Tax Matters

How Taxes affect Real Estate Transactions in U.S.
By Lorena Bracho-Mijares. Source, CIPS Global Real Estate Transaction Tools.

Foreign buyers and sellers want to know how U.S. tax law applies to them. Although real estate professionals like myself should not give  advise in tax matters, I will like to provide you with general information on how real estate transactions involving foreign ownership are taxed, keeping in mind that for detailed information is always recommended to seek expert advice.  

As a basic principle, all transactions by foreign buyers and sellers of U.S. real estate are U.S.-sourced and therefore subject to U.S. taxes on income and sales. Foreign individuals who meet certain criteria are also subject to U.S. income tax. Failure to comply in a timely manner with U.S. tax regulations can trigger serious consequences for a buyer, seller, or real estate professional.

Substantial Presence

Nonresident aliens are considered U.S. residents for income tax purposes (not immigration) if they meet the substantial present test:

• Physically present in the United States for at least 31 days in the current year, and
• 183 days during the three-year period that includes the current and two preceding years, counting:

1. Total number of days present in the United States during the current calendar year, plus
2. One-third of the days present during the immediately preceding calendar year, plus
3. One-sixth of the days present during the second preceding year.                

Even if a foreign national meets the substantial presence test, he may qualify as a  nonresident for tax treatment by filling IRS Form 8840-Close Connection Exception Statement for Aliens. In order to claim this exception the taxpayer must maintain a tax home in a foreign country. The exception cannot be claimed if the individual has applied for U.S. residency.

Income Tax for Foreign Real Estate Owners

Income earned from real estate by nonresidents generally falls under one of two tax arrangements: 30 percent withholding or effectively connected income.

• 30 Percent Withholding: Income from real estate, such as rental income, is a passive activity that is subject to a flat-rate withholding tax of 30 percent on gross income. No deductions are allowed for operating expenses, interest payments, or repairs.
• Effectively Connected Income: If a foreign person carries on a trade or business in the United States, income from that enterprise is deemed "effectively connected income" and tax is imposed on the net income according to the same graduated rates paid by U.S. residents. Deductions are allowed for operating and other expenses in relation to the business.

Foreign Investment in Real Property Tax Act (FIRPTA)

A Foreign owner's first contact with U.S. income tax system may occur at the time of sale, when money is withheld to comply with FIRPTA.

The basic requirement of FIRPTA is this: when a U.S. real property is purchased from a foreign seller, the buyer, or withholding agent (an attorney, CPA, or the real estate broker), must withhold 10 percent of the sale price -not net proceeds- and forward the amount to the IRS within 20 days after the transaction closing.

The actual amount or tax will be calculated and paid when the seller files an income tax return. Any excess paid from the 10 percent will be return to the seller.

Transactions may be exempt from FIRPTA:

• The buyer acquires the property as a personal residence and the purchase price does not exceeds $300,000.  (The buyer or a family member must occupy the residence for at least 50% of the time of the time it is occupied by anyone for the 2 years following the transaction.)
• The IRS provides a statement to the buyer that the seller is exempt from withholding.
• The seller furnish an affidavit certifying that seller is not a foreign person.

Estate Tax

The estates of foreign owners of U.S. real estate are subject to federal estate tax on assets in the United States.

A noncitizen surviving spouse is potentially in a very expensive estate tax situation. The IRS looks at intent to remain in the United States and views a noncitizen surviving spouse as likely to leave the country. Consequently, the estate is not eligible for the marital deduction, which essentially allows a residence and other assets to pass to the surviving spouse free of estate tax. The entire value  of jointly owned property is included in the estate assets, which makes the total value of the estate subject to estate tax at a rate of 45 percent.

Forms of Ownership

How a nonresident foreigner owns U.S. real property impacts its taxation during the period of ownership and upon sale. Some owners may prefer to form corporate entities to own real estate assets as a way to manage taxes, lessen or avoid estate taxes, and maintain privacy. The most advantageous form of ownership must be selected based on the owner's overall tax profile and objectives.

Direct Ownership

The simplest form of ownership is direct ownership -by an individual or partnership. It efforts the owners direct control over the property. As mentioned before, the owners are subject to income tax on revenue generated by the property and the owner must file an individual tax return. Because the buyer must supply a taxpayer identification number, ownership of the property is publicly identified. FIRPTA withholding requirements must be met when the property is sold, and federal estate tax must be considered. On the other hand, income from the property is taxed only once, as individual income to the owner, instead of the double taxation associated with corporate ownership.

Indirect Ownership through a U.S. Entity

Foreign owners may set up a U.S. corporate entity to own real estate assets as a way to manage income and capital gain taxes, maintain privacy, and limit liability. A partnership offers the advantage of income taxed only at the individual level, but it also make the partners personally liable for the actions and debts of the partnership. The corporate forms available include a S-Corporation or Limited Liability Company (LLC). Although the S-Corporation, which passes income to the individual owners, may be formed only by U.S. citizens and residents, the direct pass through of earnings can be accomplished through the LLC. 

Indirect Ownership through a Foreign Entity

For sophisticated investors and complex investments, the most advantageous move may be formation of a foreign corporation whose sole asset is the stock of a U.S. corporation, which in turn acquires the real property. Ownership through a foreign corporation may offer some tax relief if a tax treaty exists with the owner's tax home country. Foreign-entity ownership offers more privacy than direct or U.S. corporate ownership and may help the owner avoid  U.S. estate taxes.  When the corporation owns real estate, the seller must be able to prove less than 5 percent ownership over the preceding 5-year period in order to avoid FIRPTA withholding.