Blanchard, Krasner & French- “Investments in U.S. Real Property by Non-Resident, Non-U.S. Persons”
Authored by Robert W. Blanchard
The perceived economic and political stability of the United States has attracted foreign investment capital to the real estate markets. Recent declines in the value of the dollar compared to the pound, euro, and other foreign currencies has made U.S. real estate even more attractive. However, unlike the U.S. tax laws that are favorable for foreign investment in U.S. securities and bond markets, the United States does tax investments by foreign persons in U.S. real property and has enacted many anti-abuse statutes designed to make sure the tax gets collected.
The U.S. taxes both operating income derived from, and gains on sale of, U.S. real property to foreign persons at rates comparable to rates applicable to U.S. persons. In addition, to ensure that such tax is collected, withholding taxes apply to any distributions of operating income to foreign persons at the time the distribution is made (and in some cases when earned whether or not distributed) and to the proceeds from the sale of any U.S. real property or interest in a U.S. real property holding company at the time real property is disposed of or the interest in the real property holding company is disposed of. This withholding tax on disposition is generally calculated based on the gross selling price rather than net income and can often far exceed the tax due.
When real estate investments generate taxable income, foreign persons entitled to receive that income, whether directly from an investment in real property or through holding interests in United States partnerships or limited liability companies owning U.S. real property, must obtain U.S. Taxpayer Identification Numbers and file annual tax returns with the United States Government. It has been our experience that few non-U.S. investors are willing to file to obtain U.S. Taxpayer Identification Numbers or file U.S. tax returns, which under treaties are often shared with other foreign governments.
In addition to income tax from ownership of U.S. real property, if a foreign individual dies while holding U.S. real property or an interest in a U.S. partnership or limited liability company, the value of that investment is subject to United States inheritance tax and the exclusion from tax generally applicable to U.S. persons does not apply to non-resident foreign persons. As a consequence, inheritance tax up to forty-five percent (45%) may be imposed on the death of a foreign person owning U.S. real property, directly or indirectly through partnerships or limited liability companies.
As a result of the United States tax environment, various structures have been developed to eliminate the risk of paying inheritance tax, reduce the applicability of the withholding requirements, and minimize, to the extent possible, the amount of tax paid. With any investment structure there are advantages and disadvantages, which must be weighed against each other. In our experience, the most popular structure has been for a foreign investor or group of foreign investors to invest in a corporation in a tax-haven jurisdiction such as the British Virgin Islands (“Offshore Corp”). The Offshore Corp then organizes one or more U.S. corporations which own the investments in U.S. real property or interests in U.S. partnerships or limited liability companies. These U.S. corporations report and pay tax on their U.S. real estate investment activity. However, when the real estate investments are liquidated, in general, the U.S. corporations can be liquidated and the net proceeds from the investment paid back to the Offshore Corp for distribution to the non-U.S. investors free from withholding or income tax in the United States. The investment of the Offshore Corp in the U.S. real estate holding companies is often structured as part equity and part debt allowing for some repayment of investment capital without withholding taxes prior to liquidation of investments. The tax impact of using both equity and debt in the capital structure is complex and depends upon the nature of the foreign investors. Ownership interests in the Offshore Corp by non-U.S. persons are not subject to U.S. inheritance tax.
This structure may not be appropriate for all non-U.S. persons, particularly those residing in countries that impose penalties for investment in tax-haven jurisdictions. It is also not the only structure available. However, in our experience this structure has been relatively simple to set up, understand and unwind when the time comes.
This firm is happy to assist foreign investors in structuring their U.S. investments.