Saving taxes with U.S. real estate is difficult.
Here is the problem with a domestic or foreign corporation that owns real estate- Double Taxation and then a 45% death tax.
The name of the two taxes are “income tax” and “branch profits tax”. Depending upon which state in which you own the real estate, the corporate income tax is between 35% to 46% of the net income.
The next tax, the branch profits tax, is 30% of the net income less the income tax. For example, the project earns $1,000,000. Assuming a Federal and state tax rate is 40%, $400,000. The branch profits tax is 30% of $600,000 ($1,000,000 minus $400,000). This is an additional $180,000. The total tax is $580,000.
If the property is financed by debt, the general rule is the that the interest on the corporate debt is not allowed as tax deduction when paid to a foreign person (more on here).
How the foreign investor avoids the U.S. estate taxes.
If you (the non-resident alien investor) do not use a trust, then this what the IRS will do when you die (and you will die).
1. The death tax is 45% of the value of the assets owned by you or your foreign corporation,
2. Your family will be required to file Form 706-NA with the IRS. On this Form, you disclose your worldwide assets and worldwide debts. If a foreign government wants this information, the IRS will give the information to them and
3. The death tax is due in nine months. Your family will have to sale the real estate to pay the taxes.
I am aware that some internet articles advise owning real estate in a foreign corporation. And that was good tax planning last century. At the beginning of this century, the law changed. In the U.S., we have two types of tax laws. One is the tax code. The second is court cases (known as “common law”). This new law is a common law (if you need information on this new law, then please contact me, Brian Dooley, CPA, MBT, at [email protected]).
The Nevada Trust is the Best Foreign Investor Tax Structure and Strategy.
Trust have a different set of tax laws. To learn more about trusts, please see the information on this link.
Wealthy Americans and foreign investors have trusts to generate wealth and to avoid taxes. I recommend that your tax team work with the IRS to get a guarantee of your tax structure. This is known as a “private letter ruling”. For our clients, we always apply to the IRS for a private letter ruling. Without tax certainty, a tax planner is hesitant to do the best for you.
Without the IRS guarantee, you tax planner will be uncertain as to the boundary of the tax laws that apply to your trust. The tax law has ten possible tax classification for a trust. Each trust is unique and so is its tax classification. Each trust is designed solely for the needs of your family and your family’s businesses or investments. The tax classification defines the boundary of your tax planning.
In the diagram below (click here to see the full size), the first box represents the trust. You control the trust’s investments, management and payments to the family through a corporation (owned by you or you and your family). This corporation is also known as the trustee.
Best International Tax Structure for the Foreign Investor in Real Estate. The non-resident aliens are using Nevada Trusts to save taxes.
In this diagram, the last three boxes represent three different limited liability companies. The box on the far right side represents a LLC that has shares of U.S. corporations. This is to avoid the U.S. death taxes.
If a trust is not used, then the foreign investor pays U.S. death taxes on the value of investments in the U.S. stock market and ownership of privately held companies and partnerships. It is important to obtain an IRS ruling on the estate tax classification of your trust.
Since the Middle Ages, the wealthy have capitalized on trusts to avoid paying taxes. In the English feudal system, a knight’s property was given to the king upon the knight’s death. Quite an oppressive system, if you ask me.
Fortunately, we’ve progressed since feudalism. Smart, legal tax planning strategies allow international business owners and estate owners to keep more of their hard-earned money. Trusts are essential to international tax planning for businesses and estates.
A trust is “a relationship in which one person holds title to property, subject to an obligation to keep or use the property for the benefit of another.” Trusts are formed under state law and oftentimes, people will form trusts and name their spouse or children as the beneficiaries. The terms of the trust are written in the trust agreement. The agreement is between you and your corporation (the one that I referred to as the trustee).
In this next portion of this article, I have summarized the U.S. income tax law that you must know if;
1. you are going to own real estate in America either in your own name (as a non-resident alien) or
2. with a foreign corporation.
I have my summary from the IRS website in blue, below. You do not need to read this text below if you use a Nevada trust to own your U.S. real estate.
Here is what happens-
U.S. real estate professionals and rental agents/property managers are encountering an increasing number of situations that involve foreign persons’ acquiring U.S. real estate as a part-time residence, for investment or in some cases to conduct a U.S. business. The U.S. tax rules that apply to ownership and dispositions of U.S. real estate by foreign persons are different in some important respects from the rules that apply to U.S. persons.
U.S. real estate professionals must know how to properly deal with foreign investors in U.S. real estate. They must be familiar with the rules that determine whether an individual or entity is to be treated as a U.S. person or a foreign person. In addition, they must also be familiar with the fundamentals of U.S. federal income taxation of foreign investors with U.S. rental income and the estate tax and gift tax laws.
Like the American, the foreign investor can depreciate the property. Unlike the American, the tax deduction is not always allowed.
This article will explain when the foreign investor pays tax on the gross rental income and when he/she pays tax on the net rental income. The article also will explain the tax election that must the foreign investor if he/she wants to pay tax on the net income and not the gross income.
There are different depreciation rates for residential and commercial properties. This annual depreciation is deducted from income as an expense on an income tax return. When you sale the property, you reduce the amount you invested by the amount of depreciation.
Foreign Property Owner’s Tax Return Responsibility during Ownership and Rental of Real Property Interest
Before buying U.S. real property for a foreign taxpayer should discuss with the foreign investor must know client whether the rental income will be taxed
1. as investment income through withholding or
2. on a net income basis as “effectively connected with a U.S. trade or business,” without withholding (although the owner may have to file estimated tax returns).
Rental income from real property located in the United States and the gain from its sale will always be U.S. source income subject to tax in the United States regardless of the foreign investor’s personal tax status and regardless of whether the United States has an income treaty with the foreign investor’s home country.
The method by which rental income will be taxed depends on whether or not the foreign person who owns the property is considered “engaged in a U.S. trade or business.”
Ownership of real property is not considered a U.S. trade or business if it consists of merely passive activity such as a net lease in which the lessee pays rent, as well as all taxes, operating expenses, repairs, and interest in principal on existing mortgages and insurance in connection with the property. This is a bad tax result.
Why? Passive rental income is subject to a flat 30 percent withholding tax (unless reduced by an applicable income tax treaty) applied to the gross income rather than the “net rent” (which is after expenses).
Thus, the real estate taxes, operating expenses, ground rent, repairs, interest and principal on any existing mortgages, and insurance premiums paid by the lessee on behalf of the foreign owner-lessor, must be included in gross income subject to the 30 percent withholding tax. (These laws are found is section 871, 872, 881 and section 882).
The gross income and withheld taxes must be reported on Form 1042-S, Foreign Persons U.S. Source Income Subject to Withholding to the IRS and the payee by March 15 of the following calendar year. The payor must also submit Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons, by March 15.
The Best Method for Income Taxes: If, on the other hand, the foreign investor is engaged in a U.S. trade or business such as the developing, managing and operating a major shopping center, the rental income will not be subject to withholding and will be taxed at ordinary progressive rates. Tax is paid on the net income (income less expenses).
Expenses such as mortgage interest, real property taxes, maintenance, repairs and depreciation (accelerated cost recovery) may then be deducted in determining net taxable income. The nonresident must make estimated tax payments for the tax due on the net rental income, if any.
This is very important: The only way these expenses can be deducted is if an income tax return Form 1040NR for nonresident alien individuals and Form 1120-F for foreign corporations is timely filed by the foreign investor. If file late, you will never be able to deduct your expenses.
With the Nevada trust you file the simple Form 1041 and the rules above do not apply. If your return is late, you are still allowed to deduct all of your expense. Also, you will not pay tax twice.
You do not have to read the next portion of this article if your tax structure is a Nevada trust. Why? Because these complex and unfair rules only apply to foreign corporations and to foreign individuals.
Foreign individuals and foreign corporations may elect to have their passive rental income taxed as if it were effectively connected with the U.S. trade or business.
Once such an election is made by attaching a declaration to a timely filed income tax return, there is no obligation to withhold even in a net-lease situation. Once made, the election may not be revoked without the consent of the IRS.
Unless the foreign investor has properly informed the property manager that the rental income is to be treated as “effectively connected income” by submitting to the property manager with a fully completed Internal Revenue Service Forms W-8ECI, Certificate of Foreign Person’s Claim for Exemption From Withholding on Income Effectively Connected With the Conduct of a Trade or Business in the United States (PDF), the property manager must withhold thirty percent (30 percent) of the gross rental receipts so as to avoid personal liability.
A fully completed Form W-8ECI must include a valid U.S. tax identification number for the foreign landlord (in other words, the rental agent must withhold and remit the 30 percent tax to the IRS until this requirement is satisfied).
A real property manager who collects rent on behalf of a foreign owner of real property is considered a withholding agent and is personally and primarily liable for any tax that must be withheld.
This is important: The liability of the withholding agent includes amounts that should have been paid plus interest, penalties, and where applicable, criminal sanctions. Property managers who do not comply with these rules will be held liable (either individually or through their company) for 30 percent of gross rents, plus penalties and interest.
Also, property managers need to report annual rents collected on behalf of foreign landlords on Forms 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons, and 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding. These are the equivalent of Forms 1096 and 1099-MISC but are for foreign owners.
To enforce the system of withholding, the Internal Revenue Code defines a “withholding agent” to be any person in whatever capacity (including lessees and managers of U.S. real property) having the control, receipt, custody, disposal or payment of income that is subject to withholding.
Thus, a real property manager who collects rent on behalf of a foreign owner of real property is clearly considered a withholding agent.
A withholding agent is personally and primarily liable for any tax that must be withheld. The liability of the withholding agent includes amounts that should have been paid plus interest, penalties and, where applicable, criminal sanctions. The statute of limitations does not start until a withholding return is filed by the withholding agent.
Once the return has been filed, the statute of limitations begins to run at the later of two dates: the date of actual filing of the correct return or April 15 of the calendar year in which the return should have been filed. The withholding agent will remain liable if he actually knows that the foreign owner’s statements are false. The withholding agent’s duty of inquiry seems to be a “reasonably prudent test,” measured by all facts and circumstances.
This is important: A nonresident who fails to submit a timely filed income tax return can never deduct the expenses against the rental income, causing the gross rents to be subject to the 30 percent tax.
The nonresident must to retroactively file at least six years of delinquent income tax returns, or all prior year tax returns, if they have held the rental property for less than six years. However, the ability to elect to treat the rental income as effectively connected with a U.S. trade or business will be lost after 16 months from the original due date of the return, and the remaining back years may be subject to tax under the gross income method.
Rental income from real property located in the United States and the gain from its sale will always be U.S. source income subject to tax in the United States regardless of the foreign investor’s status and regardless of whether the United States has an income treaty with the foreign investor’s home country.
For tax treatment of disposition of U.S. real property interest by a foreign corporation or foreign individual see FIRPTA Withholding. Once again, the FIRPTA rules do not apply to a Nevada trust.