word: “entity”. Is a human nominee an “entity”? Survey say? “No.” An entity is anything other than an individual. T. Regs. § 1.1471-1(b)(39).
This all means that for Form 8938 purposes, no reporting is required for a principal/agent relationship (or nominee, if that is what you want to call it) that has foreign real estate held in the name of the nominee on behalf of the U.S. principal.
The nominee arrangement is lightweight, from a U.S. tax point of view:
For me, the major risk is that the arrangement will be viewed as a foreign trust by the IRS, rather than a principal/agent relationship. Would a Revenue Agent cavalierly raise that possibility on audit, in order to bludgeon you into submission on other audit issues? Nah, never. . . .
You might think that this is a way to squirrel away assets out of sight of the U.S. government. For now, maybe yes. There are two big warnings, however. The laws will change, and sooner or later everything you own will be visible to the governments of the world, including the IRS. As the old saying goes, “Over any considerable period of time, things get worse, never better” (I paraphrase slightly).
You also have a non-tax risk. There is an asset held in the name of someone else. Yes, in the case of the American correspondent, he has been married a long time and there is no divorce risk. If your nominee is not your spouse of 25+ years and utterly trustworthy, however . . . .
Life is short. Do things right.
Do not believe anything you read in this email newsletter — trust, but verify. Hire someone competent and get good tax advice.
See you in a couple of weeks.