Tax Secrets for International Investment in United States Real Estate
Without knowing a few structuring tricks, international investment in United States real estate can lead to steep income, inheritance and withholding taxes, and can also lead to additional interest and penalties. However, structured properly, income tax can be minimized and inheritance and withholding taxes can be eliminated entirely. Additionally, under recently enacted legislation providing incentives for investment in “opportunity zones,” tax on certain gains can be deferred and tax on new gains can be eliminated entirely.[1]
Unless altered by a U.S. tax treaty, a non-U.S. individual investing in U.S. real estate would be subject to withholding tax on rental income and distributions made outside the U.S., additional withholding tax on the sale of the property, U.S. income tax on rents, and U.S. inheritance tax upon the transfer of the property after death. To minimize and avoid these consequences, the most common vehicle is what is known as a “blocker” structure.
This structure involves creating a U.S. corporation to hold the U.S. property. This is referred to as the “Blocker Corp” because it is used to block withholding and inheritance tax. The U.S. Blocker Corp typically has two classes of stock, voting stock owned by a friendly, but not “related” person, and non-voting stock owned by a non-U.S. corporation, or other forms of an entity organized outside the U.S.
The non-U.S. entity is owned by a foreign investor or investors desiring to invest in U.S. real estate. The stock of the non-U.S. entity that owns the U.S. Blocker Corp will not be treated as U.S. property for purposes of U.S. inheritance tax. Therefore, if this structure is used, the death of a foreign investor will not trigger U.S. inheritance tax.
While the U.S. Blocker Corp pays tax on its income, including rents received and gains from sale of property, once the U.S. Blocker Corp has liquidated its investments in U.S. real property, the disposition of stock after the property is sold is not treated as a sale of real property, but is instead treated as a sale of an investment security. It is, therefore, not subject to capital gains tax, unless modified by treaty between the U.S. and the investor’s country of residence.
In addition, by funding the U.S. Blocker Corp. with equity and a debt instrument, interest paid on the debt instrument can be deductible to the U.S. Blocker Corp against its rental income and exempt from U.S. income tax or withholding tax to the non-U.S. investor receiving the interest payments, unless such tax is imposed by the treaty.
This blocker structure has become increasingly popular as a result of tax reforms in the United States, which reduced the U.S. corporate tax rate from 35 percent to 21 percent. When real property is sold, the U.S. Blocker Corp will pay tax on the gain realized unless it timely reinvests in other U.S. real property, but the investors can avoid withholding and inheritance taxes and minimize the income tax that would otherwise apply.
By layering in investment in U.S. real estate located in an “opportunity zone,” foreign investors can achieve even greater tax incentives. A Qualified Opportunity Zone (“QO Zone”) is a low-income area that has been designated by a State and approved by the Secretary of the U.S. Treasury (the “Secretary”). The Secretary has approved QO Zones in all states and each of the U.S. territories. Those investing in QO Zones can defer tax on gains that are reinvested in QO Zones, eliminate up to 15 percent of the tax on the gain reinvested, and eliminate the U.S. tax on any gain from the investment in the QO Zones.
Assume the U.S. Blocker Corp invests a $1,000,000 gain (i.e. from the sale of an initial U.S. investment) in QO Zone property in 2019 and sells the investment in 2029 for $3,000,000. The U.S. Blocker Corp defers the capital gains tax on the original investment until December 31, 2026, and because the U.S. Blocker Corp will have held the QO Zone investment for more than seven years, the U.S. Blocker Corp’s basis in the deferred gain is increased to $150,000 (15 percent of the deferred amount). Accordingly, the U.S. Blocker Corp only recognizes a gain of $850,000 ($1,000,000 deferred gain – $150,000 step-up in basis). Even though the U.S. Blocker Corp must recognize this gain by December 31, 2026, the U.S. Blocker Corp can continue to hold the investment in the QO Zone property beyond that date. When the U.S. Blocker Corp sells the investment for $3,000,000 in 2029, the additional $2,000,000 gain from the investment in the QO Zone property will not be subject to U.S. income tax as long as the U.S. Blocker Corp held the qualified investment (and complied with all the QO Zone requirements) for ten years. The U.S. Blocker Corp thus pay taxes on only $850,000 (resulting in total taxes paid of $178,500 based on the 21% U.S. corporate tax rate) of the total $3,000,000 gain (equivalent to less than a 6% tax rate), and as discussed above, when the U.S. Blocker Corp is liquidated, distribution of the investment and gains back to the non-U.S. investor will not result in further U.S. tax.
[1] Robert W. Blanchard ([email protected]) and Jordan E. Ondatje ([email protected]) are attorneys with the firm of Blanchard, Krasner & French (www.bkflaw.com), based in California, USA, and members of IR Global (www.irglobal.com).
[2] This article only addresses U.S. federal tax and not state or local taxes that could apply.
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