Limited Liability Corporations and Foreign Investment in California Real Estate.
There is some exciting news for foreign investors due to recent geo-political developments and the emergence of several financial factors. At its core, this coalescence of events has the major drop in the price of US real estate, combined with the exodus of capital from Russia and China. Among foreign investors, this has suddenly and significantly produced a demand for real estate in California.
Our research shows that China alone spent $22 billion on U.S. housing in the last 12 months, much more than they spent the year before. Chinese, in particular, have a great advantage driven by their strong domestic economy, a stable exchange rate, increased access to credit, and desire for diversification and secure investments.
We can cite several reasons for this rise in demand for US Real Estate by foreign Investors. Still, the primary attraction is the global recognition that the United States is currently enjoying an economy that is growing relative to other developed nations. Couple that growth and stability because the US has a transparent legal system that creates an easy avenue for non-U.S. citizens to invest.
What we have is a perfect alignment of both timing and financial law… creating prime opportunity! The US also imposes no currency controls, making it easy to divest, making the prospect of Investment in US Real Estate even more attractive.
Here, we provide a few facts that will be useful for those considering an investment in Real Estate in the US and Califonia in particular. We will take the sometimes difficult language of these topics and attempt to make them easy to understand.
This article will touch briefly on some of the following topics: Taxation of foreign entities and international investors. U.S. trade or business taxation of U.S. entities and individuals. Effectively connected income. Non-effectively connected income. Branch Profits Tax. Tax on excess interest. U.S. withholding tax on payments made to the foreign investor. Foreign corporations.
Partnerships. Real Estate Investment Trusts. Treaty protection from taxation. Branch Profits Tax Interest income. Business profits. Income from real property. Capital gains and third-country use of treaties/limitation on benefits.
We will also briefly highlight dispositions of U.S. real estate investments, including U.S. real property interests, the definition of a U.S. real property holding corporation “USRPHC,” U.S. tax consequences of investing in United States Real Property Interests ” USRPIs” through foreign corporations, Foreign Investment Real Property Tax Act “FIRPTA” withholding and withholding exceptions.
Non-U.S. citizens choose to invest in US real estate for many different reasons, and they will have a diverse range of aims and goals. Many will want to insure that all processes are handled quickly, expeditiously, and correctly and privately, and in some cases, with complete anonymity. Secondly, the issue of privacy regarding your investment is critical. With the rise of the internet, private information is becoming more and more public. Although you may be required to reveal information for tax purposes, you are not required, and should not, disclose property ownership for all the world to see.
One purpose for privacy is legitimate asset protection from questionable creditor claims or lawsuits. Generally, the fewer individuals, businesses, or government agencies know about your private affairs, the better.
Reducing taxes on your U.S. investments is also a major consideration. When investing in U.S. real estate, one must consider whether the property is income-producing and whether or not that income is ‘passive income’ or income produced by trade or business. Another concern, especially for older investors, is whether the investor is a U.S. resident for estate tax purposes.
The purpose of an LLC, Corporation or Limited Partnership is to form a shield of protection between you personally for any liability arising from the entity’s activities. LLCs offer greater structuring flexibility and better creditor protection than limited partnerships and are generally preferred over corporations for holding smaller real estate properties. LLC’s aren’t subject to the record-keeping formalities that corporations are.
If an investor uses a corporation or an LLC to hold real property, the entity will have to register with the California Secretary of State. In doing so, articles of incorporation or the statement of information become visible to the world, including the identity of the corporate officers and directors or the LLC manager.
A great example is the formation of a two-tier structure to help protect you by creating a California LLC to own the real estate and a Delaware LLC to act as the manager of the California LLC. The benefits of using this two-tier structure are simple and effective, but one must be precise in implementing this strategy.
In the state of Delaware, the name of the LLC manager is not required to be disclosed. Subsequently, the only proprietary information on the California form is the name of the Delaware LLC as the manager. Great care is exercised so that the Delaware LLC is not deemed to be doing business in California. This perfectly legal technical loophole is one of many great tools for acquiring Real Estate with minimal Tax and other liability.
Regarding using a trust to hold real property, the actual name of the trustee and the name of the trust must appear on the recorded deed. Accordingly, If using a trust, the investor might not want to be the trustee, and the trust need not include the investor’s name. To insure privacy, a generic name can be used for the entity.
In the case of any real estate investment that happens to be encumbered by debt, the borrower’s name will appear on the recorded deed of trust, even if the title is taken in the name of a trust or an LLC. But when the investor personally guarantees the loan by acting AS the borrower through the trust entity, THEN the borrower’s name may be kept private! At this point, the Trust entity becomes the borrower and the owner of the property. This insures that the investor’s name does not appear on any recorded documents.
Because formalities, like holding annual meetings of shareholders and maintaining annual minutes, are not required in limited partnerships and LLCs, they are often preferred over corporations. Failing to observe corporate formalities can lead to the failure of the liability shield between the individual investor and the corporation. This failure in legal terms is called “piercing the corporate veil.”
Limited partnerships and LLCs may create a more effective asset protection stronghold than corporations because interests and assets may be more difficult to reach by creditors to the investor.
To illustrate this, let’s assume an individual in a corporation owns, say, an apartment complex, and this corporation receives a judgment against it by a creditor. The creditor can now force the debtor to turn over the corporation’s stock, resulting in a devastating loss of corporate assets.
However, when the debtor owns the apartment building through either a Limited Partnership or an LLC, the creditor’s recourse is limited to a simple charging order, which places a lien on distributions from the LLC or limited partnership. Still, it keeps the creditor from seizing partnership assets and keeps the creditor out of the affairs of the LLC or Partnership.
Income Taxation of Real Estate
For Federal Income tax purposes, a foreigner is referred to as a nonresident alien (NRA). An NRA can be defined as a foreign corporation or a person who either;
A) Physically is present in the United States for less than 183 days in any given year. B) Physically is present less than 31 days in the current year. C) Physically is present for less than 183 total days for a three-year period (using a weighing formula) and does not hold a green card.
The applicable Income tax rules associated with NRAs can be quite complex. Still, as a general rule, the income that IS subject to withholding is a 30 percent flat tax on “fixed or determinable” – “annual or periodical” (FDAP) income (originating in the US), that is not effectively connected to a U.S. trade or business that is subject to withholding. Important point there, which we will address momentarily.
Any applicable treaties may reduce tax rates imposed on NRAs, and the Gross income is what gets taxed with almost not offsetting deductions. So here, we need to address exactly what FDAP income includes. FDAP is considered to include; interest, dividends, royalties, and rents.
Simply put, NRAs are subject to a 30 percent tax when receiving interest income from U.S. sources. Included within the definitions of FDAP are some miscellaneous categories of income such as; annuity payments, certain insurance premiums, gambling winnings, and alimony.
However, capital gains from U.S. sources are generally not taxable unless A)The NRA is present in the United States for more than 183 days. B) The gains can be effectively connected to a U.S. trade or business. C) The gains are from selling certain timber, coal, or domestic iron ore assets.
NRA’s can and will be taxed on capital gains (originating in the US) at the rate of 30 percent when these exceptions apply. Because NRA’s are taxed on income in the same manner as US taxpayers when that income can effectively be connected to a US trade or business, it becomes necessary to define what constitutes; “U.S. trade or business” and to what “effectively connected” means. This is where we can limit the taxable liability.
There are several ways in which the US defines “US trade or Business,” but there is no set and specific code definition.
The term “US Trade or Business” can be seen as selling products in the United States (either directly or through an agent), soliciting orders for merchandise from the US and those goods out of the US, providing personal services in the United States, manufacturing, maintaining a retail store, and maintaining corporate offices in the United States. Conversely, there are precise and complex definitions for “effectively connected” involving the “force of attraction” and “asset-use” rules, as well as “business-activities” tests.
Generally and for simplistic explanation, an NRA is “effectively connected” if they are engaged as a General or limited partner in a U.S. trade or business. Similarly, if the estate or trust is so engaged in trade or business, any beneficiary of said trust or estate is also engaged.
For real estate, the nature of the rental income becomes a critical concern. The Real Estate becomes passive if generated by a triple-net lease or from the lease of unimproved land. When held in this manner and considered passive, the rental income is taxed on a gross basis, at a flat rate of 30 percent with applicable withholding and no deductions.
Investors should consider electing to treat their passive real property income as income from a U.S. trade or business. The nature of this holding and loss of deduction inherent therein is often tax prohibited. However, the election can only be made if the property is generating income.
If the NRA owns or invests in or owns unimproved land that will be developed in the future, they should consider leasing the land. This is a great way to generate income. Investment in income-generating allows the NRA to claim deductions from the property and generate a loss carry-forward that will offset income in future years.
We can use many tools to assist our NRA clients in avoiding taxation on Real Estate income property, one of which is ‘portfolio interest,’ which is payable only on a debt instrument and not subject to taxation or withholding. There are several ways to fit within the confines of these ‘portfolio interest’ rules. NRAs can participate in the practice of lending through equity participation loans or loans with equity kickers.
An equity kicker is like a loan that allows the lender to participate in equity appreciation. Allowing the lender to convert debt into equity in the form of a conversion option is one way that this can be accomplished, as these provisions usually increase interest rates on a contingent basis to mimic equity participation.
There are two tax levels applicable to a foreign individual or a foreign corporation that owns a U.S. corporation.
The U.S. corporation will be subject to a 30 percent withholding tax on its profits when the income is not re-invested in the United States. There will be a tax on dividends paid to the foreign shareholders when a foreign corporation owns the U.S. business, whether directly or through a disregarded entity or a pass-through entity. The branch profits tax replicates the double tax.
The U.S. has treaties covering the ‘branch profits tax’ with most European nations, reducing the tax to between 5 and 10 percent. The 30 percent tax is onerous, as it applies to a “dividend equivalent amount,” which is the corporation’s effectively connected earnings and profits for the year, fewer investments the corporation makes in its U.S. assets (money and adjusted bases of property connected with the conduct of a U.S. trade or business). The tax is imposed even if there is no distribution.
Foreign corporations are taxed on their effectively connected income and on any deemed dividends, which are any profits not reinvested in the United States under the branch profits tax.
The rules applicable to the tax on the disposition of real estate are found in a separate regime known as the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA).
Generally, FIRTPA taxes NRA’s holdings of U.S. real property interest (USRPI) as if they were engaged in a U.S. trade or business. As mentioned earlier, this means that the traditional income tax rules that apply to U.S. taxpayers will also apply to the NRA. Obligation to withhold 10 percent of the amount realized on any disposition falls on purchasers who acquire a USRPI from an NRA.
Ownership and interests of Real Estate Property include fee ownership, co-ownership, leasehold, timeshare, a life estate, a remainder, a reversion, or a right to participate in the appreciation of real property or the profits from real property.
For purposes of definition, interest in real property would include any ownership of personal property used to exploit natural resources, land, buildings, mineral deposits, crops, fixtures, operations to construct improvements, the operation of a lodging facility, or providing a furnished office to a tenant (including movable walls or furnishings) as well as Improvements, leaseholds, or options to acquire any of the above.
There are several ways in which a partnership interest is treated as a USRPI: A domestic corporation will be treated as a U.S. real property holding corporation (USRPHC) if USRPIs are equal to or exceed 50 percent of the sum of the corporation’s assets. OR when 50 percent or more of the value of the gross partnership assets consists of USRPIs – Or when 50 percent or more of the value of partnership gross assets consist of USRPIs plus cash and cash equivalents.
The disposition of partnership interest will be subject to FIRPTA. To the extent that such partnership continues to own USRPIs, they will remain subject to this withholding.
The good news is that an interest in a USRPHC is subject to the FIRPTA tax and withholding but is not subject to state income tax. There is an obvious benefit when compared with the disposition of a USRPI owned directly. USRPI, which is owned directly, is subject to the lower federal capital gains and state income tax rates.
If, however, on the disposition date, the corporation had no USRPIs and the totality of the gain was fully recognized (no installment sales or exchanges) on the sale of any USRPIs sold within the past five years. This disposition cannot be subject to these rules.
Any USRPI sold by an NRA (individual or corporation) will be subject to 10 percent withholding of the amount realized. Withholding applies even if the property is sold at a loss.
The purchaser must report the withholding and pay over the tax using Form 8288 within 20 days of the purchase. This is to be duly noted because if the purchaser fails to collect the withholding tax from the foreigner, the purchaser will be liable for the tax and any applicable penalties and interest. The withheld taxes are later credited against the total tax liability of the foreigner.
Instances wherein withholding is not required are the following:
The seller provides a certificate of non-foreign status. Property acquired by the purchaser is not a USRPI. The transferred property is the stock of a domestic corporation, and the corporation provides a certificate that it is not a USRPHC.
The USRPI acquired will be used by the purchaser as a residence, and the amount realized by the foreigner on the disposition is $300,000 or less. The disposition is not subject to tax, or the amount realized by the foreigner on the disposition is zero.
Estate and Gift Tax: In determining who is an NRA and excluded, the test is completely different for estate tax purposes. The focus of inquiry will center around the decedent’s residence. This test is very subjective and focuses primarily on intent. The test considers factors from across the board, such as how long the NRA has been in the United States, how often they travel, and the size and cost of a home in the United States. The test will also look at the location of NRA’s family, their participation in community activities, participation in U.S. business, and ownership of assets in the United States. Voting is also taken into consideration.
A foreigner can be a U.S. resident for income tax purposes but not be domiciled for estate tax purposes. An NRA, whether a nonresident alien or non-domiciliary, will be subject to different transfer taxes (estate and gift taxes) than a U.S. taxpayer. Only the gross part of the NRA’s Estate situated in the United States will be taxed with the estate tax at the time of death. Although NRA’s estate tax rate will be the same as that imposed on U.S. citizens and resident aliens, the unified credit is only $13,000 (equivalent to about $60,000 of property value).
Any existing estate tax treaty may ameliorate these. European countries, Australia, and Japan enjoy these treaties; The U.S. does not maintain as many estate tax treaties as income tax treaties.
The IRC defines the following property as situated in the United States: A) Shares of stock of a U.S. corporation. B) Revocable transfers or transfers within three years of the death of U.S. property or transfers with a retained interest (described in IRC Sections 2035 to 2038). C) Debt issued by a U.S. person or a governmental entity within the United States (e.g., municipal bonds).
Real estate in the United States is considered U.S. property when it is physical personal property such as works of art, furniture, cars, and currency. Debt, however, is ignored if it is recourse debt, but gross value is included, not just equity. U.S.-situs property is also a US property if it is a beneficial interest in a trust holding. Life insurance is NOT included as U.S.-situs property.
The estate tax returns must disclose all of the NRA’s worldwide assets to determine the ratio that the U.S. assets bear to non-U.S. assets. The gross estate is reduced by various deductions relating to the U.S.-situs property. This ratio determines the percentage of allowable deductions that may be claimed against the gross estate.
As mentioned earlier, when real estate is subject to a recourse mortgage, the gross value of the real estate is included, offset by the mortgage debt. This distinction is relevant for NRAs whose debts are subject to apportionment between U.S. and non-U.S. assets and, therefore, not fully deductible.
Accurate planning is crucial. Let us illustrate: An NRA can own US property through a foreign corporation, and this property is not included in the NRA’s estate. This means that the US Real property owned by the NRA has now effectively been converted into a non-U.S. intangible asset.
And with Real Estate that was not initially acquired through a foreign corporation, you can still avoid future taxation to the estate by paying an income tax today to transfer the real estate to a foreign corporation (usually treated as a sale).
An NRA donor is not subject to U.S. gift taxes on any gifts of non-U.S. situs property gifted to any person, including U.S. citizens and residents. Gift taxes are imposed on the donor. Gifts from an NRA of more than $100,000 must be reported on Form 3520.46 by citizens and residents. However, Gifts of U.S.-situs assets are subject to gift taxes, except intangibles, which are not taxable.
If it is physically located in the United States, tangible personal property and real property are sited within the United States. The lifetime unified credit is not available to NRA donors, but NRA donors are allowed the same annual gift tax exclusion as other taxpayers. NRA’s are also subject to the same rate schedule for gift taxes.
The primary thrust of estate tax planning for NRAs is through the use of foreign corporations to own U.S. assets and the gift tax exemption for intangibles to remove assets from the United States. The corporation must have a business purpose and activity, lest it is deemed a sham designed to avoid U.S. estate taxes. If the NRA dies owning shares of stock in a foreign corporation, the shares are not included in the NRA’s estate, regardless of the corporation’s assets.
Let us break this down into one easy to read and understand paragraph:
In a nutshell, shares in U.S. corporations and interests in partnerships or LLCs are intangibles. The gift of an intangible, wherever situated, by an NRA is not subject to the gift tax. Consequently, real estate owned by the NRA through a U.S. corporation, partnership, or LLC may be removed from the NRA’s U.S. estate by gifting entity interests to foreign relatives.
Ownership Structures: Here, we discuss the ownership architectures under which NRA’s can acquire Real Estate. OF COURSE, the NRA’s personal goals and priorities dictate the type of architecture used. There are advantages and disadvantages to each of these alternatives. Direct investment, for example, (real estate owned by the NRA) is simple and is subject to only one level of tax on the disposition.
The sale is taxed at a 15 percent rate If the real estate is held for one year. There are many disadvantages to the direct investment approach, a few of which are: no privacy, no liability protection, the obligation to file U.S. income tax returns, and if the NRA dies while owning the property, their estate is subject to U.S. estate taxes.
When an NRA acquires the real estate through an LLC or an LP, this is considered an LLC or a limited partnership structure. This structure provides the NRA with privacy and liability protection and allows for lifetime transfers that escape the gift tax. However, the obligation to file U.S. income tax returns and the possibility for U.S. estate tax on death remain.
Ownership of real estate through a domestic corporation will afford privacy and liability protection, obviate the foreigner’s need to file individual U.S. income tax returns, and allow lifetime gift tax-free transfers. *this refers to a C corporation since a foreign shareholder precludes an S corporation.
Ownership of stock will not trigger a return filing obligation, unlike engaging in a U.S. trade or business which requires a U.S. tax return.
Ownership of real estate through a domestic corporation has three disadvantages: Federal and state corporate income tax will add a second layer of tax at the corporate level. Dividends from the domestic corporation to its foreign shareholder will be subject to 30 percent withholding. Shares of the domestic corporation will be included in the U.S. estate of the foreign shareholder.
Furthermore, the foreign shareholder will be subject to FIRPTA because the corporation will be treated as a USRPHC (upon the disposition of the stock in the corporation). The purchaser of the shares has then required the file of a U.S. income tax return with 10 percent tax withholding. Actual ownership of the real estate may be held by the U.S. corporation directly or by a disregarded entity owned by the corporation or through a U.S. partnership. An LLC that chooses to be taxed as a corporation can also be the corporation.
There are several advantages to foreign corporation ownership:
Liability protection– There is no U.S. income tax or filing requirement for foreign shareholders. Shares in the foreign corporation are non-U.S. assets not included in the U.S. estate.
Dividends are not subject to U.S. withholding. There is no tax or filing requirement on the disposition of the stock. There is no gift tax on the transfer of those shares of stock.
Disadvantages of using the foreign corporation: A) Like with the domestic corporation, corporate-level taxes will be corporate level because the foreign corporation will be deemed engaged in a U.S. trade or business. B) The largest disadvantage of ownership of U.S. real estate through a foreign corporation would be that the foreign corporation will be subject to the branch profits tax.
One of the most advantageous structures for ownership of U.S. real estate by NRAs is a hybrid foreign and U.S. corporation. It runs like this: The NRA owns a foreign corporation that in turn owns a U.S. LLC taxed as a corporation. The benefits to this type of structure are paramount to a good tax shield and offer: privacy and liability protection, escaping U.S. individual income tax filing requirements, and it also avoids U.S. estate taxes. On top of that, it allows for gift tax-free lifetime transfers and avoids the branch profits tax.
The beauty and benefit of this are that the timing and the amount of this dividend are within the NRA’s control even though distributions from the U.S. subsidiary to the foreign parent are subject to the 30 percent FDAP withholding.
There are many things to consider and several structures available to limit tax liability, preserve and protect anonymity and increase profits of US Real Estate investments by foreign investors. We must keep in mind that each investment presents its own challenges, and no structure is perfect. Advantages and disadvantages abound, which will require a tailored analysis in light of the individual or group objectives.
It’s really about implementing a structure that will successfully carry the NRA through to their END GAME, with the utmost protection from liability and the maximum return on investment.
Source by Jeffrey A Cancilla