The Foreign Investor And Unusually Low Tax Rates
By Richard S. Lehman, Esq.
Over the last 40 years, Richard S. Lehman has consistently guided clients on topics ranging from complex tax scenarios in real estate, business acquisitions and sales, securities offerings, tax contests, probate litigation and numerous other areas of commerce.
> Download this article as a .pdf
Advice For Large, Medium Size And The Smaller Foreign Investors
The boom in United States real estate caused by foreign investors is about to get bigger as a result of greatly reduced U.S. income taxes for nonresident aliens and foreign corporations.1
Because of the new Trump tax law, (“the Trump Tax Bill”) a foreign investor could receive a forty percent (40%) reduction in the U.S. income tax of his or her gains and income from their real estate investments. For those foreign investors who already were invested in U.S. real estate, their after tax returns could now be forty percent more valuable without raising a finger.2
Taxes on U.S. real estate income will now be lowered to tax rates of 21% for corporations, both foreign or domestic. With U.S. home inventories low, a world in turmoil and many countries around the world continuing to charge high tax rates, the flow of foreign investment seeking real estate in the U.S., caused by the Trump Tax Bill can only greatly increase the desires of the rest of the world to own a piece of America.
Furthermore, not only has the after tax income of real estate investments gone up for the foreign investor, the investment structure has become more simple.
This article will focus on
- alternative investment structures that will be helpful to the larger investors, the medium size investors and the smaller investors;
- the simplicity; and
- the extraordinary tools available to the foreign investor that can reduce the foreign investor’s tax burden to an even lower rate than those enjoyed by the American taxpayer.
The Trump Tax Bill not only reduces the tax rate of real estate profits, it decreased the amount of income that will be taxed annually in the early years by decreasing the time in which deductions could be taken in calculating taxable income.
Depreciation Deductions and Interest Deductions
- Depreciation Deductions
The tax deductions that allow the investors to reduce their current taxable income on real estate, such as depreciation has been accelerated so that certain components of the tangible personal property related to the building structure may be deducted at a more accelerated pace than under the prior law.
- Interest Expense, Deductions
Generally, under the new law, business interest expenses are limited only to 30% of the adjusted taxable income of the taxpayer as an annual deduction for business with annual gross receipts in excess of $25 Million.
The amount of business interest not allowed as a deduction for any taxable year may be carried forward indefinitely and utilized in future years, subject to this and other applicable interest deductibility limitations and restrictions.
Taxpayers investing in real property may elect to avoid this limitation on deductible interest.
A real property trade or business that elects to be excluded from the interest deductibility limitations will utilize an alternative depreciation system with respect to its depreciable real property. Under the alternative depreciation system, the recovery periods for nonresidential depreciable real property, residential depreciable real property and qualified improvements are 40 years, 30 years and 20 years, respectively.
Let’s take a look at what works best for the three types of investors
THE LARGE INVESTOR
The larger foreign investor’s investments may very often be more complicated either because of the size and value of the investment or because many separate investments may be made by the same investor.
For complex or multiple acquisitions, the suggested structure requires the foreign investor to establish a foreign corporation in a jurisdiction outside of the United States. The foreign corporation will be established as a “Holding Company”.
This “Holding Company” will establish several United States corporations as 100% owned subsidiaries of the Holding Company. Each United States corporate subsidiary may then invest directly and separately in one or more separate real estate transactions. The United States corporate subsidiary will be the only entity that pays a 21% tax. While this structure is complex, this structure permits the foreign investor the best of all worlds. This is the structure whereby the foreign investor establishes a foreign corporation that insures there are no U.S. estate taxes and also takes advantage of the lower income tax rates.
This structure permits the foreign investors to avoid the United States estate and gift taxes. The foreign investor will own only shares in a foreign corporation; the transfer of such shares are not subject to the United States estate and gift taxes.3 A foreign person owning shares in a foreign corporation owns nothing that is subject to jurisdiction for estate or gift tax purposes.
- The Sale of the United States Real Estate – Liquidation of the Corporate Entity.
Ultimately, in a successful real estate venture in the United States, there will be a certain amount of United States taxes that must be paid on the taxable profits from the sale of the venture. However, when the time for sales comes, the tax payment should not be onerous. The foreign (or U.S.) corporation that will own the U.S. real estate will be subject to a U.S. tax on 21% of the gain resulting from the sale.4
Most importantly, as a result of the technique of liquidating the U.S. corporation after it has paid the income taxes or capital gains taxes,
Under the United States tax laws, a nonresident alien individual or corporate shareholder that liquidates a U.S. or foreign corporation that owned real estate and sold it; and has paid all of the taxes due to the United States on gain from the sale will not be subject to any additional corporate or individual tax on the gain. A foreign real estate investor will not be subject to an individual tax on the gain from the sale of the United States corporate shares that result from the liquidation of the corporation.
- The U.S. Capital Gains Tax on Sale
Each of these United States corporations may be liquidated upon the sale of the United States real estate asset and there will be a single tax on the gain earned by the liquidating U.S. corporation at only 21%, with no additional taxes.
In addition to insuring a single U.S. income tax at lower rates and no estate and gift taxes, there will be no exposure whatsoever to the United States “branch tax” that will be discussed later in conjunction with the discussion regarding the Medium Size Investor.
Furthermore, in those instances where a United State subsidiary of a foreign corporation may hold assets that have not appreciated, the same tax free liquidation permitted to the foreign corporate Holding Company will be available. So long as a foreign corporate Holding Company (by virtue of liquidating its domestic subsidiary) is not receiving an appreciated asset, the liquidation will not result in taxation on the foreign corporation since there is no gain to be realized or recognized as a result of the domestic corporation’s liquidation.
THE MIDDLE SIZE INVESTOR
The Simplicity of the Investment Vehicle – The Income Tax and Estate Tax Savings
The Middle Size Investor may very well wish to structure his or her investment like the Larger Investor. That is the use of both a foreign corporate Holding company and a U.S. subsidiary corporation to own the U.S. real estate.5
Thankfully, there is another relatively simple solution to this tax. The individual Foreign Investor that owns a foreign corporation, which directly owns the real estate investment will pay no estate tax whatsoever upon his or her death. This is because ownership of shares in a foreign corporation is not direct ownership of the real estate asset. A nonresident alien investor that owns shares in a foreign corporation has no direct interest in the U.S. asset and consequently no exposure to the estate or gift tax.
There is, however, an unusual tax that is applied to a foreign corporation that directly owns U.S. real estate and does not distribute profits to its investors.
This tax is known as the “Branch Tax”.
However, by liquidating a foreign corporation, once all the real estate assets have either been sold or in the event the real estate assets are not subject to any gain, the Branch Tax can be avoided.6
THE SMALLER INVESTOR
Individual Ownership and Ownership by Limited Liability Companies
In the event the foreign investor is investing cash in a smaller piece of real estate that requires an investment of less than $250,000, there typically is no need for a more complicated structure than the limited liability company structure. This $250,000 number is arbitrary. There is a $60,000 exclusion for the estate tax and the balance of the estate taxes on the remaining amount is paid at a relatively low rate. These companies will be advantageous because the Trump Tax Law will permit these type of holdings to reduce their actual taxable income. Instead of charging a 21% tax rate that is available for corporations, the new tax bill will permit the limited liability company or the individual foreign investor a deduction equal to 20% of the amount of taxable income before calculating taxes. Thus, the income tax on U.S. taxable income for purposes of the U.S. income tax on real estate owned by an LLC is a tax on only 80% of the actual earnings. This deduction is subject to certain maximum amounts of income.
There may be a minimum benefit by individuals investing in United States real estate or through limited liability companies from an income tax standpoint, if the income earned is not significant. There may be the benefit of a lower tax rate and the 20% deduction from earnings. However, this benefit may be far outweighed by the use of the foreign corporate structure which does not expose a nonresident alien investor to United States estate taxes and gift taxes at all.
The long and the short of this is that with a little tax planning and use of all of the tax techniques to reduce U.S. taxes on U.S. real estate, the foreign investor should be able to earn ordinary annual income from the rental of U.S. real estate projects at a tax cost of approximately fifteen percent (15%) as a result of deductions; and a tax cost from the real estate upon sale that will be in the twenty-one percent (21%) range.
- The Portfolio Interest Deduction
Generally, the benefits of the new law are available to the American investor and the foreign real estate investor. However, there is another tax planning tool that has been in the law for a long time and that the American real estate investor does not have access to. It is, however, available under the right circumstances to the foreign investor. This is the tax planning tool known as the “Portfolio Interest Deduction.”
Not only will the foreign investor have the advantage of the new lower tax rate of the Trump Tax Bill and the new accelerated depreciation tax deductions. Subject to certain limitations, they will be able to finance their United States real estate with their own funds that may be invested in U.S. real estate in the form of a loan so long as the foreign investor owns, directly or indirectly, less than ten percent (10%) of the real estate project. Under the right circumstances, the foreign investor may enjoy “Tax Free Interest Income” that will be paid on loans that are made by the investor.
Under the right circumstances, foreign investors may receive tax-free interest from their real estate investment loans that will be deducted from the taxable income of the real estate investment, thereby reducing the taxable income from the real estate venture, overall, while increasing the income of the investor. This is because the interest income from a Portfolio loan, that is earned by the investor is not considered taxable income.
This technique will further reduce any U.S. taxes that must be paid on the real estate profits. Furthermore, these interest deductions from the current taxable income of the real estate are a cost that does not reduce the tax basis of the real estate like the deduction for depreciation. This is a completely tax free payment.
This is contrary to the deduction for depreciation that may be currently taken to offset current income, but will reduce the taxable value of the real estate asset so that on the sale of the asset, the cost basis will be reduced causing there to be larger taxable profits on the sale.
The Portfolio Interest loan and the tax deduction that accompanies its payment is not available unless the Portfolio loan meets several criteria; the most important of which is that the foreign lender and or his or her “immediate relatives” cannot together own ten percent (10%) or more of the real estate project that they have invested in.
In calculating whether an investor owns less than 10% of a particular investment, the tax law rules will require that certain relatives of the investor and certain corporations and partnerships that can indirectly increase the investor’s ownership in the real estate are excluded from ownership.
In addition to his restriction, the Portfolio Interest deduction will not be available under several other unique circumstances.
If available, the Portfolio loan deduction, coupled with the depreciation deduction and other techniques will often insure that there is a cash flow from the real estate investment but little or no taxable income whatsoever resulting from the project for a lengthy period of time.
1. Like American investors, prior to the Trump Tax Bill, the foreign investor paid a tax on real estate profits of thirty five percent (35%) for profits in excess of $75,000 when investing through a corporation; and foreign individual investors were forced to pay even larger individual income tax prior to the Tax Bill. The individual income tax rate could be as high as 39.6%.
2. This boom in real estate may lead to a scarcity of United States real estate in states that have a low state income tax due to the effect of the Trump Tax Bill.
U.S. citizens and tax residents in cities and states with high property taxes and high state and city income taxes starting in 2018 will not be able to deduct more than $10,000 in calculating their U.S. tax. In essence, there will be a “double tax” on state and city income tax and property taxes. This may start a mini migration of the wealthy to states like Florida, Texas, Nevada and other states with low city, state and property taxes.
3. United States Estate Taxes
Foreign Investors in the United States must focus not only on the United States income tax; they must also be aware of the United States Estate Tax, a tax that is imposed if a nonresident alien individual dies while owning United States real estate.
There is also a gift tax imposed on the nonresident alien individual who transfers U.S. real estate as a gift.
The U.S. charges an estate tax on a foreign investor who owns real estate in the U.S. directly or through a U.S. corporation, partnership and certain U.S. trusts. The gift tax will also be asserted on individuals in limited liability companies. This estate and/or gift tax is particularly onerous for foreign investors. While Americans may die, each owning eleven million dollars ($11,000,000) of assets without paying this tax, this is not the case for nonresident alien individuals who will be subject to the estate tax on real estate owned directly by the individual.
This estate tax imposed at death will tax the nonresident alien on any real estate that is individually owned or if the real estate is owned by a U.S. corporation that is owned directly by the foreign investor.
This is an expensive tax that increases in percentage as the value of the real estate increases. This tax can quickly expand to a tax of 40% on the value of all real estate valued at more than $60,000.
4. Dividends distributed to a foreign shareholder will be taxable to the extent of earnings and profits.
Care must be taken to prevent unnecessary cash distributions that fit this situation.
Gain on the sale of real estate will be calculated by subtracting from the ultimate sale price, the cost or the “basis” of the owner in the property being sold. This basis is calculated by subtracting the depreciation deductions claimed over the years from the cost of the assets increased by any improvements.
5. United States has numerous tax treaties around the world.
These tax treaties will continue to have their effect, though undoubtedly, there will need to be changes based upon the Trump Tax Bill. Investors from treaty countries will typically have an income tax treaty. However, there are very few estate tax treaties between the United States and foreign jurisdictions. The income tax treaties, at times, may produce even better tax results for the foreign investor, depending upon circumstances.
There are also several jurisdictions around the world that lend themselves and their corporate entities to this tax plan even though there is no tax treaty. Nonresident alien individuals may form a corporation in any one of the many countries. These countries typically will not tax corporations formed in that country unless the income being earned or the assets being held have a situs in that country of incorporation.
6. The Branch Tax – A Warning
Investment in United States real estate through a foreign corporation that does not use a U.S. subsidiary corporation can be problematic because there is a special tax known as the “Branch Tax”. Unknowingly Investors may be subject to this tax when they invest in the United States directly through a foreign corporation. However, there are multiple solutions to avoid the Branch Tax and few, if any, taxpayers in the real estate field have paid this additional tax. This tax is asserted when a foreign corporation accumulates undistributed cash that is not being used for reinvestment in United States assets.
A Branch Tax can often be eliminated by the appropriate capital structure of a foreign corporation that is conducting business in the United States. So long as accumulated cash earnings are paid in the form of interest on a loan to the foreign corporation, or a repayment of the principal of the loan; cash accumulated can be distributed. The payment of interest income to third party lenders or the actual investor will drain the cash profits and earnings of a foreign corporation and reduce cash in the foreign corporation that may be subject to the Branch Tax. However, care must be taken to insure that such loans meet a certain standard.