Not long ago, the Miami Herald decided to publish an article describing the results of a study that showed that the majority of foreign homeowners in Florida are not from Latin America, but from Europe. Europeans account for 58% of real estate purchased by foreigners in Florida. The United Kingdom alone, according to the article, accounts for a third of all international real estate transactions. However, when purchasing real estate in the United States, one must consider not only the cost of the property itself – the amount of taxes to be paid is undoubtedly an extremely important point.
It is always difficult to explain to foreign investors the complexities of the tax burden inherent in investing in real estate in the United States. Taxation represents a significant expense item that can be minimized, and in some cases even avoided, with professional investment planning. Do not be mistaken – U.S. tax law is very complex, sometimes even absurd. But we must accept it as it is, until it is repealed or replaced by new legislation.
Congress's attention has been focused on foreign investment in U.S. real estate since 1980. That was when Congress enacted the Foreign Investment in Real Property Tax Act (FIRPTA). It was designed so that foreign investors are forced to pay at least the same income tax as before, after the sale of the property in which funds are invested, or another form of its disposition. Moreover, foreign nationals investing in the U.S. have always been required to pay property tax and gift tax. The complexity of the income tax system, coupled with the convoluted property tax and gift tax schemes, has created a dangerous labyrinth from which it is possible to escape only with patience and caution.
In essence, the U.S. income tax system subjects foreign investors to taxation under one of two possible tax regimes. The first applies to the 'effectively connected' income of investors engaged in a 'trade or business' within the United States. Such activity allows net income to be taxed at the same rates that apply to the income of U.S. citizens or residents. Under FIRPTA, the ownership of real property is treated as the conduct of a trade or business. The second applies to 'passive' investors, that is, those who are not engaged in a 'trade or business'; their gross effectively connected income is generally taxed at a rate of 30%. This tax becomes all the more tangible for taxpayers who are required to withhold tax at the source or are forced to pay customs duties on goods. Of course, it should be noted that tax treaties may reduce or even exempt from the tax burden.
However, Congress is not so simple. Not for a minute forgetting its share of taxes, it also makes every effort to help investors 'get rid' of money by investing it in the United States. To attract investment, Congress created the 'portfolio interest exemption,' which allows investors to invest in the United States, for example, in real estate, and receive interest income without having to pay taxes or withholdings. In general, portfolio interest income is easily structured and has a fairly broad interpretation. There are certain limitations, such as the payment of interest to foreign banks for which lending is part of their business, or the payment of interest to foreign investors who own 10% or more of the capital of the enterprise paying the interest, or the so-called 'contingent' interest, based on income or profits from investments.
In any case, tax treaties that the United States has signed with many European countries can significantly reduce the passive income tax or even exempt the payer, whose interest income would otherwise be taxed. However, it is worth noting that such agreements also have their nuances. Interest payments may be subject to 'earnings stripping' rules, which are designed to eliminate the interest deduction from taxable income that would be possible in the absence of these rules. Despite this, when all is said and done, many investors will still gain more by investing in the United States to obtain the portfolio interest exemption than if they invested in equity capital.
Many foreign investors take the easy path of using a foreign corporation to hold real estate in the United States. Congress addressed this as well by introducing the branch profits tax. In a nutshell, this tax applies to a branch of a foreign corporation in the United States as if the branch were a U.S. corporation. In essence, the branch profits tax is close to the 30% tax on passive investments. The difference is that it is even more complex. Completely setting aside the details, the branch profits tax is calculated on an amount equivalent to dividends of the foreign corporation. This amount is the corporation's taxable income effectively connected with a real property trade or business. Unlike the 30% passive income tax, which applies only to actual payments, the branch profits tax actively extends to potential payments in repayment of a loan, and if that puzzle is not enough, it is quite possible that one may also have to pay the branch interest tax. As a result, any interest paid by the branch to a foreign lender will be treated as income derived from U.S. sources, subject to withholding and taxed at the 30% passive income tax. In fact, the branch profits tax may be imposed even when no interest is actually paid.
Nor should one forget the estate tax, gift tax, and generation-skipping transfer tax. Importantly, any foreign investor, or the executor of his will, who falls into this tax quagmire must file a tax return disclosing the full extent of his real property, wherever it is located, as well as setting out the portion of that property located in the United States. The estate tax and gift tax are payable by persons residing in the United States or, generally, having property located in the United States. Real property is clearly located in the United States. However, shares of a foreign corporation that owns real estate in the United States are not located in America, but the real estate falls under the Foreign Investment in Real Property Tax Act, and foreign corporations may be forced to pay the branch profits tax.
What about real estate owned by a partnership? You might think that 25 years after the Foreign Investment in Real Property Tax Act was enacted, everything would have been settled. One should not be deluded when it comes to U.S. tax law. In fact, it remains unclear whether a partnership is treated as an intangible personal asset, like shares of a corporation under the entity theory, or represents an undivided interest in the underlying assets of the partnership, under the aggregate theory. If the partnership is treated as an entity, then the partnership's interest in real estate of a foreign partner that is located in the United States arises, regardless of whether the partnership is foreign or domestic. However, if the partnership is treated as an aggregate, then the tax is imposed on the location of the real property in question. In this case, the Internal Revenue Service, like some courts, adheres to the aggregate theory. Yet in other cases, the Internal Revenue Service readily leans toward the entity theory.
So what can a tax law specialist advise a foreign investor wishing to purchase a nice condominium in Miami, perhaps commercial property promising a good income, or even a few acres of undeveloped land? It is no secret that acquiring property through a single-member limited liability company has certain advantages – for example, simplicity. As well as a number of disadvantages – such as the estate tax, gift tax, and the necessity of personally filing a whole pile of tax returns. An American corporation could help, but the investor would still be obligated to pay federal estate tax. He would also face the need for double taxation of corporate profits and would file tax returns disclosing the name, address, and taxpayer identification number of any person owning 50% or more of the company's share capital. A foreign corporation might also be of interest, however, the disadvantage is a similar scheme of double taxation, including the branch profits tax and the need to file tax returns disclosing the name, address, and taxpayer identification number of certain shareholders. Although it may be possible to avoid the estate and gift taxes, the provisions of the Foreign Investment in Real Property Tax Act would still apply.
A possible solution in this case could be structuring investment so that a foreign corporation owns a corporation in the U.S., which in turn owns real estate in the U.S. Naturally, such a two-tier system is somewhat complex, but again, ultimately this combination ensures the best results. This structure makes it possible to avoid real estate and gift taxes; the branch profits tax for income tax purposes may also not be applicable in this case. When filing returns, the U.S. corporation may be required to indicate only the owner of 100% of its shares, which is the foreign corporation. Overall, if we assume that there is no business income distributed outside the U.S. (for example, all profit goes to portfolio investment), then upon the sale of real estate through a taxable transaction, the domestic corporation can be dissolved and the cash transferred to the foreign corporation. In this case, they will not be subject to any U.S. withholding tax.
Of course, each case of investing in U.S. real estate should be considered separately. As Offshore Express notes, there are a number of alternative investment structures that can be used, such as entering into a trust agreement for real estate management, comprehensive insurance contracts, and real estate investment trusts. Given the globalization of investing, it should be expected that foreign investments in U.S. real estate will become increasingly popular. In this regard, foreign nationals intending to acquire real estate in the United States should clearly understand that such acquisitions will require serious tax planning.
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