U.S. tax rates and filing obligations associated with owning and selling U.S. real estate can vary widely depending on the structure and jurisdiction of the owners of such U.S. real estate. When considering an investment in U.S. real estate, a foreign person should consider the opportunities and risks inherent to the ownership structures summarized below.
A. Direct Ownership by Foreign Individual
In the simplest structure, a foreign individual would simply own his or her U.S. real estate, in such person's individual capacity.
As a result of their ownership of U.S. real estate, foreign individuals may receive rental or similar payments over the course of each taxable year. If a foreign individual is not engaged in a U.S. trade or business, and does not otherwise file U.S. tax returns, he or she will likely pay taxes (through withholding, at 30% rates) on the gross income paid to such individual. Alternatively, a foreign individual could elect to file tax returns in the U.S., as though such individual were engaged in a U.S. trade or business, and pay taxes on the net income associated with the real estate (i.e. utilize applicable tax deductions) at the graduated tax rates applicable to U.S. persons.
The favorable capital gains tax rate (currently 15%) may apply on the net income received in a foreign individual's sale of his or her U.S. real estate, assuming the holding period is satisfied and the income is not otherwise subject to depreciation recapture. Special rules under the Foreign Investment in Real Property Tax Act (FIRPTA) apply when U.S. real estate (or an interest in U.S. real estate) is transferred by a foreign individual or corporation. Under the FIRPTA rules, a 10% gross withholding tax will ordinarily apply to the sale proceeds, but a foreign individual will be eligible to claim a refund on his or her U.S. tax return in the event the 10% withheld exceeds the actual tax due.
U.S. estate tax laws will also likely require taxation on the value of a foreign individual's U.S. real estate in the event such individual dies while owning U.S. real estate.
B. Ownership by Foreign Individual through U.S. LLC
In a slightly more advantageous, but perhaps more expensive, structure, a foreign individual can own his or her U.S. real estate through a U.S. Limited Liability Company (LLC).
The main benefit of owning through a U.S. LLC is the "limited liability" that such ownership structure offers. If a legal liability arises with respect to U.S. real estate owned by an LLC, in nearly all cases, the liability will not extend to an owner of the LLC (i.e. the foreign individual). Shielding personal assets of a foreign individual can be critical depending on the type of U.S. real estate owned and the extent of such foreign individual's assets.
The income tax rates and rules applicable to individuals, discussed above (including the FIRPTA rules), will in most cases apply to a foreign individual holding ownership through a U.S. LLC. Absent an election to be taxed as a corporation, if a U.S. LLC has just one owner it is disregarded for U.S. tax purposes, and if it has multiple owners it is taxed as a partnership. The compliance burden and expense can become noteworthy because a U.S. LLC may have a tax withholding and filing obligation on top of the filing obligation of a foreign owner of that LLC. In addition, California charges LLCs an annual fee based on gross receipts.
It is commonly believed that U.S. estate tax laws will require taxation on a foreign individual's ownership of interests in U.S. LLCs, as such interests are considered "US situs property." Whether similar rules would require U.S. estate taxation of interests of a foreign LLC owning U.S. real estate is debatable. Some practitioners believe that using a foreign LLC can allow a foreign individual to harness the benefit of the preferential rate on capital gains and also avoid death taxes on the basis that the foreign LLC interests are foreign situs intangible property not subject to U.S. estate tax.
It should also be noted that U.S. LLCs are often treated as corporations by foreign taxing authorities, and the mismatch in classification can create a mismatch in income taxation between the U.S. and the foreign country in any given year.
C. Ownership by Foreign Individual through Foreign Corporation
In a structure that has obvious advantages and disadvantages, a foreign individual can own his or her U.S. real estate through a Foreign Corporation (FC).
The three major benefits of ownership through an FC are as follows: (i) a foreign individual will have limited liability as discussed above, (ii) the U.S. tax filing obligations fall on an FC and not on its owners (i.e. no individual tax returns filed by a foreign individual), and (iii) the U.S. estate tax laws will not treat an interest in a foreign corporation as U.S. situs property and a foreign individual should avoid U.S. estate tax with respect to his or her U.S. real estate.
A significant disadvantage of ownership through an FC is that an FC is not entitled to the benefit of favorable capital gains tax rates on disposition of U.S. real estate (discussed above). Instead such a disposition would be taxed at corporate tax rates (approx. 35%) under the FIRPTA rules (which can become increasingly complex when foreign entities are added to the equation). In addition, unless exempted by treaty, the repatriated income of a FC is subject to a US branch profits tax.
D. Ownership by Foreign Individual through Foreign Corporation and U.S. LLC or Corporation
For reasons discussed below, a foreign individual may choose to own his or her U.S. real estate in a double entity structure.
When investing in an existing or newly created U.S. real estate fund, a foreign individual may be advised that the U.S. real estate will be owned by a U.S. LLC. Without any ability to change the U.S. structure, a foreign individual may want to acquire his or her interest in the U.S. LLC through an FC. Here the foreign individual trades the beneficial capital gains rates to both (i) avoid filing individual tax returns in the U.S. and (ii) eliminate the risk of U.S. estate tax. A foreign individual in this double entity structure will also have double the limited liability protection. Two entities will increase costs, but otherwise, the description above for investment through a foreign corporation should apply to this double entity structure.
Aside from the U.S. tax implications discussed in each of the structures above, the foreign individual should consider the taxes of his or her home country that may be applicable to his or her ownership and sale of U.S. real estate, as well as the effect of treaties. For example, some countries may tax LLCs as corporations under foreign law, which may have significant implications in structures that rely on treaty exemptions from withholding tax.