PART II — What are the U.S. Tax Implications?
Prospective foreign purchasers of real estate situated in the U.S. should pay careful attention to the U.S. tax ramifications of their acquisition. In particular, the manner in which rental income or sale proceeds are taxed, the impact of repatriation of those profits, and transfer tax consequences, e.g., taxes on the transfer of property to heirs, warrant special consideration. In addition, there is a somewhat onerous tax withholding requirement imposed on buyers when U.S. real estate is acquired from sellers who are foreign persons, which withholding requirement is elaborated on in Part I of this article.
In many ways the tax consequences of the ownership of U.S. real estate hinge upon the manner in which the real estate is held, i.e., titled in the individual name of the foreign person or owned indirectly by the foreign person through some form of business entity or trust. In addition, the U.S. taxation of foreign persons may be modified by an applicable bi-lateral treaty between the applicable foreign jurisdiction and the U.S.
Depending on the manner in which the foreign person owns the real estate, tax planning in this area generally implicates a combination of some or all of the following goals:
- An attempt to minimize taxation of operating income;
- The avoidance of a double tax on corporate profits;
- To ensure sale proceeds qualify for long-term capital gains tax treatment;
- The avoidance of transfer taxes, e.g., estate and gift taxes;
- An attempt to minimize withholding;
- To avoid taxation of the same income by both the U.S. and foreign tax authority; and
- An attempt to minimize tax reporting in the U.S.
In most cases it is impossible to achieve all of these objectives, so the planning needs to be specifically tailored to the particular facts and circumstances of each case.
For example, if a foreign person owns U.S. real estate directly in his or her individual capacity, then the gross rental income attributable to such real estate is subject to a flat 30% tax via withholding unless the foreign person elects “net basis” taxation, in which latter case the graduated income tax rate brackets for individuals apply (up to 39.6%) to net rental income taking account of certain expense deductions allowable depending on the use of the property (personal or business). If the U.S. real estate is held by the foreign person for more than one year, then the long-term capital gains tax rate (20%) is applicable to the gain on sale. In the case of personal use property, the foreign person and family members can enjoy the use of the property without imputation of rental income but if the “net basis” election is made then deductions are limited to real property taxes and qualified mortgage interest. The big disadvantages of direct ownership by a foreign person are (i) exposure to U.S. estate tax (applies at 40%) in the event of the death of the foreign owner; (ii) that a gift of U.S. real estate by a foreign person is subject to U.S. gift tax without the benefit of the lifetime gift tax exemption available to U.S. persons; and (iii) to ensure the collection of U.S. tax upon the sale of the U.S. real estate, the foreign owner will be exposed to the Foreign Investment in Real Property Tax Act (“FIRPTA”), which, subject to certain exceptions discussed in Part I of this article, requires the buyer to withhold an amount generally equal to 10% of the gross sale price at closing (“FIRPTA Withholding”).
By way of comparison, if a foreign person owns U.S. real property through a foreign corporation, then both U.S. estate tax and U.S. gift tax can be avoided. This structure also provides the advantages of limited liability and anonymity for the foreign shareholder(s). If shareholders or officers of the corporation will enjoy ‘personal use’ of the U.S. real estate, then a major disadvantage of this structure is the imputation of rental income to such persons; that is, unless the foreign corporation charges fair market value rent to such persons, such rent is imputed to the corporation and will trigger income tax. Another major disadvantage is exposure to the “branch profits tax”, subject to potential reduction via bi-lateral treaty. In lieu of withholding on dividends paid by the foreign corporation that owns the U.S. real estate to its beneficial owners that are foreign persons, the “branch profits tax” imposes a 30% tax on the operating profits of the foreign corporation attributable to the operations of its U.S. real estate that are “deemed” for this purpose to be repatriated to the applicable foreign country. It is important to note that this 30% “branch profit tax” is in addition to the corporate tax on the foreign corporation’s earnings in the U.S. (15% to 35% on net rental income or 30% on gross rental income via withholding by lessee), potentially resulting in an effective tax rate up to 54.5%. Gain on the sale of U.S. real estate by a foreign corporation is taxable at a 35% rate, and FIRPTA Withholding is required. Thus, if income from the U.S. real estate is expected to be significant and there is no relief available from a bi-lateral treaty then this structure may not be the most attractive option.
There are additional alternative ownership structures that can be utilized, including (i) ownership through a U.S. corporation owned by a foreign corporation; or (ii) ownership through a partnership (U.S. or foreign) or a limited liability company taxed as a partnership; or (iii) ownership though a trust (U.S. or foreign trust, grantor or non-grantor trust). Again, all of these structures are designed to achieve as many of the above-enumerated planning goals as possible, and the optimal structure always depends on the facts and circumstances of the particular case; that is, there is no ‘one size fits all’ structure.
At the end of the day, foreign persons intent on acquiring U.S. real estate should consult with tax advisors with knowledge of the legion of complex tax rules that confront the foreign owner of U.S. real estate. The failure to do so could easily result in dramatically higher than anticipated tax rates, an inadvertent but costly failure to comply with U.S. tax reporting and compliance rules, and exposure to U.S. transfer taxes as a result of the untimely death of a foreign owner or a gift of the U.S. real estate without proper planning. If you would like to discuss any of these issues, please feel free to contact our firm and we will be happy to evaluate your options.
A 2008 Senate report revealed an annual revenue loss of $100 billion attributable to the use of undisclosed offshore bank accounts by U.S. taxpayers for purposes of evading U.S. taxes. That same year, the Tax Division of the U.S. Department of Justice (“DOJ”) launched an aggressive enforcement campaign to combat the use of foreign accounts to evade U.S. taxes and reporting requirements. Since 2008, the DOJ has prosecuted numerous holders of undisclosed foreign bank accounts, as well as foreign persons who encouraged and assisted such U.S. account holders in establishing and maintaining such accounts for purposes of evading their U.S. tax obligations.
In 2009, and as amended in 2011, 2012, and 2014, an Offshore Voluntary Disclosure Program (“OVDP”) was implemented by the IRS to encourage U.S. taxpayers to disclose the existence of their offshore accounts in exchange for a substantially diminished likelihood of criminal prosecution – NOT unequivocal immunity – and the application of a relatively ‘taxpayer-friendly’ penalty regime when compared to the penalty regime applicable to taxpayers who are detected on IRS audit or otherwise ‘outside’ the OVDP.
Impetus to participate in the OVDP increased in August of 2013 when the DOJ announced the Swiss Bank Program (“SBP”), pursuant to which Swiss banks, in exchange for non-prosecution agreements, came forward and admitted to helping U.S. taxpayers conceal foreign bank accounts, and disclosed the names of thousands of U.S. account holders to the DOJ. In October of 2015, the IRS revealed there had been more than 54,000 voluntary disclosure under the OVDP, which resulted in the collection of greater than $8 billion in taxes, penalties, and interest. The DOJ has since expanded its offshore enforcement initiative well beyond Switzerland, moving into many different jurisdictions including, but not limited to, Belize, the British Virgin Islands, the Cayman Islands, the Cook Islands, India, Israel, Liechtenstein, Luxembourg, the Marshall Islands and Panama.
Taxpayers desiring to participate in the OVDP are first required to complete preliminary forms disclosing information pertaining to their undisclosed offshore bank accounts. Based on that information, the IRS Crimi9nal Investigation Division (“CID”) determines whether the taxpayers is already under IRS audit or being investigated by the DOJ in connection with one or more undisclosed offshore accounts. If the answer is yes, then the taxpayer is not allowed to participate d in the OVDP. If the answer is no, then the taxpayers is preliminarily cleared into the OVDP pending the provision of additional and more detailed account information. After CID receives the second submission of required information from the taxpayer and formally clears the taxpayer to participate in the OVDP, the bulk of the account and other required financial information is submitted to the IRS and forwarded to a central location where it is processed and analyzed by a special IRS OVDP division. All required payments under the OVDP are made contemporaneously with this final “bulk” submission.
In addition to back taxes, civil penalties, and interest, participating taxpayers are subjected to an “Offshore Penalty” for failing to file a “Report of Foreign Bank and Financial Accounts” (“FBAR”) with the U.S. Government. The Offshore Penalty under the current version of the OVDP is generally 27.5% of the highest aggregate account balance of the undisclosed offshore bank account during the eight-year OVDP ‘covered period.’ In situations where one or more of the OVDP participant’s undisclosed offshore bank accounts are held by a financial intuition on the Treasury’s “BlackList”, i.e., a list of institutions whose personnel were found to have actively aided and abetted U.S. taxpayers in establishing such accounts, the Offshore Penalty is increased to 50% of the highest aggregate account balance.
If a taxpayer’s non-compliance were discovered by the IRS ‘outside’ the OVDP, several additional penalties could apply such as the civil fraud penalty (75% of the unpaid tax), the FBAR penalty (can be as high as the greater of $100,000 or fifty percent (50%) of the total balance of the foreign bank account per violation), and penalties for failure to file certain information returns, e.g., Form 5471, Form 8938, Form 3520, Form 3520-A, etc. (generally $10,000 per year each). A willful failure to file an FBAR can also result in criminal prosecution; that is, a person who willfully fails to file an FBAR is subject to up to five years in prison and/or a maximum fine of $250,000. In all cases, each failure to file for a particular tax year is a separate violation.
In addition to the DOJ’s offshore enforcement initiatives, the U.S. Treasury has recently entered into a series of bi-lateral ‘intergovernmental agreements’ (“IGAs”)with a legion of countries under which the party countries have agreed to share information concerning holders of bank accounts on their respective soil that are citizens or tax residents of the other party. The rollout of the information exchanges under many of these IGAs is imminent. Last year the DOJ hired more than 80 new attorneys, and has developed and implemented an international enforcement training series to ensure their attorneys are conversant with offshore enforcement practices and procedures.
The takeaway from all of this for U.S. taxpayers holding undisclosed offshore bank accounts is that there is simply nowhere to hide anymore. You will eventually get caught! The failure to take advantage of the relative safe harbor of the OVDP prior to detection by the IRS and/or the DOJ is likely to result in criminal prosecution and/or financial ruin.
A “disregarded multi-member limited liability company” (“Disregarded MM LLC”) is a multi-member limited liability company for state law purposes but is disregarded as an entity separate from its owner for federal income tax purposes. All of the members of the Disregarded MM LLC are grantor trusts, with the same individual senior family member (“Senior”) serving as grantor of all such grantor trust members. One such trust member might be Senior’s revocable trust, and the other trust members might be intentionally defective grantor trusts established by Senior for the benefit of his children or grandchildren (“Lineal Trusts”).
From a cost savings perspective, this structure allows a client to avoid filing an annual federal income tax return for the Disregarded MM LLC. Further, the use of the “disregarded entity” adds significant value to the structure through enhanced asset protection and the opportunity to utilize valuation discount principles in making the gifts. In addition, the forgoing structure achieves income tax neutrality because the Disregarded MM LLC’s existence is ignored for federal income tax purposes. Similarly, because the Lineal Trusts are income tax defective, their existence is ignored for federal income tax purposes, and because the grantor bears the federal income tax burden with respect to the Lineal Trusts, the growth of the assets contained in such trusts is accelerated.
A wide variety of assets could be contributed by Senior to the Disregarded MM LLC to set the stage for tax planning involving the utilization of lifetime gift tax credit. The following example illustrates the potential of the Disregarded MM LLC for making gifts in a scenario where an entity classified as a partnership for federal income tax purposes could not be utilized.
Senior is the grantor and sole lifetime beneficiary of a revocable trust (the “Revocable Trust”), which Revocable Trust owns one or more installment sale notes receivable (the “Notes”). Senior forms a single member limited liability company under Florida law (the “LLC”), contributing the Notes to the LLC in exchange for 100% of the membership interests. The LLC is comprised of 100 Class A Voting Units and 9,900 Class B Non-voting Units (the “Non-Voting Units”). For federal income tax purposes, the LLC is disregarded as an entity separate from its owner unless the LLC elects to be treated otherwise. The LLC has not made such an election.
Senior establishes three (3) Lineal Trusts with Senior as the grantor. The beneficiary of each of the Lineal Trusts is one of Senior’s children. Senior transfers by gift one-third (1/3) of the Non-Voting Units to each of the Lineal Trusts in exchange for a membership interest in the LLC. The LLC is now a multi-member limited liability company for state law purposes but for federal income tax purposes is disregarded as an entity separate from its owner. The Lineal Trusts now own 99% of the LLC.
In general, a gift of an installment sale note receivable – including a gift of a partnership interest in a partnership holding installment notes receivable — is treated as a disposition made other than a sale, exchange, or satisfaction at face amount, in which case the donor immediately recognizes a gain in an amount equal to the spread between the fair market value of the note on the date of the gift and the adjusted basis of the donor in the installment note receivable. However, the transfer of an installment note receivable to and from a grantor trust is not a taxable disposition. Similarly, the transfer of an installment note receivable from a grantor trust to a disregarded entity wholly owned by the grantor should not be a taxable disposition. Thus, neither the contribution of the Notes by Senior to the LLC, nor the gifts of the Non-Voting Units by Senior to the Lineal Trusts, should result in an acceleration of the Notes under the installment sale rules.
Again, the use of the “disregarded entity” adds significant value to the structure through enhanced asset protection and the opportunity to utilize valuation discount principles in making the gifts. In addition, the forgoing structure achieves income tax neutrality because the LLC’s existence is ignored for federal income tax purposes. Similarly, because the Lineal Trusts are income tax defective, their existence is ignored for federal income tax purposes. Thus, Senior is deemed to be transacting with himself, and the whole series of transactions should be ignored for income tax purposes under the theory of Rev. Rul. 85-13. However, the advisor must be careful to ensure sure that (i) the LLC retains its status as a “disregarded entity”; and (ii) the Lineal Trusts retain their status as “intentionally defective grantor trusts” at all times prior to the complete satisfaction of the Notes.
Rev. Rul. 2004-77, 2004-31 I.R.B. 119 (8/2/2004); Regs. Section 301.7701-2(a)(providing that (i) a business entity is any entity recognized for federal tax purposes (including an entity with a single owner that may be disregarded as an entity separate from its owner under Regs. Section 301.7701-3) that is not properly classified as a trust under Regs. Section 301.7701-4 or otherwise subject to special treatment under the Code; (ii) a business entity with two or more owners is classified for federal tax purposes as either a corporation or a partnership; (iii) a business entity with only one owner is classified as a corporation or is disregarded); Regs. Section 301.7701-2(c)(1) (providing g that, for federal tax purposes, the term “partnership” means a business entity that is not a corporation under Regs. Section 301.7701-2(b) and that has at least two owners); Regs. Section 301.7701-2(c)(2)(i) (providing that a business entity that has a single owner and is not a corporation under Regs. Section 301.7701-2(b) is disregarded as an entity separate from its owner); Regs. Section 301.7701-3(a) (providing that (i) a business entity that is not classified as a corporation under Regs. Section 301.7701-2(b)(1), (3), (4), (5), (6), (7), or (8) (an eligible entity) can elect its classification for federal tax purposes; (ii) an eligible entity with at least two owners can elect to be classified as either an association (and thus a corporation under Regs. Section 301.7701-2(b)(2)) or a partnership; and (iii) an eligible entity with a single owner can elect to be classified as an association or to be disregarded as an entity separate from its owner); Regs. Section 301.7701-3(b)(1)(providing that in the absence of an election otherwise, a domestic eligible entity is (a) a partnership if it has at least two members, or (b) disregarded as an entity separate from its owner if it has a single owner).
Regs. Section 301.7701-3(b)(1)(ii). All Section references contained in this Article are to the Internal Revenue Code of 1986, as amended (the “Code”), or to the Treasury Regulations promulgated thereunder (“Regs”).
Rev. Rul. 60-352, 1960-2 CB 208 (gift of partnership interest in a partnership that held installment notes receivable resulted in acceleration of all deferred gain); Regs. Section 1.453-9(b)(2)(Holder’s basis in installment note receivable is an amount equal to the excess of the face value of the obligation over the total amount receivable by the holder if the note were completely satisfied).
Rev. Rul. 74-613, 1974-2 CB 153.
In the wake of the media hype surrounding the fabled “fiscal cliff”, Congress and the President have passed the American Taxpayer Relief Act of 2012 (the “Act”). To assist you in understanding the implications of the Act, the following is a brief yet comprehensive summary of the landscape for federal income, estate, and gift taxes beginning January 1, 2013.
- For single taxpayers with taxable income in excess of $400,000 and for joint filers with taxable income in excess of $450,000, the maximum tax rates for qualified dividends and capital gains will now be 20% (factoring in the 3.8% Medicare tax attributable to Section 1411, the effective rate will be 23.8%) instead of 15%. The maximum tax rate for all other taxpayers remains at 15%; moreover, a zero-percent rate will continue to apply to qualified capital gains and dividends to the extent income falls below the top of the 15% tax bracket.
- A 39.6% rate will apply to joint filers with taxable income in excess of $450,000 and for single taxpayers with taxable income in excess of $400,000 (up from 35% in 2012). Otherwise, the Act preserves all of the tax rates from 2012.
- The Act did not affect the 3.8% Medicare tax which went into effect January 1, 2013. Thus, for single taxpayers with taxable income in excess of $200,000 and for joint filers with taxable income in excess of $250,000, the 3.8% Medicare tax applies to interest, dividends and other investment income as well as income from trades or businesses in which the taxpayer is a passive investor. For example, if a single taxpayer had $150,000 of W-2 income and $125,000 of net investment income, the tax would be assessed against $75,000 which is the excess of the $275,000 AGI over the $200,000 threshold amount for single taxpayers, and would result in an additional $2,850 tax liability.
- The Act results in a permanent increase in the Alternative Minimum Tax (“AMT”) exemption amounts. The AMT exemption amount for the 2013 taxable year is $80,800, less 25% of AMTI exceeding $153,900(zero exemption when AMTI is $477,100) for joint filers and surviving spouses, and $51,900, less 25% of AMTI exceeding $115,400 (zero exemption when AMTI is $323,000) for single taxpayers. For all periods following the 2012 taxable year, the AMT exemption amounts will be indexed for inflation.
- The Act sets the estate and gift tax exemption amount permanently at $5,000,000 per person, adjusted annually for inflation for all periods following the 2011 taxable year. Current inflation data suggests an estate and gift tax exemption amount equal to $5,250,000 for the 2013 taxable year.
The Act continues the reunification of the gift tax and estate tax established in 2010 but increases the maximum gift tax rate and estate tax rate from 35% to 40%.
The Act results in a permanent ability of estates to elect to transfer any of the decedent’s unused exemption amount to the surviving spouse, which unused exemption amount can then be applied against any tax liability of the surviving spouse attributable to subsequent inter-vivos gifts and testamentary transfers.
- The Act extended certain tax benefits including (i) the exclusion of cancellation of indebtedness income resulting from discharged qualified principal residence indebtedness; (ii) treatment of mortgage insurance premiums as deductible qualified residence interest; (iii) two (2) year extension of ability to elect to deduct state and local sales and use taxes instead of state and local income taxes; (iv) non-taxable IRA transfers to eligible charities; (v) two (2) year extension of above-the-line deduction for qualified tuition and related expenses for higher education; and (vi) the $1,000 child tax credit.
- Due to the expiration of the 2% payroll tax cut, the Social Security withholding tax rate on wages earned by employees has increased from 4.2% to 6.2%. For single taxpayers earning wages in excess of $200,000 and joint filers earning wages in excess of $250,000, the Medicare surtax withheld from wages has increased by 0.9% (from 1.45% to 2.35%).
Due to the exigencies of the circumstances and the fact that most of the changes were rate-driven, the Act does not contain much ambiguity. Thus, the Act itself does little to create new opportunities for creative tax planning. However, the new and separate 3.8% Medicare tax might present some planning opportunities.