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Tax planning for ownership of US real estate  

Private Clients - 14 Jun 2017

Tax rules governing US property ownership are insufferably complex and can have different implications for residents and non-residents. In this article, we outline some key considerations for prospective and existing US property owners.  

You may be looking to buy a holiday home near Disneyland or have your eye on a potentially lucrative real estate investment opportunity. Either way, tax planning can be a minefield and throw up all kinds of challenges.

What might be considered a sensible move from an income tax or capital gains tax planning perspective, can present unwanted results from an estate or gift tax perspective and vice versa.

Whether you are a resident or non-resident of the US could also have implications. The Internal Revenue Code (IRC) requires US residents to pay taxes on their worldwide assets and earnings.

Meanwhile, non-resident aliens (NRAs), including non-resident corporations, are only obliged to pay federal and – potentially - state taxes on income and gains from property that have a US situs.

 

Income tax and capital gains tax

The introduction of the Foreign Investment in Real Property Tax Act (FIRPTA) in the US in 1980 put an end to non-residents claiming exemption from federal tax on the sale of a property.

So, residents and non-residents must pay US taxes on any profit generated from renting a property located in the US and also on any gain realized on sale.

For a property owned in a personal capacity by an NRA, tax starts at 30% on the gross rents received during a year, though if the NRA elects to treat the rental activity as a business, deductions can reduce the income. In contrast, a US resident is by default taxed on a net basis, but the rate of tax depends on their particular circumstances. The highest rate of individual federal tax is currently 39.6%. 

Any losses derived from the activity can be offset against other similar income, or otherwise carried forward for future use. The Internal Revenue Service (IRS) requires an NRA to file an annual tax return using form 1040NR to report the income and pay the tax due.

The maximum rate of tax on a gain on sale of a property is 20% if the property has been held in a personal capacity for at least 12 months. There is also a 0% and a 10% rate depending on the size of the gain.

If the property is held for less than 12 months, a disposal could send the tax rate up to 39.6%.

If the property was owned by a company or an offshore trust different rules and tax rates can apply. A company for example does not benefit from the lower 20% capital gains tax rate, rather pays tax of up to 40% at the corporate level. A company files a form 1120-F, while a trust uses form 1040NR the same as an individual.

There is also a potential for a second layer of tax to apply on the distribution of earnings out of a corporation to its shareholders known as the branch profits tax. Most tax treaties override this obligation, but if the corporation is in a jurisdiction that has no tax treaty with the US, then the tax can still apply at a rate of 30%.

Certain types of trust known as foreign grantor trusts are treated such that the person who puts the assets into the trust – the settlor – is the designated taxpayer on the income and gains rather than the trust itself. The determination of whether a trust is a grantor or non-grantor trust is a complex area beyond the scope of this article.

 

Special withholding tax provisions

When a non-resident sells property situated in the United States, FIRPTA imposes a 15% withholding tax on the gross sales price of property.

Every state also has its own rules on collection of tax on disposal and many of the state rules are similar to the FIRPTA rules. 

The collection responsibility is imposed on the buyer and the required amount must be submitted to the IRS within 20 days of the transfer date or be subject to possible penalties. Certain forms must also be filed providing all the required information to the IRS. 

Exceptions to the requirement to deduct the tax do exist but require appropriate applications to be made to the IRS, for example, if the disposal of the property will result in a tax loss.

However, the FIRPTA withholding requirement still exists on the gross proceeds. The seller or the buyer can therefore petition the IRS for an exemption from the withholding or where appropriate a reduction in the amount of withholding where the general 15% gross basis deduction is inappropriate. 

This does require action well in advance of any completion as a certificate is required from the IRS approving any exemption or reduction. In the absence of a valid certificate, but where one has been applied for, the withholding tax must still be deducted but not necessarily paid to the IRS until a decision on the certification has been received.

 

Estate tax

The rules on the imposition of the federal estate tax are somewhat similar to income tax, but unlike for income tax there is no substantial presence test (SPT) separating residents from non-residents. 

Every US state has the right to impose its own system of death duties, although, as with income tax, not every state has such a tax.

The determination of residence for federal estate tax purposes is based primarily on the intent of the taxpayer. Residence for federal estate tax is more akin to the British concept of domicile. 

A person who has never lived in the US but holds US property at their death is clearly a non-resident for federal estate tax purposes. Similar to income tax, a deceased US citizen is treated as resident for federal estate tax purposes even if they have a domicile in a foreign jurisdiction. 

Equally, there may be an estate and gift tax treaty that overrides or changes the right to tax and the rules on domicile.

 

Deceased non-residents

A decedent who is not a resident and not a citizen of the US at death is only subject to federal tax on US situs property, which includes real estate. A limited exemption of $60,000 is allowed against the value of the property when calculating the tax that is due. The rate of estate tax quickly rises to 40% for estates in excess of $1 million. If the property is held personally by the heirs, any future gain realized on disposal will be calculated with reference to the appreciation in value over at the market value at date of death.

If the property is held within a non-US corporation, it will fall outside the scope of US federal estate tax. 

This is because it is the company that is deemed to own the property, not the shareholders, and so on the death of the shareholders the property will remain owned by the foreign company and no federal estate tax can apply. This is predicated on the company operating correctly, with board meetings, shareholder resolutions and distribution or dividend policies in place.

The IRS has the power to disregard the corporate form if the company is not operating correctly.

Similar estate tax benefits can be achieved where property is owned in an irrevocable trust that is considered to have been settled with a completed gift and therefore outside of the scope of estate tax. 

 

Trust structure vs corporation

Many practitioners prefer the flexibility of a trust structure over a corporation, but the key to any estate tax benefit will be in the drafting of the trust such that the settlor does not retain sufficient powers or benefits from the trust to make all or part of the property considered to be in his or her estate at death.  An additional consideration is whether the trust is funded with cash and acquires property in its own name or if the property itself is contributed to trust.

There are no rules equivalent to the FIPRTA withholding tax provisions in respect of the estate tax. 

Clearly the heirs who stand to inherit the property or the shares of the company will still have all those considerations in mind in respect of future income earned or gains realized on sale. 

Where the property is held in a corporate vehicle, the base cost of the shares inherited may be the market value at date of death, but there is no corresponding uplift for the property itself within the company. 

This can present problems for heirs who wish to dispose of the property rather than continue to hold it within the corporation. It also raises extra reporting requirements for heirs who happen to be US citizens or residents.

As a final note, it should be pointed out that a disposal for capital gains tax purposes can occur if the property is initially owned personally and later contributed to a foreign corporation. Equally gift tax can arise on the contribution of the property to a trust whether onshore or offshore.

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David Foster

David Foster

Private Client Associate Director

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