Six tax planning considerations for owning US real estate

Both residents and non-residents must pay US taxes on any profit generated from renting a property located in the US and on any gain realised on its sale. A non-resident alien has more choices, however:

• For a property owned in a personal capacity by a non-resident alien, the default position is that federal tax is payable at 30% on the gross rents received during a year.
• A non-resident can however elect to treat the rental activity as a business. In that case, the income is taxed at graduated rates and deductions for costs are allowed, which can reduce the taxable income.
• A US resident is always taxed on a net basis after expenses. The highest rate of individual federal tax where graduated tax rates apply is currently 37%. 

In either case, when taxed on a net basis, 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 a non-resident alien to file an annual tax return using form 1040NR to report the income and pay the tax due.

For capital gains, the maximum federal rate of tax on a gain from the sale of a property is 20% – provided the property has been held in a personal capacity for more than 12 months. There are also 0% and 10% rates that can apply, depending on the gain’s size. If the property is held for less than 12 months, a disposal could increase the tax rate up to 37%.

If the property is owned by a company or an offshore trust, then different rules and tax rates apply. Following reforms in the Tax Cuts and Jobs Act in December 2017, a company would incur federal corporation tax of 21% while trusts are taxed at similar tax rates to individuals. A company must file a form 1120-F, while a trust uses form 1040NR (the same as an individual).

Where a foreign corporation receives US rental income, there is also potential for a second layer of tax. This would apply to the distribution of earnings from a corporation to its shareholders and is known as the branch profits tax. Many tax treaties override or limit this obligation, but if the corporation is in a jurisdiction that has no tax treaty with the US, the tax may apply in full, at a rate of 30%. To manage this, a US corporation could be used as an intermediary vehicle between the property and the foreign corporation.

For trusts, certain types, 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 any income and gains, rather than the trust itself.

Finally, it should be noted that state income and corporation tax may also be payable on rental income or gains, depending on where the property is located.

Under FIRPTA, non-residents selling property in the United States face a 15% withholding tax on the gross sales price. The responsibility for collection falls on the buyer, and the required amount must be submitted to the IRS within 20 days of the transfer date. Failure to do so can result in a penalty.

There are exceptions – for example if the disposal of the property will result in a tax loss  – but these require an application to the IRS. The seller or the buyer must petition the IRS for an exemption from the withholding or, where applicable, a reduction in the amount of withholding where the general 15% gross basis deduction is inappropriate. 

In all cases, a valid certificate is needed from the IRS approving any exemption or reduction. The application should be made well in advance of completion because, without a valid certificate, the withholding tax must be deducted. If a certificate has been applied for, however, the provisional withholding amount can be placed in escrow until a decision is received from the IRS. Additionally, every state also has its own rules on collection of tax on disposal. Many are similar to those of FIRPTA. 

The scope of federal estate and gift tax is dependent on whether someone is US tax domiciled. Unlike for income tax, though, there is no substantial presence test (SPT) separating residents from non-residents. The determination of domicile for federal estate tax purposes is based primarily on the intent of the taxpayer.

• A person who has never lived in the US but holds US property at their death is clearly non-domiciled for federal estate tax purposes.
• A deceased US citizen, meanwhile, as with income tax, is treated as domiciled for federal estate tax purposes even if they reside in a foreign jurisdiction. 
• There may be an estate and gift tax treaty that overrides or changes the right to tax and the domicile rules.

As a general rule, even if someone is non-domiciled, they will potentially be liable to US estate and gift tax on US tangible property under US domestic tax rules. Estate tax treaties may, however, exempt certain items (such as chattels held within a property) or provide for an additional exemption amount. 

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

Provided the deceased person is not domiciled in the US and not a US citizen at death, their estate will only be subject to federal tax on US situs property, which includes real estate.

There is a limited exemption of US$60,000 against the property’s value when calculating the tax that is due. The rate of estate tax quickly rises to 40% for estates in excess of US$1mn, however if the property is held personally by the heirs, any future gain realised on disposal will be calculated with reference to the appreciation against the market value at the date of death. A marital exemption only applies if the recipient is a US citizen. For a married couple who are not domiciled, US estate tax would apply only on the first to die.

Individuals owning US property should take advice as to whether special provisions in their wills are required to minimise their liability or an estate tax treaty could exempt a larger amount.

Finally, property held within a non-US corporation will fall outside the scope of US federal estate tax. The company, rather than the shareholders, is deemed to own it and continues to do so after the death of the ultimate owner. This is predicated on the company operating correctly, with board meetings, shareholder resolutions and distribution or dividend policies in place, however. The IRS has the power to disregard the corporate form if the company is not doing so. Similar estate tax benefits can be achieved where property is owned in an irrevocable trust. Where this is considered to have been settled with a completed gift, it is outside of the scope of estate tax. 

In all cases, there is no automatic withholding tax (such as FIRPTA). Any tax due should be paid by filing form 706NA.

Since both trusts and foreign corporations can be intermediaries, providing a barrier to estate tax, the question arises of which should be preferred.

Historically, many practitioners have opted for the flexibility and lower tax rates of a trust structure over a corporation. Following the US tax reform in December 2017, however, foreign corporations are often the favoured vehicle today. This may, however, change should corporation tax rates increase to 28% as proposed by the President.

Whichever option is used, careful planning is required. 

In respect to trusts, the key is to ensure the settlor does not retain powers or benefits such that the property would be considered part of the 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.

Where a corporation is used, it is important to show the company is properly managed so that it is not disregarded by the IRS as a fake company.

Where the property is held in a corporate vehicle, the base cost of the shares inherited may be the market value at the date of death. There is no corresponding uplift in the base cost of the property itself within the company. Similarly, an automatic uplift in base cost does not apply where a trust is an intermediary for the purpose of estate tax. In both cases, this can be problematic for heirs who wish to dispose of the property rather than keep it within the corporation or trust. Tax will be due on any gain realised.

Furthermore, both trusts and foreign corporations raise extra reporting requirements for heirs who happen to be US citizens or residents.

It should also be noted 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.

Finally, the tax rules applying in the taxpayer’s country of tax residency always need to be considered. Regardless of the US tax code, in some jurisdictions, foreign corporations and trusts may be inefficient vehicles when it comes to tax. This should always be part of the considerations when deciding whether to use trust, a company or neither.

Summary

Navigating the US tax rules for real estate is exceptionally difficult with residency status having a significant impact. However, the most effective solutions are likely to depend not just on residency but also on State tax rules, treaties and, for non-residents, their own domestic tax codes. Seeking advice and careful planning is essential.