1. Introduction:
With
the recent turmoil in China’s stock market, Chinese investors are becoming
increasingly interested in safer, more stable and more secure investments, such
as the U.S. real property. However, there are many obstacles to investing in a foreign
real estate market, and the differences between the tax rules in the U.S. and
that in investors’ home countries are also confusing.
This
article will present approaches for foreign investors to save tax while investing
in the U.S. real estate market.
2. Definitions:
To avoid potential confusions,
definitions of certain words used in this article are given below.
·
Foreign investors: "non-resident
alien" (NRA) is the U.S. government's name for a citizen of a country
other than the U.S. who also lives outside the U.S. However, the term can also
refer to citizens of a non-U.S. country who are temporarily residing in the U.S.
In this article, the example of Chinese investors is used as an introduction,
but the approaches can be applied to foreign investors in general.
·
U.S. Real property: Real Property usually includes
the following:
o Land, real property improvements (e.g., buildings, other
permanent structures, and their structural components)
o Leasehold interests, and un-severed natural products
of land (e.g.,
growing crops, timber, mines, wells, and other natural deposits)
o Personal property associated with the use of real property, such
as moveable walls, furnishings, mining equipment, farm tractors, drilling
rigs etc. Exceptions include: the personal property is: a. disposed of
more than one year before or after the disposition of the real property, or b.
separately sold to persons unrelated either to the seller or to the buyer of
the real property.
·
Passive income (non-ECI): non-ECI refers to fixed, determinable, annual
or periodic income derived by a foreign investment or business activity. Passive
income is subject to 30% tax withholding on a gross basis unless reduced by
applicable tax treaty. In case of gain from sale, buyer is required to withhold
10% of the gross amount realized to ensure collectability.
·
Effectively connected income (ECI): ECI refers to income “connected to a trade or business, and is
taxed on a net basis at the graduated tax rates that apply to any US citizen,
resident or entity.
3. Tax-saving approaches
to invest in U.S. Real Estate Market:
3.1 Net basis elections
A foreign investor “who derives income
from real property but does not engaged in any U.S. trade or business (e.g.,
the investment is raw land or net leased property) ”is allowed by Code §§
871(d) and 882(d) to “elect to be taxed on a net basis at graduated rates as if
the income were ECI ”.
Compared with being taxed on gross
basis, Net basis election is beneficial because it relieved investors of the
30% tax on gross rents and allows investors to deduct substantial expenses (e.g.
depreciation, interest) associated with the real estate. Therefore, the taxable basis and tax
expense under Net basis election will be largely reduced. Exceptions include:
·
Interest income on a debt
obligation secured by a mortgage on U.S. real property;
·
Rental income from
personal property;
·
Income from real property
that is not held for the production of income (e.g. personal residence).
3.2 Real Estate Investment Trust (REIT)
A REIT is an entity that meets certain
technical requirements and that elects REIT status. One important tax-saving
feature of REIT is that the dividends payments made to shareholders are tax
deductible. In addition, gains realized from selling U.S.-controlled REIT are
not subject to tax. Therefore,
investing through REIT will save foreign investors tax expenses. Requirements to qualify as a REIT as follows:
·
At least 90% of net
income exclusive of capital gains must be distributed to shareholders.
·
Minimum owners’ number is
100, “no five or fewer individuals may own directly or indirectly more than 50%
of the total value of the REIT stock”.
·
At least 75% of the total value of the REIT’s
assets must consist of cash, real estate, loans secured by real estate, or U.S.
government securities.
·
At least 95% of the
REIT’s gross income must be composed of interest, dividends, and rents from
real property, plus six other specified sources of income.
·
75% of the REIT’s gross
income must consist of rents from real property, interest on loans secured by
real estate, and seven other sources of income.
·
REITs must adopt a
calendar year as their tax year.
Gains on disposal of shares in a foreign-controlled
REIT by foreign investors are subject to tax as ECI. However, if such shares are
publicly traded and the investor owns or owned a 5% or less interest, such
gains are still tax-exempt.
3.3 Non-recognition Provision under
IRS
Section
1001(c) of the Internal Revenue Code
(IRC § 1001(c))
stated all realized gains and losses must be recognized “except as otherwise provided in
this subtitle”. The three most
significant non-recognition provisions are:
It refers to a
transaction or series of transactions that allows for the disposal of an asset
and the acquisition of another replacement asset without generating a current
tax liability from the sale of the first asset. A like-kind exchange on the
basis that the form of the taxpayer’s investment changes while the substance of
the investment does not. In a like-kind exchange, the realized gain or loss
usually never disappears; rather, the unrecognized gain or loss typically
carries over into the new asset.
· Transfers between spouses and certain former spouses:
No gain or loss shall be
recognized (therefore no tax or tax benefit would be imposed) on a transfer of
property from an individual to (or in trust for the benefit of)
(1)
A spouse, or
(2)
A former spouse, but only if the transfer is incident to the
divorce (such transfer must occurs within 1 year after the date on which the
marriage ceases, or is related to the cessation of the marriage).
3.4 Reduced withholding tax.
According to IRS, the foreign person disposing of a U.S. real property interest may
have the 10% withholding reduced if certain conditions are met and Form 8288-B,
Application for Withholding Certificate for Dispositions by Foreign Persons of
U.S. Real Property Interests, is timely filed and accepted by the IRS. Such conditions include:
·
The disposition of the
U.S real property interest takes place under one of the non-recognition
provisions of the Internal Revenue Code
(further discussed in 3.3).
·
When the transferor’s
maximum tax liability on the disposition is less than the amount otherwise
required to be withheld.
·
The transferor or
transferee enters into an agreement with the IRS by posting a type of security
(letter of credit, bond, etc.).
·
The transferor or
transferee may enter into a 12-month agreement with the service to obtain a “blanket
withholding certificate” for multiple properties.
3.5 Utilizing the “Rebuild
America Partnership” plan
One proposal of the
plan was to give foreign pension funds approximately equal treatments with U.S.
pension funds by “exempting gains recognized by foreign pension funds from the
disposition of a U.S. real property interest”. This means that foreign
investors can sell U.S. real property via foreign pension funds without having
to pay any taxes on gain realized.
4. Conclusion
In lights of the
discussion above, Net Basis Elections and investing through REIT seems to be
the most efficient ways for foreign investors to avoid taxes when investing in
the U.S. real estate market. However, foreign investors should conduct
cost-benefit analysis with each approach to decide which one fits them the
best.
References
Deloitte. (2014).
Introduction to the taxation of foreign investment in U.S. real estate.
Retrived from: http://www2.deloitte.com/us/en/pages/tax/articles/introduction-to-the-taxation-of-foreign-investment-in-us-real-estate.html
Madan, A. (2014). Avoid
paying US Estate Taxes by setting up a two-tier partnership. Madan Chartered
Accountant. Retrieved from: http://madanca.com/blog/avoid-paying-us-estate-taxes-setting-two-tier-partnership/
Rucci, B. (2014).
Structuring foreign investment in U.S. real estate. Russell Bedford. Retrieved from: http://www.russellbedford.com/index.php?option=com_content&view=article&id=997:structuring-foreign-investment-in-us-real-estate&catid=91:features-and-analysis&Itemid=90
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