To limit the U.S. tax exposure on an investment in U.S. real estate foreign investors may use different structures. This article explains the various structures.
Ownership Without Interposing Corporation – An Overlooked Structure
Perhaps the most cost efficient structure from a pure income tax standpoint would be for the foreign investor to own his or her real estate investment without any interposing any corporation. Assuming that the real estate activity rises to the level of a U.S. trade or business, current rental income will generally be taxed at a 35%U.S. federal rate (plus possible state and local taxes) of net income (i.e., after deduction for expenses). The key advantages of this structure are the low U.S. federal capital gains rates on sale (15%, except 25% to the extent of prior depreciation), and the ability to repatriate funds free of any second level of tax. The key disadvantages of this structure are that the real estate will be subject to U.S. estate tax on the death of the foreign individual and that the individual will be obligated to file U.S. income tax returns with respect to the property. In addition to the administrative burden, the filing obligation will mean that the individual will not have anonymity from the U.S. government with respect to this investment. Because of these disadvantages, this structure is relatively uncommon. However, the low tax on sale and the ease of repatriation of funds without additional tax are significant advantages that should not be overlooked in appropriate circumstances.
Single Tier Corporate Ownership
The next structure for the foreign individual to consider is ownership through a single corporate entity. In most cases, this will not be advisable. Although the corporate level tax rates on current income are similar to those of individual ownership, there can be higher taxes on sale and on repatriation of funds. On repatriation of funds, distributions by the U.S. corporation will be subject to a 30%withholding tax (subject to reduction by many treaties) to the extent of earnings and profits and a U.S. shareholder level
FIRPTA tax to the extent distributions exceed earnings and profits. However, if there are no assets remaining in the corporation other than sale proceeds, the corporation can generally be liquidated and the proceeds repatriated free of a second level of tax. Thus, subject to certain restrictions, it may be possible for the corporation to retain earnings until the property is sold and avoid a second level of tax on repatriation. In addition, the single level U.S. corporate ownership will not shield against the imposition of U.S. estate tax on the death of the shareholder and will provide only limited anonymity because the tax return of the U.S. corporation tax return requires disclosure of the name, address and taxpayer identification number of any person owning 50% or more of the stock of the corporation.
Ownership through a foreign corporation alone also has key disadvantages. The basic U.S. federal tax rates on operating income will be similar to the non corporate and U.S. corporate ownership. However, the foreign corporation will be subject to an additional “branch profits tax” of 30% (subject to reduction by treaty) on, in general, its annual earnings and profits. Taking account of the deductibility of the basic income tax in computing branch profits tax, the effective federal tax rate would be approximately 56.5%. Gain on sale of the real estate would be taxed at the same rates as current income, except that if there are no other U.S. assets in the corporation, it should be possible to avoid the branch profits tax. However, sale of the stock of the foreign corporation should be free of U.S. federal income tax (except that the buyer will likely demand a significant discount in price for taking over inherent tax liabilities).
With respect to repatriation of funds, there is no dividend withholding tax, but repatriation may be a factor in computing the branch profits tax. An important advantage to this structure is that the stock of the foreign corporation is generally thought not to be subject to U.S. estate tax on the death of the individual. Like the single level U.S. corporate structure, the single level foreign corporate structure provides only limited anonymity because the tax return requires disclosure of the name, address and taxpayer identification number of any person owning 50% or more of the stock of the corporation. A second foreign corporation could be interposed if greater anonymity is desired.
The Foreign/U.S. Corporation Combination Structure
The most common structure used for foreign investment in U.S. real estate is a foreign corporation whose sole asset is all the stock of a U.S. corporation, which, in turn, acquires the real estate investment. While this two-tiered structure is more intricate than the other structures discussed above, it has many advantages that make its usefulness worthwhile despite the added complexity and cost to administer.
In this structure, the complex branch profits tax will not be applicable since the operating asset, i.e., the real estate investment, and the income generated there from reside in the U.S. Corporation. In addition,while the U.S. Corporation must disclose the identity of its 100% shareholder by name, that will identify only the foreign corporation. The foreign corporation is under no such obligation to disclose its shareholder since it is not engaged in a U.S. trade or business. Assuming no operating income is to be distributed out of the U.S., once the property is sold by the U.S. corporation in a fully taxable transaction and one level of U.S. tax has been paid on the resulting gain, the U.S. corporation can be liquidated,with the cash coming out to the foreign corporation free of any U.S. withholding tax. The foreign corporation is then free to distribute the cash to the ultimate shareholder, at any time, with no U.S. tax impact. In addition, the stock of the foreign corporation could be sold free of U.S. federal income tax (except that the buyer will likely demand a significant discount in price for taking over inherent tax liabilities).
Moreover, the conventional wisdom is that neither U.S. estate nor gift tax will apply to a lifetime gift or testamentary transfer of the stock in the foreign corporation. One disadvantage to this structure, as opposed to a structure of holding the real estate in a foreign corporation is that in the latter case it is more likely that it will be possible to distribute refinance proceeds free of U.S. tax.
There may be variations on the structure if multiple properties are to be acquired. If a long term hold is desired, the foreign corporation may hold a U.S. corporate parent to allow the filing of a single consolidated tax return offsetting gains against losses. On the other hand, completely separate lines of ownership may be set up for each property to facilitate repatriation of funds on a sale.
The foreign/U.S. corporation combination is usually the structure of choice,with due consideration to multiple property issues.
For a free consultation or to set up a Tax structure contact our Tax Partner here.