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Real Estate Holding Structures for Foreign Investors

by Moses Man, CPA | Jul 18, 2017
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Washington state, in particular the greater Seattle and Bellevue regions, have experienced significant activities in the real estate market in recent years. Foreign investors have been a primary driver of the activities in these regions. According to a recent article in The Seattle Times, during a span of a seven-month period in 2016, Seattle experienced more inquiries from mainland-Chinese homebuyers than any other American city. The foreign real estate investment activities in the region grew further when Vancouver recently enacted a 15 percent tax on foreign buyers in the Vancouver metro area.

In a far too common scenario, a foreign investor arrives in the US for a limited amount of time. During that time, the investor meets with the real estate agent, tours a few houses, signs a purchase and sales agreement, and flies back to his or her home country. These are accomplished in the span of days, often without legal and US tax considerations.

For a foreign investor, the lack of, or poorly executed, US tax planning with respect to his or her real estate investment could result in adverse or unintended US tax consequences. This article will examine the US tax consequences of various types of holding structures that may be used for a foreigner to invest in US real estate.

Direct Ownership

Under a direct ownership structure, the foreign investor takes title to the real property under his or her name.  The investor would be required to file an annual US income tax return to report the income generated by the real property, which would be subject to a gross rental income tax of 30%.  Alternatively, if an election is made under I.R.C. Section 871(d) to treat the rental activities as an effectively connected trade or business in the US, the net rental income would be taxed at the investor’s graduated tax rate. The requirement to file a US income tax return annually can often times deter the investor away from this structure.

Upon sale, the investor can reap the benefits of the long-term capital gains rate. Furthermore, a 15 percent withholding under the Foreign Investment In Real Property Tax Act (FIRPTA) would apply. However, the FIRPTA withholding tax generally would be credited on the investor’s individual income tax return.

The direct ownership structure suffers from a lack of legal liability protection, but perhaps the biggest downside is the application of the US estate tax. For non-resident aliens, the current estate tax rate is 40% and is levied on US situs assets, which includes real property located in the US.

Ownership through LLC and Partnerships

The LLC ownership structure is commonly used, because it is relatively simple to implement and the cost of implementation is low. Under this structure, the tax result generally would be the same as the direct ownership structure, and the same estate tax exposure remains.

If multiple investors exist, the LLC will default to a partnership for US tax purposes. Due to the flow-through nature of a partnership, the taxation on rental income and the ability to enjoy the long-term capital gains rate is the same as the direct ownership structure. Under I.R.C. Section 1446, the partnership would be responsible to withhold tax on the partnership’s effectively connected income (i.e., rent and capital gains) allocable to foreign investors on a quarterly basis. The withholding rate is currently at 39.6 percent. Furthermore, the partnership is equired to withhold on any withholdable payments under I.R.C. Section 1441 and 1442, also known as FDAP.  The withholding mechanism of I.R.C. Section 1446 takes precedence over the FIRPTA withholding.  As such, under this structure, there is generally no FIRPTA withholding upon disposition of the real property.

An interest in a partnership is generally considered as an intangible for gift tax purposes; as such, the gifting of a partnership interest is not subject to gift tax. Upon the death of a foreign partner, the estate tax would apply to his or her allocable value in the partnership. However, there is an argument that in lieu of a domestic partnership, a foreign partnership may be used instead to avoid the US estate tax.

Ownership Through a Domestic Corporation

Under this structure, the net rental income is taxable at corporate tax rate up to 35 percent. Similarly, the gain from the sale of the real property is subject to the same corporate income tax rate. Since the owner of the real property is a US corporation, FIRPTA withholding is not applicable upon disposition of the real property. Upon distribution to the foreign investor, the dividends (to the extent of earnings and profits of the corporation) is subject to a 30 percent withholding tax. The withholding tax may be reduced under an applicable treaty.  The shareholder can generally bypass a second layer of US tax if the corporation disposes of the real property, recognizes the gain on the disposition, and liquidates.

The stocks of a US corporation are deemed to be an intangible under gift tax laws. As such, the gifting of the US corporation stocks is free from gift tax. However, the same stocks are considered US situs property and is subject to the estate tax.

The domestic corporation holding structure should be used in rare instances due to the poor combination of the income tax and estate tax.

Ownership Through a Foreign Corporation

Under this structure, the foreign investor forms a foreign corporation, which directly holds the US real property. Similar to the Direct Investment structure, the gross rental income is subject to 30 percent withholding by the lessee. Alternatively, foreign corporations may elect to be taxed on net rental income at the corporate tax rate. In addition, foreign corporations are subject to the branch profits tax of 30 percent, which can be reduced via an applicable tax treaty. When the real property is disposed, corporate income tax rate is applicable to the gain, and FIRPTA withholding of 15 percent would also be applicable.

One can circumvent the branch profit tax and FIRPTA withholding by inserting a domestic corporation in the structure. Under this structure, the foreign corporation would be the sole owner of the domestic corporation and the domestic corporation would own the real property. Country selection would be critical in this type of double corporate structure to ensure beneficial withholding rates between the investors and the corporations.

The stocks of a foreign corporation are not considered US situs property.  As such, the estate tax would not be applicable. Furthermore, the gifting of the stocks of a foreign corporation is not subject to US gift tax.

Each structure described above carries its own intricacies. There is no one-size-fits all structure. A long list of tax and non-tax factors should be considered as part of the planning process. Examples of factors include:

  1. Investor profile (i.e., individual, entities, location)
  2. Earnings reinvestment vs. repatriation
  3. Investor’s privacy concerns
  4. Exit planning (i.e., expected timing and method)
  5. Anticipated US tax residency status
  6. Future investors

Although this article only examines the US income tax consequences, a comprehensive tax plan should also consider the investor’s local country tax consequences. For example, how will the local country tax the investor’s and the holding company’s current earnings? Will there be a timing difference between when the revenue will be recognized in the US versus in the local country?

When considering the location of holding companies, it is prudent to examine various tax treaties. Tax treaties often provide favorable withholding rates on dividends and interest income as well as a reduction in the branch profits tax. Certain tax treaties also provide guidance on the taxation of real property transactions. The limitation on benefits articles should also be carefully examined to ensure the applicability of the tax treaty.

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Moses Man is a CPA at M Squared Tax PLLC, a boutique CPA firm specializing in international taxation. He is the Chair of the International Tax Committee, which is planning the International Tax Conference. You can contact him at moses@msquaredtax.com.

This article appeared in the spring 2017 issue of WashingtonCPA Magazine. Read more here.

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