There is no U.S. federal law that restricts individuals or organizations outside the United States from purchasing U.S. land. Neither do many states significantly limit these investments. Thus, after the real estate market tanked in the 2008 recession, purchasing cheap real estate property in the U.S. became an attractive target, leading to a significant increase in foreign investment in U.S. real estate.
For tax purposes, investing in U.S. real estate creates a “permanent establishment.” This means that the investors will be subject to tax or other filing requirements depending on the type of investor and the type of investment entity. (For instance, the property can be held directly by the non-U.S. owner or indirectly through a U.S. business entity.) Here are some of the most important tax and disclosure requirements to consider when providing tax planning advice for non-U.S. investors and their accountants.
TAX TREATMENT OF THE INVESTMENT INCOME
The default tax treatment for rental income is “fixed, determinable, annual or period (FDAP) income,” which is considered not “effectively connected” with a U.S. trade or business. This means that the gross rent is taxed at a fixed 30% rate with no allowable deductions (IRC §864(c)(4), 871(a), and 881(a)). Under IRC §882(d), taxpayers can elect to treat the rent as “effectively connected” income, thus allowing them to claim related deductions, such as property taxes and depreciation, and taxing the income at the taxpayer’s marginal tax rate.
For example, Maurice is an unmarried individual from outside the U.S. He has rental income from a U.S. investment of $20,000 and rental expenses of $5,000. Without the election to treat the rental income as “effectively connected,” his tax liability is $6,000 (30% withholding tax on $20,000). With the election, his tax liability is only $1,613 (regular tax rates applied on net rental income of $15,000). Note that the tax rate for rental income is rarely (if ever) reduced by an income tax treaty.
The type of business entity holding the U.S. real estate property is also an important factor to consider. For U.S. investors, real estate is usually held by a limited liability company (LLC), which has minimal additional reporting requirements. Yet non-U.S. investors who use an LLC to hold their U.S. real estate must also file a U.S. income tax return. If the LLC has more than one owner, there may be additional withholding requirements.
For non-U.S. joint investors, it’s often better to use a regular C corporation to own the U.S. real estate or for the LLC holding company to make a “check-the-box” election to be taxed as a corporation in order to avoid these withholding and associated reporting requirements. Note, though, that this election comes at a cost: Corporations are subject to a flat tax rate of 21%, with additional tax on dividends when the net earnings are repatriated. The tax on dividends is usually 30% but may be reduced by an applicable income tax treaty. For example, the U.S. income tax treaty with the United Kingdom permits tax on dividends to be as low as 5% (depending on ownership).
Assume that Maurice is a shareholder of Foreign Co., which owns U.S. real estate and elects to treat the rental income as “effectively connected.” In this case, the tax on the rental income is $3,150 when it’s earned (the net rental income of $15,000 multiplied by 21%). An additional $3,555 will be assessed when the earnings are repatriated to Maurice’s country (($15,000 – $3,150) multiplied by the 30% withholding tax).
If Maurice were a U.K. tax resident, he may take a tax treaty position that would reduce the tax on the repatriated funds to $750. If a tax treaty reduces the tax on the dividends, this tax position must be disclosed by attaching Form 8833 to Maurice’s U.S. tax return.
If the investment is owned by a non-U.S. individual or grantor trust, the owner may be subject to U.S. estate tax on the investment at the time of death. This is more significant than one might assume because, although the estate tax exemption amounts have substantially increased for U.S. citizens, the old estate tax rules still apply to non-U.S. investors (IRC §2102(b)(1)). Those investors with U.S. real estate valued at more than $60,000 at the time of death will be subject to U.S. estate tax. (The tax rates start at 26% and rise rapidly to the maximum tax rate of 40%.)
For example, if Maurice dies and his estate includes U.S. real estate valued at $250,000, the estate will be subject to estate tax of $57,800. Maurice can avoid having his estate exposed to this tax by holding his U.S. investments in a corporation organized outside the U.S. (a “blocker corporation”). This scheme works because corporations aren’t subject to estate tax in the U.S. and, as a foreign corporation, this entity wouldn’t be includable in Maurice’s U.S. estate.
ADDITIONAL DISCLOSURE AND WITHHOLDING REQUIREMENTS
There are many additional filing requirements for foreign investors in addition to the treaty disclosure requirements mentioned. If the real estate is held in a disregarded entity or a U.S. corporation, Form 5472 will be required to report any transactions between the U.S. entity and the foreign owners (or related parties). The penalty for failure to file this form (or late filing) is currently $25,000 per missed or late form. Other filings may be required, particularly if there’s a U.S. withholding requirement (for example, for dividend payments or if the real estate is held in a U.S. partnership).
When the U.S. investment property is sold, 15% of the sales price must be withheld at the time of the sale—even if the property is sold at a loss. Furthermore, the owner must file a U.S. income tax return in order to report the actual gain or loss on the sale and then apply for a refund (if applicable). The sale is likely to be treated as a capital gain or loss—the treatment of which depends on the type of owner of the U.S. property. For foreign corporations, the tax rate for capital gains is the same as the rate for ordinary income, and net capital losses can’t offset other income. Individuals outside the U.S. may offset up to $3,000 of capital losses from effectively connected income against their other effectively connected income for the year.
Non-U.S. investors should consider establishing a foreign blocker corporation in order to avoid U.S. estate taxes. Those who invested at the height of the recession who now hold highly appreciated positions may also look to divest themselves of these investments by diversifying in order to avoid not only estate taxes, but to reduce the substantial reporting requirements.
© 2019 A.P. Curatola