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U.S. Tax and Transactional Issues Relevant to Foreign Owners of U.S. Real Estate and Parties to the Sale Thereof; PART II – What are the U.S. Tax Implications?
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.
U.S. Tax and Transactional Issues Relevant to Foreign Owners of U.S. Real Estate and Parties to the Sale Thereof; PART I – Foreign Owner Transfer of a U.S. Real Property Interest
PART I – Heightened Interest in Tax Implications of Foreign Owner Transfer of a U.S. Real Property Interest
The number of foreign persons investing in U.S. real estate has continued to rise in recent years. The National Association of Realtors reports that foreign buyers purchased more than 104 billion dollars in U.S. real property from March 2014 to April 2015. Florida was named the state most favored by foreign buyers, garnering twenty-one percent (21%) of the total purchases made by foreign buyers. This trend spotlights the importance of the Foreign Investment in Real Property Tax Act of 1980, I.R.C. § 1445, more commonly known as FIRPTA. Also, recent changes to FIRPTA made in December, 2015, resulting from the Protecting Americans from Tax Hikes Act, mean the amount of taxes to be withheld on certain transfers of a U.S. real property interest by foreign nationals has increased.
FIRPTA was enacted, in part, to ensure that foreign sellers pay taxes on the sale of a U.S. real property interest. Under FIRPTA, all sellers of a U.S. real property interest (considered to be transferors) are presumed to be foreign and the burden of proving otherwise is placed squarely on the shoulders of the property buyer. Buyers of a U.S. real property interest, considered to be transferees and withholding agents by the Internal Revenue Services (IRS) for purposes of FIRPTA, must withhold and remit taxes to the IRS in the amount equal to fifteen percent (15%) of the amount realized from the sale of real property (usually the contract price) in order to be protected from any tax liability which the seller fails to satisfy to the IRS.
As the withholding agent, the buyer/transferee is required to remit the tax withheld from the amount realized on the sale to the IRS within twenty (20) days of the property transfer utilizing the appropriate IRS forms which require that the seller/transferor has a U.S. tax identification number. The foreign transferor can have the amount to be withheld reduced if it applies, no later than the day of closing, for a withholding certificate and demonstrates the existence of certain conditions meriting a reduction in the amount of taxes due on the property transfer.
The buyer/transferee is relieved of the withholding requirement if the seller/transferor gives the buyer a certification, signed under penalties of perjury, that the seller/transferor is not a foreign person. The certification is required to contain the seller/transferor’s name and address, and tax identification number. The buyer can only rely on this certification if the buyer has not been provided with a notice or does not otherwise have actual knowledge that the seller/transferor is a foreign person.
In a buy-sell transaction of a residence for $300,000.00 or less involving a foreign seller/transferor, a buyer is not required to withhold and remit taxes to the IRS if the buyer is an individual and is willing to sign an affidavit stating that the buyer or a member of the buyer’s family will be occupying the purchased residence for at least fifty percent (50%) of the time that the purchased residence is occupied during the first two (2) twelve (12) month periods following the transfer. When the amount realized on the transaction exceeds $300,000.00 but is less than $1,000,000.00, and the buyer, who is an individual, is willing to sign an affidavit stating that the buyer or a member of the buyer’s family will be occupying the purchased residence for at least fifty percent (50%) of the time that the purchased residence will be occupied during the first two (2) twelve (12) month periods following the transfer, then ten percent (10%) of the amount realized must be withheld. These exceptions to the withholding requirement can benefit the foreign seller because funds will not be withheld from the sales proceeds in an amount up to fifteen percent (15%) of the amount realized; however, they can result in exposing the buyer to liability for taxes, penalties, and interest owed by the foreign seller to the IRS resulting from the sale of the residence.
The withholding rate remains at fifteen percent (15%) when the amount realized is greater than $1,000,000.00 regardless of the use of the property. Likewise, the fifteen percent (15%) withholding rate applies when the buyer is not an individual or when the property will not be utilized by an individual buyer as a residence.
FIRPTA does not apply only to transactions involving residential property; rather, it includes any real property located in the U.S. or the U.S. Virgin Islands, personal property associated with the use of real property, and interests in a mine, well, growing crops, timber or other natural deposits, as well as rents paid to a foreign person (note: withholding rules governing rental payments made to a foreign person are beyond the scope of this article). A foreign person includes non-resident alien individuals, as well as partnerships, trusts, estates, and (certain) corporations and limited liability companies domiciled outside of the United States. And, whether involving individuals or entities, FIRPTA applies to real property transfers including, but not limited to gifts, sales, exchanges, redemptions and transfers.
Since seller/transferors are presumed foreign, and it is the buyer/transferee’s burden in a transaction involving the transfer of a U.S. real property interest to prove otherwise, or to be saddled with potential tax liabilities related to the disposition of U.S. real property by a foreign transferor, buyers or transferees (other than certain U.S. governmental entities) are advised to seek legal counsel if the seller/transferor is unable to produce the certification described above attesting that it is not a foreign person.
Minimum Cost Restructuring with Real Estate Provides Asset Protection and Flexibility
There is an inherent risk of liability that goes along with property ownership. You as a property owner could potentially be subject to tort claims stemming from activities that occur on the land. If the property were held in your individual name or in the name of your Revocable Trust at the time a tort claim was made and the claim resulted in a judgment against you or your trust, your personal assets, or the assets of your Revocable Trust, could be attached to satisfy the judgment. However, if the property is held in a separate LLC, only the property held in the LLC can be used to satisfy the judgment. This restructuring is advantageous to you because it would give you maximum protection for your personal assets.
This structure maximizes the asset protection for Corporations as well, because any judgment against one piece of real estate could only be satisfied by that piece of real estate and not the assets of corporation or the other pieces of real estate since they are in separate LLC’s.
Having each piece of real property in a separate LLC has advantages from a business standpoint in that it makes it simpler to bring in a developer as an owner of the real estate. Bringing in a developer as an owner when the real estate is held by an S corporation is difficult because an S corporation can only be owned by certain individuals and trusts, whereas most developers will be some form of business entity. However, any business entity can be a member in an LLC, and by having each piece of real estate in a separate LLC, you can bring in a developer as a member for just the one piece of property. Also, if you do bring a developer in on a joint venture, by the real estate being in an LLC, you have the flexibility to provide different allocations of distributions and taxes between you and the joint venture partner. This flexibility would not be available if the real estate was held in an S Corporation. Finally, when you decide to sell the real property you can sell the entity rather than selling the actual real property.
Each piece of real property in a separate LLC has advantages from an Estate Planning standpoint in that it makes it simple to transfer ownership. The ownership of real estate held by an LLC is represented proportionately by a member’s shares of an LLC. Rather than filing a new deed, members can transfer ownership of the property to their children by simply issuing them membership interest in the LLC. This makes gifting away interest in the real estate very simple to do. Also, it is easier to gift interest in an LLC than it is to gift away stock in an S Corporation, because an LLC has no restrictions on who can be an interest holder whereas there are limits who can be a holder of stock in an S Corporation. Therefore, each gift of stock out of the S Corporation would have to be analyzed to ensure it was going to an eligible S Corporation shareholder.
For Real Property currently held in your individual name or in your Revocable Trust, we suggest creating a single member limited liability company (LLC) for each parcel of real estate you currently hold. A LLC holding company should be created to be the single member of each of the LLC’s holding the real estate. You or your trust would be the sole member of the LLC holding company. You would still maintain control of each LLC holding the real estate because the holding company is the sole member of each LLC and you would be the manager of the holding company.
For Real Property currently being held in the name of a Corporation, we recommend creating a single member LLC for each piece of real estate and then having the Corporation contribute the real estate to the individual LLC in exchange for ownership interest in the LLC.
Any real estate that you acquire in the future should be held in a separate LLC with the LLC holding company as its sole member. Because of the business and estate planning advantages a LLC has over a S corporation, it is best to never acquire any real estate in a S corporation.
Protecting Your Real Estate Investments While Deferring Taxes in a § 1031 Like-Kind Exchange
When structured correctly, the exchange of real estate property using closely held business entities can result in advantageous tax treatment under the Internal Revenue Code of 1986, as amended (“IRC”), while simultaneously insulating the owner(s) from liability from potential judgment creditors. Section 1031 of the IRC, known as the “like-kind” exchange section, begins with the following statement: “[n]o gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.” If the requirements for a like-kind exchange are met, this provision allows owners to defer the recognition of gain on appreciated real property if the real property is exchanged for replacement real property of “like kind”. Put differently, if an investor is looking to acquire real estate and also dispose of current real estate holdings, the immediate need to pay federal or state income taxes on the gain that would otherwise result from the sale may be postponed through a like-kind exchange.
§ 1031 Requirements:
The above definition contains several essential components that must be met for a transaction to qualify as a like-kind exchange. The following is a brief outline of the more material of these factors:
- There must be an “exchange of property.” A simultaneous swap of real property will satisfy this requirement. The exchange may also be a deferred exchange (meaning the current disposition of property and later acquisition of the like-kind property) or a reverse exchange (meaning the current acquisition of property and later disposition of like-kind property), but additional rules and requirements will apply to these transactions, including the need to use a Qualified Intermediary for deferred exchanges and reverse exchanges, and the need to meet strict time frames for the identification and acquisition/disposition of the replacement property.
- The property must be “held for productive use in a trade or business or for investment.” While no definite time period meets the “held for” criteria, the longer the property is used in a trade or business, or held for investment purposes, the greater the likelihood that the transaction will qualify for the §1031 exchange. With limited exceptions, the IRS generally takes the position that personal residences and vacation homes do not qualify for like-kind treatment.
- The properties to be exchanged must be of “like-kind.” The IRS will consider the nature of the properties involved to determine if the like-kind requirement is met. Exchanges of most real property will qualify for like-kind treatment (e.g. the IRS has considered vacant land similar enough to improved land to qualify for a like-kind exchange). To the extent the investor receives cash or other property that is not like-kind, the IRS will require recognition of gain and payment of the resultant taxes.
Real Estate Transactions Using LLCs:
Many investors choose to structure their real estate transactions by setting up limited liability companies (“LLCs”) or other closely held business entities, and purchasing real property through such entities. Assuming an LLC is properly created and maintained, and its member(s) do not elect to classify it as a C-corporation for federal income tax purposes, the LLC form can insulate its member(s) from liability from potential judgment creditors while allowing pass-through taxation. Pass through taxation results in only one set of taxes for the individual member(s) (or shareholders if S-corporation classification is elected) (as opposed to C-corporations that are taxed at the entity level and again at the shareholder level when distributions are made).
Additionally, holding each property in a separate LLC can reduce the exposure to risk for investors owning multiple properties in this manner, which can result in significantly more favorable loan terms. For example, a creditor who obtains a judgment against the real property owned by one LLC where the fair market value of such property is insufficient to satisfy such judgment cannot reach either the personal assets of the owner(s) of such LLC or personal assets of the other LLCs, and cannot reach the properties owned by the other LLCs in an attempt to satisfy its judgment. The insulation from risk created by the separation of ownership of the property creates an incentive for a lender to provide better loan terms, particularly when the loan is collateralized by a portfolio of properties owned in this manner.
§ 1031 Exchanges Through Single Member LLCs:
In Florida, individual investors or entities may form Single Member LLCs (“SMLLC”) to own particular real estate assets. While SMLLCs do not provide all of the protections of multi-member LLCs, a sole member of an SMLLC may receive like-kind exchange tax treatment for the exchange of either 100% of his or her membership interests in, or the real property owned by, such SMLLC for either the real property owned by a third party entity or individual, or the membership interests of a third party’s SMLLC that holds replacement property. This result is possible because the SMLLC is “disregarded” for federal income tax purposes as an entity separate from its owner; that is, federal tax law simply ignores the existence of the entity, instead treating all of the assets as owned directly by the sole member. Consequently, an investor may also receive like-kind exchange treatment if all of the § 1031 elements are met and the investor sells property owned by one of its SMLLCs and acquires replacement property using another of its SMLLCs as a part of the same transaction (or deferred or reverse like-kind exchange, as applicable).
With the economy rebounding and real estate prices on the rise, like-kind exchanges should again become a prevalent tool in effective tax planning for real estate investment activity. However, tax planning for real estate transactions often involves a complicated analysis of all applicable factors and should be tailored to each individual’s situation on a case-by-case basis. Additionally, the IRC, the Treasury Regulations promulgated thereunder and other IRS publications contain certain exceptions and guidance on how to accomplish like-kind exchanges. The above is not intended to provide legal, financial or tax advice—it is only a brief outline of how like-kind exchanges under the IRC may provide owners with an opportunity to defer recognition of taxable gains for significant periods of time. Owners should always consult with a qualified attorney to assist in analyzing and structuring their proposed transactions to take full advantage of the protections and savings afforded by applicable law.