Reducing Taxation for Foreigners Investing in U.S. Real Property
Now is perhaps a better time than ever to invest in U.S. real estate in terms of security, income, and long-term appreciation. However, as can be expected, the U.S. seeks to tax the appreciation on these properties when they are sold and tax their value when transferred by gift or upon death. This tax burden falls heavier on foreigners, because foreigners don’t enjoy certain credits and deductions reserved to U.S. citizens and to some “tax residents”. With advance legal planning, foreign real estate investors can still minimize some U.S. tax consequences of their investments using certain legal structures. For those currently owning U.S. real estate in their individual names (or through an LLC) you should move quickly and transfer title of these real property investments to legal structures that will reduce legal risks and avoid unnecessary taxation. In any case, it is very important to have a comprehensive plan before signing a purchase/sale contract. In fact, many people give advice about these structures (verbally or with disclosures in small print that say they don’t give “U.S. legal or tax advice”), but only an international tax attorney can design, create, and defend a legal structure that is personalized and capable of overcoming an IRS audit or the scrutiny of the court when someone files a law suit or probate.
Even if a foreigner does not file U.S. tax returns or have any business in the U.S., the mere fact of owning U.S. real estate results in a U.S. estate tax return filing requirement after the foreigner’s death. The estate of a U.S. citizen or tax resident includes all assets the decedent owned anywhere in the world. On the contrary, a foreigner’s taxable U.S. estate only includes U.S. situs assets. The definition of U.S. situs assets includes real property located in the U.S., but excludes some intangible property such as stock in foreign corporations.
The estate tax is levied at a rate of 40%. Persons considered U.S. tax residents enjoy a credit that shelters the first $5.25 million of their assets from taxation, as opposed to foreigners who have only a $60,000 credit. In other words, when a foreigner dies owning U.S. real estate, an estate tax is levied on the value of that property in excess of $60,000 and could result in a lien on the property if not paid. Moreover, unlike with the estates of U.S. persons, real estate passing through a foreigner’s estate is generally taxed at its full market value without any reduction for mortgages and regardless of how much they paid for it. An unlimited marital deduction that essentially exempts transfers between spouses is also not available when the surviving spouse is a non-citizen.
How then can the U.S. estate tax be eliminated for foreigners holding U.S. real property? Simply put, the U.S. estate tax does not reach stock held by a foreigner in certain types of foreign corporations that in turn own U.S. real estate. In order to effectively transfer indirect ownership of the property upon death, the foreigner simply uses a will or trust to govern disposition of the stock in the foreign corporation. Since the foreign corporation stock is not a U.S. situs asset, it is not included in the foreigner’s U.S. taxable estate.
Of course, in order for such a structure to withstand IRS scrutiny, it must be properly planned, documented and maintained. Not only that, an estate tax efficient, corporate structure can carry with it income tax consequences that should be weighed considering the type of property, investment horizon, intended use, etc. That being said, an offshore structure properly linked with a carefully structured U.S. LLC holding the property also has several non-tax benefits such as keeping the property outside of a U.S. probate court, as well as providing a certain degree of anonymity as to who is the ultimate beneficial owner of the property. Moreover, the foreigner can be insulated from liability from accidents that might occur on the property if properly structured and operated.
The legal issues involved in real estate investment actually begin with deciding what terms and conditions to add, change or remove from the “standard” real estate purchase agreement. Then the property must be physically inspected and legal title to the property must be checked to determine if there are any legal problems with the property and resolve them before closing where many pages of complex legal documents will need to be reviewed quickly and signed. An experienced tax attorney usually has plenty of time between signing the purchase agreement and closing to identify and implement the most tax efficient and legally protected structure for the real estate investment. However, we are regularly called in to “clean up” a situation where the real estate was already purchased using a real estate attorney without international tax experience or even worse no attorney at all. Sometimes an LLC was created to hold title but no one drafted the proper legal documentation or made the correct IRS filings. Whenever it is that the investor realizes they have unnecessary legal and tax exposure, we can be brought in to quickly assess the situation, determine what needs to be done and correct it efficiently and effectively. Our services for foreign real estate investors include:
- Drafting, reviewing and negotiating purchase and sale agreements.
- Serving as escrow/closing agents and providing title insurance.
- Forming Limited Liability Companies and other U.S. entities to limit personal exposure relating to the property.
- Drafting, reviewing and negotiating partnership or operating agreements to avoid future disputes between business partners and other investors.
- Preparing loan documentation for tax-advantaged “portfolio debt” financing arrangements.
- Working with banks, trust companies and foreign law firms to establish, maintain or clean up offshore structures for compliance with applicable U.S. tax law.
- Designing, documenting and implementing the optimal legal structure for:
- Income tax efficiency
- Estate tax efficiency
- Limited personal liability
- Asset Protection
- Dispute Resolution
- Estate Planning
- Probate Avoidance
 Care must be taken to prevent a foreigner from being taxed as a U.S. person by not establishing a U.S. domicile. The rules for determining domicile for estate tax purposes are quite different from the substantial presence or “count the day” rules for income tax purposes.
 In this case it may be wise to use a Qualified Domestic Trust (“QDOT”).