By Ryan Dudley, CPA, CA, MIT, principal and International Tax Practice Leader, Friedman LLP
Investors from around the world are attracted to US real estate as a stable long-term investment. Yet for many investors, the scale and complexity of the U.S. income tax system can become a post investment nightmare.
High tax rates and enormous compliance costs can significantly reduce the overall profitability of such an investment. However, with the right planning, many of these pitfalls can be avoided.
Rental income derived from U.S. real property is taxable in the United States. Foreign investors are generally subject to:
A withholding tax regime that applies a fixed 30% rate to the gross US sourced “fixed determinable annual periodic” income (“FDAP”); or
A net basis tax regime, that applies graduated tax rates to income, net of deductions, that is “effectively connected” to a US trade or business (“ECI”).
Where the rental income is FDAP, the gross rental income is taxed at a flat rate of 30% without deductions, including depreciation and interest. During the early years of an investment, interest, depreciation and management costs typically eliminate the net income from real estate investments, so this tax may exceed the profits for many years.
However, there is a simple solution. Foreign investors can elect out of FDAP into the ECI regime and so only pay tax on the income after expenses.
All gains from the sale of real property are treated as ECI and are taxable in the United States (regardless of whether the rental income was FDAP or ECI). Further, where a foreign investor acquires stock in a U.S. corporation and the majority of the assets in that corporation are U.S. real property assets, any gain on the sale of the U.S. corporation stock should also be ECI.
Investors need to consider whether to hold the U.S. real property directly, including via a flow-through structure, e.g., a partnership, or whether to interpose a corporate entity.
The primary benefit of holding real property directly is that the tax rates applicable to an individual can often be lower than the tax rates applicable to a corporation. For example, the capital gains tax rate for an individual is currently 15%, whereas there is no concessional tax rate for capital gains derived by corporations.
In addition to the difference in tax rates, U.S. corporations may be subject to dividend withholding tax and foreign corporations may be subject to branch profits tax (which is the economic equivalent of dividend withholding tax). Dividend withholding and branch profits taxes are applied at the statutory rate of 30% (although this may be reduced by a treaty).
One planning opportunity for foreign investors into U.S. real property is to use leverage. By optimizing the amount of debt in acquiring U.S. real property, the investor can limit the amount of U.S. income tax they suffer on the income and gains from that property.
Interest deductions may offset rental income and generate losses that may be used to reduce future capital gains. interest paid to unrelated parties may avoid interest withholding tax by virtue of a domestic exception (the “portfolio exception”) or be reduced under an applicable tax treaty, potentially to zero. Further, unlike payments of dividends, repaying the principal of a loan does not attract withholding tax.
Optimizing the amount of debt needs to take account of numerous limitations restrictions. For example, interest charged on related party debt must reflect an arm’s length rate. Various judicial doctrines require a substance over form approach and recast excessive related party debt as equity.
Similar rules apply to unrelated party debt where a related party provides a guarantee. In the case of an investor using a corporation, the “earnings stripping” rules may apply to defer interest deductions into the future.
Finally, investors who are considering using related party debt should be aware that the interest will not be deductible in the current year if it is not paid by year-end.
While the above describes some of the pitfalls associated with investing in US real property, there are many others. Foreign investors are often surprised how intrusive IRS information filing requirements can be and the penalties associated with non-compliance. Federal and state estate taxes apply to U.S. real property should the investor die while holding that property. Similarly gift taxes can apply should the property be gifted.
Investing in U.S. real property can be financially rewarding for foreign investors. However, there are many U.S. tax pitfalls which can diminish profits and introduce significant compliance costs.
With early tax planning, this tax burden can be minimized and foreign investors can avoid unexpected tax consequences from investing in U.S. real property.
