Entity Structure and Tax Strategies for Foreign Investors Into US Real Estate

Mark Perlberg:
Okay, in three, two, one. All right. Welcome everybody. Thanks for coming in. Some of you may be tuning into the recorded version of this. Some of you guys are investors and some of you guys are going to be CPAs, interested in the topic of structuring and tax strategies for foreign investors into US real estate. Now there are tons of opportunities here and I want you guys to think about this, especially you syndicators out there and you people looking for foreign capital and passive investors. The reason why some of these foreign investors may be interested in investing in you and teaming up with you is because the US offers a stable economy. We have a relatively stable government. We have our dollar bill, that dollar bill valuation of our real estate. We have financial systems in place for financing and acquiring debt in a relatively stable environment as well.
And then the demographics. We have many thriving and developing metropolises. There are tax incentives to encourage real estate investors and we are a nation of people who are all descendant of other countries, so we likely have connections through either you or your peers of people in other countries looking for places to diversify their investments and invest potentially in US real estate. But there’s lots and lots of other things to consider before you do it. Now for those of you don’t real know me yet, I’m Mark Perlberg, I’m a CPA. I specialize in real estate tax strategy, and our objective throughout our relationship is to think about things beforehand, and to plan in advance as we navigate through the tax code, instead of waiting until the last second and realizing we missed out on any opportunities. We want to think about being compliant, we want to consider tax treaties.
We also want to consider all these sorts of withholding requirements that we will get into. There are state taxes, and there are also special treatments of foreign investors when it comes to the disposition of the real estate. Lots of things to consider, and when we consider these things, we want to consider the proper entity structure and how we can maintain compliance. All these variables to consider and all the opportunities. I have the help of a fantastic resource who’s been helping me out with some of my clients, and that person is Patrick McCormick. Patrick, can you introduce yourself. And Patrick’s going to then show us some slides and talk us through some of the considerations you can have with either your clients or you yourself when you are bringing on foreign investors.
Patrick McCormick:
Totally my pleasure, Mark, to be here. Thank you so much for the invitation to take part today. Thank you so much for having me, and thank you so much to the audience for their participation in today’s program as well. Yeah, Mark, it’s still telling me I can’t share my screen.
Mark Perlberg:
Oh wait, sorry about that.
Patrick McCormick:
Take your time. No rush.
Mark Perlberg:
Who can start sharing Zoom? Here we go. Let’s see how this works.
Patrick McCormick:
Perfect. We’re all good now on my end. All good. And here we go. Terrific. The ins and outs of FIRPTA, is what I’ve titled today’s program, just so the audience is aware. So everybody has a bit of context of my entire practice, I’m a United States based attorney. The entirety of my practice is multinational tax, international tax considerations. Whether it’s working with, what we’ll be talking about today, non-residents with United States activities. We term those inbound transactions, inbound activities or outbound activities. The converse United States taxpayers with activities, transactions, income sourced to other jurisdictions. What we’re concentrating on today are the FIRPTA provisions, more generally the considerations, tax considerations, American tax considerations, to be even more specific. They come into play when you have a non-resident who is investing in United States sitused real property. To what Mark mentioned before, there are tax consequences, and there are very unique tax consequences that come into play on the disposition of a United States real property interest. Here’s a bit of background on the American side.
One of the really majorly appealing options for non-residents looking to invest in a jurisdiction is actually the United States, and the reason for that in part is due to the United States’s exemption of capital gains tax for non-residents. If you look at it from a globalized perspective, non-residents with United States activities generally are exempt from capital gains tax on US sourced income to the extent that income does not originate from a United States trade or business that’s established by the non-resident. There are special rules though that come into play under section 897 of the code, and we’ll go into this in detail, but under section 897 of the code, there are special rules that come into play to automatically associate the sale of a US real property interest with a US trade or business, thereby making that disposition subject to United States Tax even though those dispositions most often would not be taxable on the American side.
So let’s get started with some background considerations, discussing generally in more detail how non-residents are taxed from an American perspective. Default statutory US rules non-residents are taxable on income effectively connected with their United States trade or business or what’s called their FDAP income, fixed or determinable, annual or periodic income. We very often, and it’s usually absolutely critical from an inbound representation, when you’re working with inbound clients, always critical to evaluate whether the non-resident, excuse me, resides in a treaty party jurisdiction with the United States. That is a country that has a tax treaty in place with the United States. Because if you’re looking at, or say in any situation, where you have individual who resides in country A and has income that sourced to country B, country B’s taxation can be altered dramatically by an income tax treaty being in existence between A and B. If that’s the case, the default rules for taxation are modified fairly substantially from a United States perspective. Those modifications are very relevant from a foreign real estate perspective.
However, they’re less relevant than they are with other types of investments on the American side. And the reason for that, and it’s intertwined with the reason for the gains associated with the disposition of US real property being taxable in a special category by the United States. Really it comes down to countries wanting to protect their ability to tax income associated with an asset that, by its very definition, has strong, strong connections to that country. Say if you’re looking at stock, say you have a multinational enterprise that is based in the United States and it pays out a dividend to non-resident investors, that dividend is going to be US sourced income. However, you don’t see the huge intertwining of the rules, the special rules coming into play. The income tax treaty provisions can be much more forgiving in that context where you have these entities that, yeah, it’s a corporation that’s established within the United States, but it can generate income multi nationally.
It can, by its very definition, have multinational activities. If you have a real property that’s located within the United States, then at its very core that all of the income associated with the property has a very strong connection to the United States. As a result, and this isn’t unique just to the United States, you see it across jurisdictions, there’s a real prioritization, from a tax perspective, to make sure that a source jurisdiction can capture the income associated with a real property interest located within its country. The trader business standard under default provisions, this is outside the context of real estate. If you’re just looking at, say we have non-resident individual A and she is a resident of the United Kingdom, she’s anticipating exploring the United States market to see whether there are any opportune investments for her. First thing to consider is whether her activities rise to the level of a United States trade or business within the United States.
If that occurs, she generates, what’s called effectively, connected income, which means her income tax base from a United States perspective is expanded fairly significantly. Trad or business, as I mentioned here on the slide, undefined in the code/regulations case law really dictates. What’s a trader business from a United States perspective? You’re looking at profit-oriented activities which are regular, substantial and continuous, being properly classified as a United States trade or business. A couple things to consider in this context. It’s really macro level to stress, it’s a very low threshold. Activities of an agent can be imputed to a principle. Foreign corporations have been held to have a US trader business just by virtue of having sales through a single United States agent. Even when the agent has no responsibility or has assumed rather, I apologize, full responsibility for the sales. So there’s very minimal requirements associated with the non-resident trade or business in the United States.
FDAP income conversely is a bit of a catchall category for US sourced income that is not categorized as effectively connected income. Bit of a catch-all for ordinary income items that are US sourced that are not subject otherwise to US tax interest, dividends of rents, royalties, annuities are all covered under FDAP income. There is interplay between effectively connected income and FDAP income. Basically if a income item fits under both categories, which is very often going to be the case for ECI income, because ECI, if it’s ordinary income, it’s very likely to fit under the FDAP category as well. When an income item fits under both categories, then the ECI rules are the rules that dictate how the income is going to be taxed. That becomes beneficial on the American side, because what you’re really looking at from a functional perspective in terms of how the income is taxed effectively connected income is taxed on a net basis at graduated rates, very similar to how a United States based taxpayer is subject to tax deductions credits fully available.
FDAP income, conversely, is subject to a flat 30% rate of tax under statutory provisions that can be reduced under income tax treaties. Taxes collected through withholding by payors. Really critical to stress for FDAP income, deductions, credits whole nine yards, you don’t get to take any of them to offset your FDAP income. It therefore creates a great preference, in most cases, and particularly with real estate where you’re producing significant expenses in order to generate income. It can create a significant preference for income to be categorized as effectively connected, and we’ll talk about, momentarily, the considerations that come into play there, particular to real estate investments.
Here’s some more information on how tax occurs and juxtaposing the two categories. Like I mentioned before, when you’re looking at income tax treaties, I’ll say as well, when you’re looking at income tax treaties generally, certainly it’s not the bulk of what we want to cover today by any means, but income tax treaties, generally from an ECI perspective, they modify the effectively connected income with the United States trader business category, and it shifts to whether business profits or attributable to a United States permanent establishment.
It’s a heightened standard, however any real property income is going to meet. Either it’s going to be whether it’s under a treaty or under statutory provisions of income associated with US real property that’s owned by a non-resident is going to pretty much universally be subject to US tax. When you look at FDAP income, the change in tax from an American perspective is primarily related to the rate of taxation. FDAP income, from a statutory perspective, is subject to a flat 30% rate of tax.
Under treaty provisions you can see rates of reduced rates of tax anywhere between 0% to 15% depending on the type of income item. I’m actually in the process, I was just talking about it with Mark before today’s program, of writing a full treatise on non-resident taxation, is particularly associated with sourcing of income, which is really where everything goes from a non-resident perspective. Anytime questions come up on that end, by all means, feel free to let me know. Here’s some more juxtaposition of the ECI and FDAP categories. I think Mark has something to add so I’ll defer to him momentarily and just leave this slide up.
Mark Perlberg:
And so when we talk about FDAP and the 30% withholding, I believe you said that this is gross, correct, as opposed to net income?
Patrick McCormick:
Absolutely. 100%.
Mark Perlberg:
So this is an opportunity and that’s why we always say it’s so important to plan in advance, right? Because one of the benefits of real estate is because when we have depreciation, we can accelerate depreciation, we likely will not have any tax liabilities for my investors when we consider all the write-offs that can offset those revenues. But if you have FDAP income and we haven’t done the proper planning in place, you don’t have the right professionals to support you in the structure and we wind up with FDAP income, now we have this huge withholding, it’s going to take a big chunk of your cash that you have to set aside for the withholding tax and pretty much, it’s going to restrict your ability to have that liquidity and working capital for your investments.
Patrick McCormick:
Absolutely, and that’s a fantastic point too and brilliant. We’ll get into it in more detail. Really, there’s a special, to mention now, there is a special election that’s available in the code to make sure one of the real threshold questions that comes into play, from an ECI versus FDAP perspective. Why I wanted to spend a decent amount of time on it at the outset is based on the slide here in regards to non-residents investing in real property, owning real property in the United States that’s generating current income. One of the threshold considerations that always comes into play when a non-resident is generating current income from a real property investment in the United States is look under US standards. Does the non-residents level of involvement with the real property rise to a level sufficient for it to be treated as a US trade or business, be able to be treated as effectively connected income, be able to offset deductions, credits, expenses. As a result, there’s an election available under section 871D, for individual, section 882D.
For corporations to automatically treat income generated by American real property as effectively connected income. You have to make the election on a timely filed return, or on a return within the statute of limitations for the refund. Property must be income producing for the election to be made. You can’t have a property where say it’s an investment property, now you’re incurring expenses but not generating income. You’re not able to make the election in that case. There are specific items excluded from this election as well. They’re usually the ancillary income items that are associated with real estate investment, one of the ones I mentioned here, dividends paid by a corporation invested in American real property. At the end of today’s program when we discuss strategies for ownership of American real properties, that becomes a very pertinent consideration, and we’ll go back to that.
Here’s some more information on how you make the election itself. 871-10(d) (1)(ii) of the regulations has the information that’s needed on this statement that you include with the tax return where you make the election. And it’s really giving the IRS a full picture of any improvements of the real situation with the property, so that an appropriate tax base can be determined for the property itself. Now looking at the provisions that come into play on disposition of a US real property interest. So now we’re not looking at current income, we’re looking at what occurs when a US real property is sold by a non-resident. There are special provisions in the US code, the US Foreign Investment in Real Property Tax Act of 1980, I believe, is when the FIRPTA provisions or first enacted, if memory serves me correctly, it’s codified in section 897 of the code.
The section 897 dictates that gain from disposition of the United States real property interest by a foreign person is automatically classified as effectively connected income and is automatically subject to tax as a result. Let’s go back juxtaposing the two categories. When you’re looking at FDAP income like we talked about before, it’s a catchall for US sourced income items aside from capital gains. If you sell a US real property interest, that’s going to be generating capital gains income that wouldn’t be captured by the FDAP category. The other main category to capture taxable income for a nonresident, like we talked about previously, is the ECI category. The non-residents activities in mere passive investments, say in a US real property interest, say it’s not income producing, say they just own a passive US interest as a family vacation home in the United States, those activities aren’t profit oriented.
They’re not regular, substantial and continuous within the United States. As a result… And here’s my cat saying hello to us again. As a result of that, you will not have a US trad or business under statutory standards. What section 897 does, and again it goes back to the idea of the US prioritization, in any countries’ prioritization of capturing income tax with real property within its borders, section 897 gets enacted to make sure that even irrespective of the usual capital gain exclusion that applies to non ECI, non effectively connected, non-business items of a non-resident US real property that sold by a non-resident will automatically be classified as ECI, and will automatically, as a result, be subject to tax. Now the fact that it’s classified as ECI can be beneficial, in certain circumstances, like Mark referenced in the ordinary income category. Say you purchase a US real property for a million dollars, you sell it for a million two, you can offset the 1.2 million in gain with the one million purchase price.
You’re not looking at it, say, from an FDAP perspective where you have a flat 30% rate of tax, you’re taxed at graduated rates. You can be subject, if you purchased for a million dollars and you sell for $800,000, you’re not going to be subject ultimately to any tax on the American side. There can be withholding requirements which come into play here though, like I mentioned here on this slide, and we will go into in detail momentarily. It’s really when you look at the two tax mechanisms from an American perspective, those being the ECI and FDAP tax mechanisms, ECI, very similar to how US taxpayers are taxed graduated system voluntary tax returns. The FDAP system being a gross-based system with withholding as the mechanism for tax collection. The FIRPTA provisions are a really interesting combination of the two insofar as you’re taxed at ordinary income rate… Or no, I apologize completely, you’re taxed automatically on the gain at capital gains rates subject to deductions, to credits, to offsets for basis, whole nine yards.
However, one of the ways that tax, and by default, an automatic tax collection method is imposed under FIRPTA, via withholding, and that withholding occurs by the transferee of a US real property interest. The withholding occurs, let me see if there’s anything that I want to, this just really covers who, or actually let me trace it piece by piece, actually. Section 897 generally is applicable to any type of non-resident, non-resident alien individuals, non-resident corporations, foreign partners of a partnership can be liable for their pro rata share of US real property. Interest gain, foreign estates and trust are also subject to FIRPTA. They’re treated as non-residents for income tax purposes.
One special provision that I note here in regards to… Let’s look at flow through entities on the American side. A flow through entity being a disregarded entity, a partnership, some type of non-corporate entity where all of the income tax attributes automatically flow through to the underlying stakeholders. If you have a non-resident of the United States, non-resident individual, let’s say who establishes a disregarded entity in the United States, she’s the 100% owner. She’s the 100% owner of that disregarded entity. That entity, if it holds a US real property interest and sells the US real property interest, that entity will be subject to the FIRPTA provisions including the FIRPTA withholding that we’ll discuss momentarily.
Mark Perlberg:
And just to throw something in there. When we think about capital gains, what can we do to mitigate or eliminate capital gains? We still have the 1031 exchange, foreigners can do the 1031 exchange. If you do it though, I’m pretty sure… We will double check. You will have to do a 1031 exchange for another US source property. Now let’s say you don’t do a 1031 exchange. There are complications, especially with syndications, you may want to do a drop in swap or what’s called a tendency in common to allow it to exchange your interest in one piece of real estate for another to roll it over. It can get a little bit tricky there. So other things that we can do to mitigate the tax liabilities when we do these transactions, and if we sell, if you are continually investing and you buy another real estate, invest in other real estate, sorry, fumbling on my words. Cost segregation, fantastic way to also create write-offs to offset any liabilities created from capital gains. Lots of planning that we can do to mitigate the tax liabilities from dispositions.
Patrick McCormick:
Absolutely fantastic. Now getting into what does or does not constitute a US real property interest. There’s really two prongs to it. First is very straightforward of real property in the United States is a real property interest is a United States real property interest in the FIRPTA rules are applicable, excuse me, to any disposition of a United States real property interest. The FIRPTA rules also apply to what is called a United States real property holding corporation. That’s a United States, it’s a domestic corporation where more than 50% of the corporation’s assets are United States real property interest.
Any US shareholder selling shares, disposing of shares, of a corporation must establish that the corporation was at no time a US real property holding corporation during the shorter of… And there’s my cat, making some slide that changes. She wants to move on with the next slide. I’m not ready yet. Any US shareholder who’s selling a stake in a corporation has to establish that it is not a US real property holding corporation during the shorter of the taxpayers holding period in the interest or the five-year period ending on the date the taxpayer disposes of the interest.
If it is, then it can be the sale of the property, can it be subject to FIRPTA of the US real property interest if it is so classified, US real Property Holding Corporation. Important to mention, there are a number of ways to basically cleanse an entity of US real property holding corporation status prior to a sale to make sure that you’re not subject to FIRPTA when you dispose of the stock. If a US real property holding corporation sells all property in a taxable transaction, ie is actually subject to tax, US real property interest status of the corporation will cease at that point. Because it’s really the United States goal is to make sure they’re capturing all taxable income from a United States perspective. Once they’ve done that, there’s no need to maintain the status as a US real property holding corporation. So that status does seize disposition.
Some background here on what a disposition is for FIRPTA purposes. Any transfer that would constitute a disposition for any purpose of the internal revenue code reaches beyond just mere sales and exchanges. Any disposition, though, of a foreign corporation is not subject to FIRPTA even if it’s holding more than 50% US real estate. What I mean by that, let’s give an example so it’s not to confuse the audience. Let’s say we have non-resident individual A, B, C and D. They own 100% of US corporation E. US corporation E owns entirely real property that’s located in the United States.
If A, B, C and D dispose of their shares of the US corporation, that US corporation absolutely can, and they will be classified as a US real property holding corporation based on the USRPHC definition. If we change the example ever so slightly and make it so the corporation E is a foreign corporation, then that sale would not be subject to FIRPTA, even if foreign corporation E holds 100% US real estate. A holding corporation can only be a US real property interest if it’s a United States corporation. Any foreign corporation will not be classified as a US real property holding corporation.
To mention here as well, in regards to real estate, if you have, always an important consideration, any time a non-resident sells a home that she’s used as a personal resident residence, let’s say you have US green card holder lives in the US from 2015 to 2020, 2021, she gives up her green card. 2022 she sells her old US home. That is subject to those section 121 exclusion of up to $250,000 of gain for a primary residence of $500,000 for gain, if you are married filing jointly, although most often non-residents and anyone who’s filing as a non-resident cannot file married filing jointly. So you’re usually, from a non-resident perspective, looking at the $2,250,000 exclusion, but that absolutely is available for non-residents. Non-residents, I also note here they’re not subject to FIRPTA on disposition of a partnership interest directly, but section 864(c)(8) can subject them to effectively connected income tax on the disposition of that interest in basically a back doorway.
864(c)(8) is a new code provision under the 2017 tax cut and jobs act, so it became effective in 2018. It’s codification of the services position regarding a non-resident disposing of a US partnership interest or any partnership interest, actually. Basically what you do is you keep the general flow through concept and under 864(c)(8) you look at the extent any partnership was engaged in a US trade or business, and then, essentially, and it gets a bit more complex, as you might anticipate, but essentially what you look at is you make that determination. The pro rata or the extent to which the non-resident is treated as engaged in a US trade or business through the partnership activities and then say if the partnership, 70% of its activities constitute a US trade or business, then 70% of the disposition price, the disposition gain, will be taxable by the United States.
Now in terms of the withholding obligations that come up under FIRPTA, and these are the provisions that are most often associated with FIRPTA generally, Section 1445 A, requires the transfer of a United States real property interest to deduct and withhold a tax equal to 15% of the amount realized on the disposition unless there is an applicable exception. The amount realized for these purposes is the sum of the cash paid to the transfer, or the fair market value, or other value of property transfer to the transfer, and the outstanding amount of any liability assumed by the transfer, or you aggregate all three of those numbers and the transferee then has to withhold at 15% of that number. So let’s say for example, let’s go back to the example I gave before, a million dollar purchase price on a property.
1.2 million is the sales price. The transferee has an automatic and… Mark, just let meme know if my math here is wrong. It would be a 180 assuming that there is no liability on the property, the withholding amount is $180,000 at a 1.2 million purchase price. That’s almost the entirety of the non-residents… Or it could actually be, depending on improvements, things like that, it could significantly exceed actually the entirety of the non-residents tax liability to the United States. Let’s change the example. Let’s go to the second example that I gave previously. One million purchase price, $800,000 disposition price. So you’re selling it at a loss. At an $800,000 disposition price, there is still going to be a withholding of $120,000 on that sale even though the non-resident ultimately is not subject to tax from an American perspective. So it’s a hugely, hugely negative result to be in that situation where you’re selling a property at a loss, and under statutory US provisions you’re also subject to significant withholding on that sale.
The primary, there’s a multitude, or there’s a number, I would say, of exceptions that can apply to FIRPTA withholding the primary exception. The one that I personally most often utilize and the best one I certainly think that’s out there is in regards to what is called a withholding certificate. Basically what you do here, Revenue Procedure 2000-35 outlines the requirements, outlines the protocol, that you use for a withholding certificate. You basically reach an agreement with the Internal Revenue Service prior to the sale occurring. You’ll want to have an agreement in place anywhere from 30 to 90 days, I would say, before the sale to ensure that hey, if you’re going to be subject to withholding on a sale that’s greater than what your ultimate tax liability associated with that sale would be, then it allows the transferee to withhold at a reduced rate, or potentially if there’s ultimately going to be no liability, to not withhold at all.
Basically what you’re looking at under section 1445(a) is the transferee has a requirement to withhold then transmit the withheld amounts to the Internal Revenue Service via form 8288, is the form that you utilize, the 8288 forms. You utilize that and I believe the 8288-A also gets included with a FIRPTA filing with the withheld amount, once that gets transmitted. When you’re looking at a transmittal of withheld funds that exceeds the amount of taxable gain that the taxpayer would have, what the taxpayers are required to do is go in the year afterwards, file a tax return and claim a refund for the over withheld amount. Obviously it’s much, much more appealing to not have to go through those hoops, to not have the delay, from a time, value or money perspective, of having the Internal Revenue Service hold your funds for, can often be, over a year without you having access to those funds, with you having to claim a refund on over withheld amounts.
Very often your best route is to get the withholding certificate in place, just because there can also be headaches associated with filing an actual tax return itself as well. Mention now on my front of estate tax perspective because it’s another huge consideration that comes into play for non-residents making investments in US real property or transfer tax considerations. A non-resident is subject to a state tax by the United States on any property whether tangible or intangible sitused within the United States. You look at sitused rules to determine where a property is going to be treated as being located. These determinations can get complex with certain assets, say like stock in a corporation. Intangible assets can be complex. Real property is rarely, if ever, complex as to where its sitused. Real property is sitused true in accordance to where the assets are physically located. Say you have a property in Miami, that’s a US real property for transfer tax purposes.
If you have a property in Mexico City that’s not a US real property, you’re looking at properties within the 50 United States or the District of Columbia, are subject to United States transfer tax. The reason this gets a ton of attention, in regards to non-resident transfer tax planning generally, I mean gets a ton of attention is given the significant disparities in exemption amounts available to United States taxpayers and to non-residents. United States taxpayers currently receive a lifetime exclusion of, I believe, it’s $11.58 million, so it’s about 23.2, apologies, for a married couple gets during their lifetime. For the vast majority of folks, that’s going to allow them to pass their estates entirely free of tax. There’s been, with the 2020 election coming, on the American side, there seems to be a good amount of momentum to lowering that exemption back down even to $3.5 million moving forward. However, currently it’s a huge, huge exemption that’s out there for American individual taxpayers.
Non-resident individuals receive a comparatively minuscule exclusion. Their exclusion is merely $60,000 on the estate tax side. I break down the numbers, how they work from a tax perspective here. You get taxed essentially $345,800 on your first million, 60,000, after accounting for the exclusion of US sitused assets. Then you’re taxed at a flat 40% rate above that number. Say you have five million in US assets at the time of your death, if you’re holding them in your individual name, if you have individual ownership of those assets, you’re creating close to a $2 million transfer tax liability from an American perspective. Gift tax. Non-residents transferring a United States real property interest will also be subject to gift tax if that real property interest is actual real property located in the United States. Gift tax, the big change from the state tax perspective is the scope of tax. Gift tax does not target intangible assets.
It only targets physical assets located within the United States. Either real property or tangible personal property, say, cash, hard currency sitused in the United States is subject to gift tax. So if you have a US real property located in the United States, if you make a gratuitous lifetime transfer of that property to a child, to any other party, that transfer is also subject to gift tax. The way we get around that, and here’s more. I’ll go to the slide momentarily, actually. The way we get around the transfer tax exposure, and it’s absolutely critical, and it’s a foundational consideration for any non-resident investing in US side real estate. US side assets generally, a foundational aspect to it is making sure you’re not creating a state tax exposure or any type of transfer tax exposure, and the best way to do that is by investing through some sort of separately taxable, non individual, foreign entity.
Say if you set up a foreign corporation, say you have non-resident individual A owns Miami real property that’s worth $5 million. If she dies with that real property in her name, she’s going to be subject to a $2 million US transfer tax. If instead she were to own that US real property through a foreign corporation or through a foreign nongrantor trust, some type of foreign entity that’s separately taxable from an American perspective, she is not subject to US transfer tax on that transfer, because what she owns directly in her name is stock in a foreign corporation that’s a non US sitused asset. As a result, she’s not subject to transfer tax on that asset even if the foreign corporation owns entirely US real estate. Foreign corporations definitionally are not ever subject to transfer tax. So you can easily insulate yourself from transfer tax requirements just by making an investment properly through a foreign corporate entity through some sort of separately taxable foreign entity structure.
To mention here now, the final part of today’s program, and I’ll get through this in a couple minutes so we can address any questions that are there as well… See a couple. They’re in the panel that I’m seeing non-resident real estate investment structuring. Anytime you’re talking about non-resident investments in the United States, there are a few primary considerations, income tax consequences, estate and gift tax consequences. When you go outside of the tax realm, two other very important considerations are anonymity and simplicity of the structure, minimization of filing requirements. The latter is fairly straightforward, self-explanatory. You want to have a fairly, especially if you’re making your initial investment, initial endeavor in the United States, having a straightforward ownership structure can be appealing, both because it reduces cost associated with the structure. Very often non-residents making initial US investments are investing smaller amounts to basically dip their toe in the water before becoming engaged in full-time US real estate investment activities.
It allows for reduced cost. It also makes things more straightforward both from a management perspective, from a compliance perspective, whole nine yards. It’s very appealing to have a straightforward structure. Anonymity comes into play in regards to taxpayers not wanting to reveal their personal identity to the United States government. Mark can talk to this I’m sure even better than I can. If you have a non-resident investor, not I, will mention on my side as well from a multinational perspective, non-resident individuals who are earning effectively connected income, like I mentioned before, subject to tax at graduated rates, the way they pay their tax is by filing a tax return with the United States.
A non-resident individual files a form 1040NR. A non-resident corporate entity files a form 1120F. If they file that form, they disclose their identity, disclose their address, whole nine yards. Very often taxpayers are concerned that if they file a tax return in their individual capacity in the United States, they’re risking the United States digging into their worldwide activities and they’re potentially risking complexities from the United States government, the Internal Revenue Service, in particular that they don’t want to have to deal with. So it’s one of those things that it’s very important when you’re considering how to invest. Mark anything on your end? Mark, you’re on mute.
Mark Perlberg:
Right. And this has become a bit of a more appealing structure in the recent years, as we know, with the tax cut and jobs act we have that 21% flat corporate tax rate that makes it much more appealing. Also with the tax cut and jobs act, as we know, that we can only deduct $10,000 when we have a flow through entity of that state and local taxes. But if that income is within a corporation, we can deduct all of our state and local tax obligations against federal income. And so also when we think about these branch taxes, which can be pretty pricey on top of the 21% capital, 21% flat rate right there, there are other ways that we can use that money and take it out without just paying that dividend tax. How can we do this? We can borrow from the corporation, is one method. We can borrow some of that capital and use that for other business endeavors, and that’s a way that we can actually activate that capital as opposed to just to distributing it and incurring that hefty branch profit tax.
Patrick McCormick:
Absolutely, on mine. Totally, totally agree, and those are some of the foundational considerations when you’re looking at how to invest in the United States and how to set up the ownership structure. The most straightforward option that you have is individual ownership of an income generating. For purposes of illustration, let’s assume the American real estate investment here is income generating individual ownership or ownership through some sort of look through structure, whether a disregarded entity, partnership, what have you, whatever the case may be. The benefits that you can see here, the sale on disposition is subject, like we talked about before, that’s capital gains income. It’s subject to capital gains rates. The US rate of tax for capital gains income currently for individuals ranges between 0% to 20%. Most often it’s 15% or 20%, like Mark mentioned, after 2000 or after 2017 tax cut and jobs act, there was a reduction in the rate of corporate tax to 21% from 35%.
Corporations aren’t subject to capital gains tax. They’re not subject to a differentiation. I would say they’re subject to a 21% rate of tax irrespective of whether the income is ordinary or capital gains. So with the lowered corporate tax rate, the paying tax, at individual capital gains rate, is less of an appeal, but it’s still a marginal appeal, a marginal benefit that is out there. Detriment. The primary detriment here is the enormous estate and gift tax exposure that you have. You also need to file individual tax returns if you’re generating current income that you’re treating as effectively connected income.
[inaudible 00:49:17] mentioned here as well, and it’s one important thing to mention always to keep in mind for non-resident investors, whether it’s in US real property interest or generally. If you have a non-resident investor who’s just generating FDAP income, if they’re not engaged or treated as engaged in a US trade or business, they will not have to file US tax returns. If all of the tax requirements, from a United States perspective, are properly collected through withholding at this source, there’s no US tax return filing requirement, which can be very appealing for non-resident investors who were looking to engage in US investments.
The ability, say, in private equity in that realm, in that area, one of the things that we often talk about are blocker entities, essentially setting up some sort of corporate structure to make sure that the non-resident investors who are usually investing in that realm, private equity… There’s my dog saying hello. In the non-resident realm, when you’re investing in the United States in some sort of US private equity structure, let’s say having a blocker entity overseas, blocks the income from flowing through to the individual, blocks the individual from having effectively connected income and potentially having to file a US tax return. Second option for ownership is ownership through a foreign corporation. Biggest benefit, as compared to the first example, is it gives you that protection from a transfer tax perspective. You’re also subject to corporate tax rates on ECI income, which can lower the effective tax rate when you look at it from an ordinary income tax perspective, and there are moving parts here all over the place.
I’ll try to keep it as straightforward it as I can, but when you’ve got current income that’s being earned by a US real property investment individual, ordinary income rates range from 0% to 37%. Very often, or most US individual income rates are over 21%. Corporations are taxed a flat, none graduated 21% rate of tax under current US law. That means, as a result, very often your current income earned from a real property investment can be taxed at a lower effective rate by the United States if the ownership is through a corporate entity. One thing I do want to mention here as well, when you’re looking at what I always look at from my perspective, I know I speak from Mark on this, and I speak for anybody who’s really working from a multinational perspective, or I should be speaking for anyone who’s working from a multinational perspective, the goal here is always to create the lowest cost overall from a global perspective, the lowest tax cost for the client, there are what are called foreign tax credits.
If you’re a non-resident paying tax to the United States, very often, depending on your jurisdiction, you’re going to be able to offset much of the foreign country tax by virtue of foreign tax credits for the tax you’re paying to the United States. Where really the differentiations come, most importantly, into play on the American side in the ownership structure, is where the American side tax exceeds the residents’ country taxation. So say if you’re being taxed by your home country at a 25% rate of tax and you can lower the US rate of tax from 20% to 15%, then that’s not as big of a deal, because irrespective of that lowering you’re going to get, whether it’s 15 or 20%, you get a tax credit, or in your home country for that amount, assuming that you do, you’re not going to be as concerned to the American tax consequences. And quite often you can, as a result, end up prioritizing things like the anonymity, whole nine yards.
Juxtapose that with a situation where, say, if the US effective tax rate is 25% and you live in a country where the effective tax rate will be 35%, then lowering that US effective… I apologize, I have that backwards in my head. I apologize. Say 25% is your US tax rate, 10% is your home country tax rate, lowering the US tax to 15% is hugely advantageous, because that’s going to lower your global effective tax rate to 15%. The biggest detriment of the foreign corporation approach is actually what Mark mentioned, is in regards to branch profits tax, you’re exposed to branch profits taxes, a second layer of corporate tax on A, imposed just on a foreign corporation. It’s essentially done to replicate a non-resident setting up a US subsidiary.
It’s actually worse, the branch profits tax. Anybody who’s interested in the branch profits tax, I have an article that I’ve wrote for Tax Notes, which is one of the big US side tax publications, a couple years ago, that I’d be more than happy to circulate. It’s a pretty narrow topic I guess, I would say, as to how it applies. One thing to mention though it does, it’s something to very much keep on your radar. This is something where income tax treaties can come into play to lower the rate of effective tax on setting up a branch or on conducting US activities through branch operations. My favorite ownership structure, I would say, from my perspective, is, what we call, the corporate, corporate approach. It’s ownership of an income generating American real estate investment through a foreign corporation, which itself is owned by a United States corporation. Benefits, protection from estate and gift tax exposure is still there because you have a non-resident who owns shares in a foreign corporation. Non-resident owns foreign corporation.
Foreign corporation owns US corporation. US corporation owns the target investment. They’re also here under this structure. There’s no branch profits tax, because the branch profits tax is really meant to capture tax in situations where you have a foreign corporation that has not separately incorporated within the United States. When you set up a separate US corporation, you automatically avoid branch profits tax. You don’t have to worry about that under a structure where you set up a US corporation. You’re also not subject to FIRPTA under this approach when you have a US corporation, because a US corporation is the entity selling the property.
So particularly, for US real estate, I really, really, really like the corporate, corporate approach. The other option that’s out there, that also is very appealing, is a foreign nongrantor trust, and that can actually be more appealing depending on what the individual’s investment goals are. It gives you the same protection from estate and gift act exposure. You don’t have branch profits tax because that only applies to foreign corporations rather than any other type of foreign entity detriment. You are subject to FIRPTA here. There are also negative consequences to any US beneficiary of a foreign nongrantor trust. So now with that being the case, Mark, you go ahead. You first.
Mark Perlberg:
So for some of the audience here, especially the beginning investors, when you hear about all these percentages, taxes, when you hear about the 30% branch tax on top of the 21% flat tax rate, how does it make sense? Well, we also want to consider, before we consider all the other, there’s tons of strategies that we don’t even have enough time to go into all of them, how we can mitigate that, but also, when you look at the way that we report these real estate investments on paper, right? Even if you have a cash flow positive asset, we have this thing called depreciation, right? As I was talking about earlier, and we can best leverage and utilize depreciation and cost segregation to accelerate depreciation to make it so, and almost always, in about close to a hundred percent of the tax returns I’ve seen for real estate investments, these investments will operate at a loss even if they are sound investments, depreciation will offset any revenues, the depreciation combined with all the other, so we should not see that.
Now when we think about cost segregation and we’re utilizing bonus depreciation to have that upfront, that high, all those increased deductions for depreciation, it may result in some state tax liabilities, because some states will not recognize bonus depreciation. However, some states like Texas and Florida have no state tax. I’ve never seen a state with a higher tax rate than our marginal federal tax rates. So we’re still going to be positioning ourselves to take advantage of all of the strategies that we know of that are beneficial for real estate. Investors are still going to help you out in spite of all of these additional things that we have to consider and potential tax consequences when being foreign investors.
Patrick McCormick:
Absolutely. Now I see a question here. Checking the questions from the audience. A question from Johnson [inaudible 00:59:12] Hello, I’m a Canadian and I’m interested in investing into a US real estate syndication. I plan to buy units of the LLC through an LP to avoid double taxation in Canada. What is the best strategy to avoid withholding tax? Could I claim depreciation to reduce taxable income to zero and eliminate withholding, assuming after I get an ITIN? If you’re looking at it, a lot of this, a lot of the ramifications, and the first thing to think about on the American side always is if you’re interjecting a foreign entity into the ownership structure, how that foreign entity is going to be classified for American tax purposes. I do a lot of work with Canadian investors. Canada, Mexico and the UK are probably the three I work most on, my practice is global at this point, but those are the three that I really work the most often with on my end.
From a Canadian perspective, when you’re looking at entity classification, the per se corporations on the Canadian side, ie, the types of entities that are automatically classified as corporations for American tax purposes are companies and corporations. Any type of entity that is neither designated as a company nor corporation under Canadian rules, under Canadian corporate rules, is generally going to be able to elect its American classification. It’s required to make that election within 75 days of the entity becoming relevant. Otherwise, it makes a prospective entity classification change. However, that being said, and that may or may not be harmful, to make a prospective change depending on what the assets are, depending on whether there’s built in gain. Essentially the entity classification change can but will not necessarily create a recognition of built-in gain. So you’re best off making the entity classification election initially at the time of relevance.
Ultimately where that’s important, from our perspective, is treatment of the LP, determining how the LP is going to be looked at on the US tax side. And then looking at the four investment structures. In that context, if the LP is regarded as a passer entity for American tax purposes, you’re going to have essentially this ownership structure that’s on the screen now, the individual ownership or through a disregarded entity, because if the LP is disregarded, you have no separately taxable entity in the ownership structure here, assuming that the LLC is taxed as a pass through for American tax purposes, which is usually going to be the case when you’re looking at a real estate syndicate investment. If you have purely pass through transactions, this is going to be what your ramifications are. If you’re instead looking at the entity, the LP rather, as a corporate entity for American tax purposes, you have these ramifications, you’re going to prefer these ramifications because certainly, as a prerequisite, you always want to have some sort of corporate separately taxable entity in this structure to avoid tax consequences.
Really thinking it through, and to get to the crux of your question regarding avoidance of withholding, the two times at which withholding can occur are in regards to current income that’s being earned, say rents that are being received. There can be withholding on those rents if payable directly to a non-resident. There can also be withholding under FIRPTA at the time of disposition of real property interest. When you’re looking at the former category, the current income, usually the most straightforward way to avoid withholding is to make the election, to treat the income, as effectively connected to supply the withholding agents with the pertinent information that you’re making the election, to be taxed at a graduated basis as effectively connected income on rental income, one income associated with the property, because then the withholding requirements come into play under FDAP income.
You’re not going to have those same withholding requirements for effectively connected income on the sale of the property. Typically, the best way to avoid a withholding obligation is the withholding certificate that I mentioned before. Go to the IRS, get a determination, be proactive about it, figure out how much the tax liability is going to be, and then from there you can get an idea of, hey, this is the amount I’m going to pay to the government and not have an over withholding occur as a result. Mark, anything on your end on that?
Mark Perlberg:
No, I think that was a pretty thorough answer. That was great.
Patrick McCormick:
Terrific. Yeah, and that’s the only substantive question I see. Unless anybody has anything else, and I know we’re right about at closing in on time today, so any additional questions that we can field, by all means. Although certainly I always tell people with any program, anytime I can help, part of my practice means being available 24/7. So I’ve always got to keep myself available anytime I can assist formally or informally. I saw a couple emails coming in already, so I’ll be getting in touch with anybody sending emails. Anytime I can assist again formally or informally, always my pleasure, and thank you so much to everybody for their time today. Mark, I’ll throw it back to you.
Mark Perlberg:
Yeah. Okay, fantastic. Well, whoa, whoa, sorry. Patrick, that was wonderful. I really appreciate your insight. So this is a lot of information we got here, I will be putting the recording, I will email it to the attendees once I complete the recording. It’s going to be on my YouTube page and on my website, so if you want to re-watch the material. Also, Patrick, if anybody reaches out or if you want to put your contact information in the chat, we could also see it in the slides, what your contact information is. If you want to follow up with me or Patrick, lots of opportunities in considerations with planning here, so stay in touch, and if you have any follow-up questions, we will be more than happy to discuss them with you. Patrick is a fantastic resource.
He has been phenomenal helping me out. Some of you CPAs listening, Patrick does lots of free CPE as well. That’s how I found him, and he’s a fantastic resource. You guys know how to contact me. For anybody who doesn’t have my contact information, I’m putting it in the chat. Mark it markperlbergcpa.com and stay tuned. I’m going to email you. My upcoming webinars are all going to be fantastic. Some stuff from beginning business owners and investors, and we’re going to keep things lively and fun and just try to add as much value to all of our listeners as possible. So that’s all I got. Patrick, thank you so much for coming, and thank you all for listening, and who will be listening in the future. I really hope you guys got a lot out of this. Keep in touch. Lots of great stuff to come. Patrick, anything else from you?
Patrick McCormick:
All said on my end. Y’all have a pleasure. Absolute pleasure. Oh, oh, y’all have a good one. Absolute pleasure being here.
Mark Perlberg:
All right, thank you everybody. Have a fantastic rest of your day. Hope you learned a little and keep us in mind. We’d all love to help you out with your future investments endeavors.