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Foreign Investment in U.S. Real Estate-Why Tax Planning is Essential By: Steven E. Varela, Esq. Foreign persons purchase real estate in the U.S. for a variety of reasons, such as, for temporary/indefinite employment in the U.S. , a vacation home, for their children who may be studying or living in the U.S., a permanent home, or as an investment for capital appreciation and/or income generation. Regardless of the reason, there are a myriad of U.S. tax implications to consider “prior” to such investment to ensure that the purchase is properly structured to avoid any unintended tax consequences. Imagine a scenario where a foreign person purchases U.S. real estate only to have more than 50% of the value of the investment evaporate due to U.S. taxes. It could very well happen. However, employing timely and proper tax planning will ensure that foreign buyers have the opportunity to weigh the risks and make informed decisions instead of getting blindsided by Uncle Sam years later. Foreign buyers face a multitude of tax issues during all phases of the transaction life cycle from acquisition, ownership, and disposition of U.S. real estate. Planning for these tax issues typically involve the following considerations: Minimizing taxes on the sale of the property Avoiding or minimizing U.S. withholding tax on rental income (generally 30% on “gross” rents) Avoiding U.S. estate tax (35% in 2012 and 55% in 2013, unless Congressional action is taken) Minimizing compliance and contact with U.S. tax system/authorities Accomplishing all of these objectives at once is extremely difficult and will inevitably involve compromising on one or more of the objectives to find the right balance that is most suitable to the foreign buyer. Although acquiring U.S. real estate generally has no immediate tax consequences, a foreign buyer should maintain proper documentation of their purchase. When the foreign buyer desires to subsequently sell the property, the documentation will play a role in possibly defraying some of the tax and financial implications from the sale transaction. Specifically, the U.S. has a special tax regime known as the Foreign Investment in Real Property Act or “FIRPTA” which applies specifically to foreign owners disposing of U.S. real property. FIRPTA is not a tax per se, but is a withholding obligation imposed on the new buyer. Under FIRPTA, a buyer is required to withhold 10% of the “gross” purchase price and remit such amount to the IRS on behalf of the foreign seller. At closing, the amounts withheld are generally remitted to the IRS along with certain tax documentation identifying the reason for the withholding and providing the transaction specifics. At the end of the tax year, the foreign seller is required to file a tax return to determine its ultimate tax liability related to the transaction. The FIRPTA withholding amount is essentially an advance payment of the tax and is a mechanism to ensure that the IRS is able to collect any taxes owed by the foreign seller, which may otherwise go uncollected given that the foreign seller may reside in another jurisdiction making it virtually impossible for the IRS to collect. When a foreign seller files its tax return and the tax liability is determined, any excess amounts paid to the IRS due to the FIRPTA withholding will be returned to the foreign seller. Conversely, any shortfall in the amounts previously remitted under FIRPTA compared to the actual tax liability would then need to be paid by the foreign seller. In some instances, a foreign seller’s ultimate tax liability may be less than the amount required to be withheld under FIRPTA. If this is the case, a foreign seller can apply for a withholding certificate from the IRS for a reduced withholding. As part of the application process, the foreign seller will need to refer to the transaction documentation related to the initial acquisition. If the documentation is unavailable, it may inhibit a foreign seller’s ability to obtain a withholding certificate. However, provided that the documentation is available and in order, obtaining a withholding certificate is especially beneficial to a foreign seller primarily from a cash flow perspective in that it generally enables quicker access to the excess withheld funds than when proceeding in the traditional manner. Generally, foreign persons are subject to a different set of tax rules than those that apply to U.S. citizens and resident aliens. Failure to understand such differences may expose a foreign person to significant U.S. tax liabilities. For example, absent any elections to the contrary or the availability of a tax treaty, rental income earned by a foreign individual directly owning U.S. real estate is subject to a 30% withholding tax on the “gross” rents without consideration of any expenses associated with earning such rent, such as, property maintenance, insurance, property taxes, depreciation, etc. What exactly does this mean? Basically, each time a tenant remits a rental payment to the foreign-landlord, the tenant should be withholding 30% of such amount and remitting to the IRS. This represents a true tax and, therefore, a true cost of owning and operating the property as a rental in addition to the normal expenses associated with maintaining the property. An unknowing foreign buyer who makes their purchase decision based in part on the ability to generate a certain level of cash flow from the property may be in for an unwelcome surprise. However, with proper planning, this tax can be reduced and even eliminated. Another instance where foreign persons receive different U.S. tax treatment than U.S. citizens and resident aliens is in the area of U.S. estate taxes. Generally, foreign persons are only subject to U.S. estate taxes on their U.S. situs property (i.e., property located within the United States), such as real estate. U.S. citizens and resident aliens are currently permitted a $5.12 million exemption whereas foreign individuals can only shelter $60,000 from U.S. estate tax. In the case where a foreign individual directly owns U.S. real estate and in the absence of an applicable tax treaty, a tax rate as high as 35% in 2012 and a 55% in 2013 can apply to the value of the property which exceeds the $60,000 exemption amount. The impact of the U.S. estate tax on a foreign buyer’s investment can be crippling to say the least. Fortunately, implementing a proper ownership structure may effectively eliminate this tax. In addition to the tax considerations, there are also various non-tax issues to consider. Legal title to real estate is generally a matter of public record in the United States. Foreign investors are often concerned about liability and privacy in relation to their ownership of U.S. real estate. Privacy is a particular concern for the very wealthy who do not want to have residential addresses made available through public records which in many cases are readily accessible on the internet. For the most part, trusts and other entities offer some measure of protection to preserve an owner’s identity. For example, trusts do not have to be registered in the U.S. and only the names of trustees may appear on real estate records. Other options include forming corporations or limited liability companies. Although public registration is required for these entity types, the names of the owners are not a matter of public record in most states. It is not uncommon for foreign persons to express a desire to minimize its contact with the U.S. tax system and tax authorities. Such an aversion is not necessarily rooted in the notion that foreign persons do not wish to pay tax, but would rather do so anonymously or in a less intrusive manner, in the same way that they can invest in the U.S. securities markets largely without having to identify themselves to the U.S. tax authorities. Unfortunately, the U.S. system of taxing real estate transfers does not facilitate anonymity. Anonymity will come at a cost, most notably by requiring the use of some form of non-fiscally transparent entity which will inhibit the availability of preferential tax rates, such as the reduced capital gains tax rates applicable to individuals. In any event, the tax authorities, federal and to some extent state, may nonetheless have the power in some circumstances to require disclosure of the identities of the ultimate owners of real property. There is no single or “one size fits all” plan that will meet all of a foreign buyer’s objectives and the planning process involves navigating a litany of obstacles and challenges. Furthermore, each person’s situation is unique and their priorities may differ. Fortunately, planning is possible and many of the challenges can be properly addressed. Therefore, it is extremely important to involve a trusted and knowledgeable tax professional at the beginning stages to assist a foreign buyer in understanding the consequences of the proposed investment and to enable them to make an informed decision rather than waiting to learn that the investment has been significantly eroded by U.S. taxes that could have otherwise been minimized or eliminated. Steven E. Varela, Esq., CPA is an attorney with offices in Miami Beach, Florida and focuses his practice on real estate, domestic and international tax planning, and corporate law. Mr. Varela is licensed to practice law in New York, Florida and Washington D.C. He is also Certified Public Accountant in the State of Florida. Steven can be reached at 305-479-5676 or at firstname.lastname@example.org.
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