By Sol Zimmerman, RESA, and Aninda Dhar, RESA
When an overseas buyer contemplates purchasing U.S. real estate, there are many factors that are often considered.
However one thing that is commonly overlooked can have adverse effects.
It is important for a foreign investor of U.S. real property to be mindful of U.S. taxes including potential income, gift and estate tax consequences of their investment prior to any transaction.
While it is unnecessary to become an expert in U.S. tax laws overnight, it behooves you to at least have a conversation with a U.S. tax professional prior to a purchase.
The following topics may be of particular interest and is of course by no means a comprehensive and exhaustive analysis of any facet of U.S. tax law and cannot be construed as tax advice.
General Taxation of Foreign Investors
First one must have an idea if they are holding this property for personal use, investment or rental. If the investor wants to leave the property empty and periodically (or never) use it, that’s fine.
The investor is just hoping for appreciation which is common in the New York City market.
Now if the one wants to put a tenant in the property, some choices have to be made since they will be earning rent which is U.S. source income.
In general and simplified for purposes of this article, one can elect to be taxed on net income or gross income.
Under the net income regime, rental income earned by the foreign investor can be offset by related deductions such as maintenance, taxes and, perhaps most importantly, depreciation.
For example – an investor from China purchases a one bedroom in Chelsea and rents the property to a tenant for $4,500 per month.
The Chinese investor is permitted to deduct depreciation, maintenance, taxes etc from this amount to calculate net income annually (it frequently comes out to a tax loss due to depreciation).
The Chinese investor is the subject to tax on the net income amount at graduated income tax rates (the highest is currently 39.6% for individuals and 35% for corporations). By contrast, if the foreign investor wishes to be taxed on the gross rent, the tenant is obligated to withhold 30% of rent and remit it to the IRS. In above example, if the rent is again $4,500, the tenant is obligated by law to withhold 30% of the $4,500 ($1,350) and remit this amount to the IRS. The Chinese investor receives the remaining $3,150 after the withholding.
What Happens if the Foreign Investor Dies?
The U.S. imposes an estate tax (tax upon death) on assets located in the U.S. and, real estate can trigger the estate tax.
Probably the most troubling aspect in this area is that the threshold amount whereby foreigners are subject to the U.S. estate tax is relatively low at the time of this article: $60,000.
While the tax rate changes frequently and really depends on the climate, it is generally significant.
An investor may wish to consider obtaining a life insurance policy to cover the estate tax or consult with a trusts and estate professional in the U.S. for planning ideas.
Be Careful with the Gift Tax
The donor of a gift may be responsible for paying gift tax. A gift is any transfer whereby the recipient transfers less than full consideration in return.
There is an annual exclusion of $14,000 which permits a donor to gift $14,000 tax free per annum. The top gift tax rate is 40 percent at the time of writing.
With New York City real estate prices this can be significant. We frequently encounter family members (usually parents) purchasing New York City real estate for other family members.
Triggering the gift tax inadvertently is very possible and the tax liability can be significant.
Be Really Careful with the Branch Profits Tax
Foreign corporations engaged in a U.S. trade or business are potentially subject to the branch profits tax if they have a U.S. branch (e.g., an LLC). The branch profits tax is a calculated with an intricate metric, which essentially imposes a 30% tax on the “dividend equivalent amount”.
We frequently see foreign corporations that own U.S. real estate with a domestic LLC. Unfortunately, the foreign shareholders were never advised of the potential impact of the branch profits tax.
Any sale or exchange of the NY Property will be subject to the Foreign Investment in Real Property Tax of 1980 (“FIRPTA”).
In general, we note that this legislation operates by subjecting nonresidents holders of U.S. real property interests to 10%-15% tax withholding upon the disposition of such property on the gross proceeds.
A certificate may be obtained to have a lesser amount withheld (usually an amount based on net gain instead).
In either event, foreign investors should try to obtain tax identification numbers early as possible so they may apply for these certificates or facilitate the return of any money withheld at closing.
Sol Zimmerman, CPA , is a partner with EisnerAmper LLP. Aninda Dhar, JD, LLM, is a senior manager, EisnerAmper LLP. Both are members of the Real Estate Services Alliance (RESA), an organization with NYC-based real estate service professionals that complement one another’s expertise. RESA offers real estate owners the very best specialists in the business. From brokerage services, due diligence, title and legal assistance, our group members can assist in all stages of a transaction. Once owned, RESA members can help an owner maximize the performance of an investment by helping with architectural services, construction, lease-up, management and accounting. RESA members are experienced veterans from top NYC firms and provide services for all real estate needs.