Tax Planning for Foreign Investors Acquiring Smaller ($500,000 and under) United States Real Estate Investments

Tax Planning for Foreign Investors Acquiring Smaller ($500,000 and under) United States Real Estate Investments

This is principally an article about tax planning for the non resident alien individual and foreign corporate investor that is planning for smaller size investments in United States real estate (“Foreign Investor”).¹

As a result of 35 years of Florida real estate experiences with foreign investors that purchase condominium units, smaller homes and many other forms of U.S. real estate investments, this article also has a few practical suggestions for the Foreign Investor.

The first suggestion is that today the Foreign Investor has the time to think about making your purchase and it need not be hurried. The U.S. real estate market is very depressed. At the same time the U.S. real estate market will not be depressed forever.

Next, use only a very limited amount of borrowed funds. Because the U.S. real estate market is heavily depressed, it is extremely difficult at this time and full of opportunities and traps. The first trap is to finance your real estate with debt that requires an immediate need for funds to finance real estate that may not be leased for a considerable time. You must be prepared for long term holding even if you are thinking short term.

Third, one must seek good professionals in the United States who are also knowledgeable about the needs of the foreign investor. You must have an independent tax lawyer, real estate lawyer, an accountant and several property appraisers to rely on.

Next, do not buy 2nd and 3rd class just because of its price. Buy first class. You can do this today in America and buy for great prices.

Tax planning for the foreign investor acquiring real estate with cash investments in the range of approximately $500,000 or less requires a look at both the U.S. income tax consequences and the U.S. estate and gift tax consequences.

Definitions of U.S. Taxes

The foreign investor will need to be concerned about three separate U.S. taxes. They are the income tax, the estate tax and the gift tax.²

There is a U.S. income tax that is applied on annual net income which starts at 15% and can be as high as 35% for both corporations and individuals. There is a tax on capital gains from the sale of assets which is only 15% to an individual taxpayer, but may be as high as 35% to a corporate taxpayer.

There is an estate tax when a non resident alien individual dies owning U.S. real estate or shares of certain types of entities that own U.S. real estate. The first $60,000 of value is excluded. Thereafter this estate tax can be as high as 45% of the equity value of the real estate.

There is also a gift tax if a non resident alien individual gifts U.S. real estate to a third party. This can be as high as the estate tax, depending upon the value of the gift.

With all of this in mind we can review the various options of U.S. real estate ownership.

1. Individual Ownership of U.S. Real Estate
   
   An individual foreign investor may own U.S. real estate in his or her own individual name. This represents the simplest form of ownership with the least amount of paperwork involved. If it is rented out the individual owner will have to file a U.S. income tax return reporting the U.S. income.
   
   This form of ownership is only chosen by a small percentage of foreign investors. This is for at least two reasons. The first reason is liability. The owner of U.S. real estate will be personally liable for any damages that result from that real estate. While often insurance is more than sufficient to cover such claims, most investors do not want to expose themselves personally to individual liability.
   
   Furthermore, investors from many countries are fearful of revealing their wealth for security reasons. An investor’s individual name as an owner of real estate will appear in the public records where that real estate is located.
   
   This form of ownership does however provide the best income tax benefits. The individual investor will pay tax only on the investor’s U.S. income and will probably only pay a tax from operations in a relatively small tax bracket. The tax on the profit from the gain from the sale of the real estate will be only 15%.
   
   If one does choose to own U.S. real state individually, the foreign individual investor will be subject to an estate tax in the event that investor was to die owning the U.S. real estate.
   
2. Limited Liability Company Ownership
   
   Foreign investors may use an entity acceptable in every state in the U.S. known as a limited liability company. This type of company is treated as if it does not exist for U.S. tax purposes and therefore the tax consequences of owning a United States limited liability company that owns U.S. real estate is similar to the tax consequences described for the individual foreign investor above.
   
   However, the big difference is that the limited liability company, as the name says, provides the investor with limited personal liability for losses related to the real estate investment.
   
   What this means is that the individual foreign investor’s personal assets are not exposed to the liabilities of the investment. This is often the best vehicle for a smaller investor in U.S. real estate. The limited liability company provides for the best income tax treatment and limited liability for the investor’s wealth.
   
3. The Foreign Corporation
   
   As a general rule, it is not a good idea for a foreign investor to use a foreign corporation that will then directly invest in U.S. real estate. This is because foreign corporations that invest in U.S. real estate can be subject not only to U.S. corporate income taxes but might also be subject to a branch tax equal to 30% of the foreign corporate investors’ undistributed U.S. profits.
   
   A foreign corporation is, however, very often the investment vehicle of choice for a foreign investor that is investing significant amounts of money in U.S. real estate, such as $1 Million or more. This is because estate tax becomes a major potential liability for substantial fortunes invested in U.S. real estate and U.S. estate taxes may be completely avoided if the individual foreign investor owns a foreign corporation that may in turn own the U.S. real estate.
   
   There are no estate taxes in this situation because when the foreign investor dies, the foreign investor has only transferred to his or her heirs’ shares in the foreign corporation and there is no direct interest in U.S. real estate.
   
4. U.S. Domestic Corporate Ownership
   
   The use of a United States corporation by an individual foreign investor who invests in the United States real estate is very limited by itself. That is because shares of stock in a United States corporation that owns U.S. real estate are also included in the foreign investor’s estate, if the foreign investor dies owning those shares. Thus ownership of a U.S. corporation to own U.S. real estate does not solve any U.S. estate tax problems. It does, however, create an extra tax burden for the foreign investor in United States real estate. That is because there will be an income tax on a United States corporation that earns the income as a tax on the gain for the sale of the real estate asset. Unlike the tax on an individual, which is limited to 15%, this tax can be as high as 35% when earned by a United States corporation. This can also lead to double taxation when dividends are paid to a foreign investor from the United States corporation.
   
   There are however, two situations in which investment in United States real estate by the ownership of a United States corporation does make sense. They are as follows:
   
   Gift of Shares
   First, if f the foreign investor intends to ultimately make a gift of his shares in a United States company that owns U.S. real estate to third parties, such as family members, etc., there will be no U.S. gift tax asserted on the gift of those shares. There would have been a U.S. gift tax had the real estate been given directly. Thus, the gift tax may be avoided if shares in a United States corporation are transferred prior to the foreign investor’s death. By gifting the shares the original owner will avoid the estate tax.
   
5. Foreign Corporation and U.S. Corporation.
   
   Another extremely important use of a United States corporation is when it is part of a chain of corporations that ultimately owns the U.S. real estate. For example, if the foreign investor were to establish a foreign corporation that became the 100% owner of a United States corporation that owned United States real estate, the foreign investor will be able to avoid any United States estate tax completely since nothing in the U.S. is transferred in the event of the death of the foreign investor.
   
   This method of ownership is often recommended for large investments in United States real estate where the estate tax can become a major issue. It does however involve potential double taxation and other traps and tax benefits that must be individually applied.

Term Life Insurance

There is another alternative to having the best of both worlds, which is to pay United States income taxes as an individual investor or as a limited liability company while not being concerned with the effect of United States estate taxes in the event of a premature death. That alternative is for the foreign investor to acquire sufficient “term life insurance” that pays only a death benefit for the contemplated life of the investment.

As an example, assume an investor invests one-half of One Million Dollars in United States real estate which doubles in value and is worth One Million Dollars upon the foreign investor’s death. Assume a United States estate tax of $350,000 on the value of United States real estate. The value of a $350,000 life insurance policy for say a ten year period only of a relatively young man or woman will not be at all prohibitive from a cost standpoint.³

Tax attorney Richard S. Lehman will answer any questions posted re: Tax planning for the non resident alien individual and foreign corporate investor that is planning investments in United States real estate.

Footnotes:

1. See article “Tax Planning for Foreign Investors Acquiring Larger ($1,000,000 and over) United States Real Estate Investments” for a companion article on Tax Planning for Foreign Investors Acquiring Larger United States Real Estate Investments.
   
2. In addition, several of the individual states in the U.S. charge their own separate income tax on income earned in that state.
   
3. Another estate planning tool that allows a non resident alien investor to invest in United States real estate without incurring U.S. estate tax is the use of a Non Grantor Trust. This is a devise whereby the investor purchases the U.S. real estate using a foreign trust and foreign beneficiaries, such as family members, so that trust will ultimately benefit others. This vehicle is specifically not being discussed in this article since it does involve the investor’s alienation of the property to a trust that is extremely restrictive of any powers that the investor can have over the real estate owned by the Non Grantor Trust.

The Tax Consequences of the “Claw Backs” In Madoff and Other Ponzi Schemes

The headlines are now informing Madoff and other Ponzi Scheme victims about the most recent piece of bad news. That is the word “claw back”. In short, investors who received cash investment returns from a Ponzi Scheme in excess of the actual invested funds are being forced to pay that excess cash back. HOWEVER, THESE “CLAW BACK” PAYMENTS WILL BE TAX DEDUCTIBLE.

Those victims that are hit by a “claw back” may or may not have a choice about when they can deduct any moneys they repay as a “claw back”. Whether they have this choice could mean a big difference in the amount of money in tax refunds that will be payable to the “Claw Back” victim.

As an example, assume the following:

Mr. Smith invests $500,000 in 2005 and earns and pays U.S. income taxes on $125,000 in 2005, $125,000 in 2006 and $125,000 in 2007. In 2008 Mr. Smith withdraws all $875,000 from his Ponzi Scheme account and closed the account. Assume Smith paid in the 35% tax bracket on his $375,000 in earnings for total taxes paid of $131,250. Assume Mr. Jones made the same investment but never withdrew any funds. Jones loses $875,000. Assume that the $375,000 of “earnings” is “clawed back” from Mr. Smith but not paid back by Mr. Smith until 2011 when all the litigation was settled.

The law is clear that moneys clawed back from Mr. Smith, for which he had paid taxes on, would be deductible by Mr. Smith in the year 2011 when they were paid back. But what if Mr. Smith had very little income for 2008 and 2009 and 2010 and 2011 and used and carried back his $375,000 in losses in those four years, where would he be? The value of Mr. Smith’s tax refunds for the deducted repaid amounts in those years might be based on tax brackets that average 18%. In that case Mr. Smith would receive a tax refund of $67,500 even though Mr. Smith has paid taxes of $131,250 in prior years on the claw back income.

The Choice

There is a solution that will provide for a full return of all of the taxes paid by Mr. Smith of $131,250 plus interest. However, that solution may not be available to any Taxpayers that have filed previously and received tax refunds while making use of the “Safe Harbor” rules published by the Internal Revenue Service in Rev. Proc. 2009-20. The “price” of enjoying the Safe Harbor rules was to waive the Taxpayer’s rights to make use of a particular Code Section in the Internal Revenue Service that provides for this tax fairness.

Code Section 1341 of the Internal Revenue Code provides that under certain circumstances Taxpayers who have received funds that they have reported as taxable income that must be paid back at a future time will have a choice. They can deduct the funds that must be paid back in the year in which the payment is actually made, or go back to the years that the income that is being repaid was reported. This refund is determined by calculating the actual year of income and excluding the repaid amount. It eliminates the repaid income from the Taxpayers’ taxable income for that year, thus recalculating the amount of taxes due and providing for a refund of excess taxes paid on the money returned from prior years.

This Code Section is very valuable in the event a Ponzi Scheme victim must pay back funds in a year in which the victim is in a very low tax bracket and those same funds had been reported in a prior year in a very high tax bracket, like Mr. Smith.

Those Taxpayers who did not rely on Rev. Proc. 2009-20 should be able to rely on Code Section 1341 to increase the amount of their refund, if appropriate.

Furthermore, refunds paid pursuant to Code Section 1341 will carry interest from the prior year’s date for the amount of the overpayment. This will be an extremely useful tool to investors suffering from claw backs in a Ponzi Scheme.

The use of Code Section 1341 can increase tax refunds and interest payments by 100% and more.

LEHMAN TAX LAW
2600 N. Military Trail, Suite 270
Boca Raton, FL 33431
(561) 368-1113
Fax: (561) 998-9557