[Transcript] Foreign Investment in U.S. Real Estate

 

Foreign investment in us real estateArthur Rinsky:

Okay. I wanted to welcome you all to the Royse Law Foreign Investment in U.S. Real Estate webinar. We have on our panel Dave Spence who has his Masters in tax and also teaches at the Masters in tax program at San Jose State and heads up the estate planning practice at the Royse Law Firm. Mark Mullin, who did the lion’s share of work on the slides, did a lot of excellent work on them. Recent graduate of NYU’s Masters in tax program in 2015. And finally, I’m Art Rinsky, and I’ve been a tax lawyer 42 years, and as I joke with Mark, I graduated from NYU so long ago Abe Lincoln was president.

So, we don’t have a lot of time so let’s kind of go through an overview of what we’re going to try to talk about in the hour that we have. Number one is self-explanatory. The importance of investing in real estate by foreigners particularly in California because the property tends to appreciate. And then, in this outline, these are the topics we’re going to try to cover. The relevant basics in terms of reporting. The really two global issues that we’re dealing with is the federal income tax that can go as high as 40% and we have a federal estate tax and gift tax that can also go as high as 40%. And a lot of the planning and issues that you’ll hear discussed today relate to how you dance around or minimalize those particular taxes

There are then relevant entity issues in avoiding or minimizing those taxes. FIRPTA, which is the … was passed I think in the mid-80s to deal with investment by foreigners in real estate to try to get some of the revenue that foreigners were earning from engaging in owning and investing in U.S. real estate.

And there are the federal transfer tax considerations, which as I mentioned with the rate of 40%, you need to pay strict attention to them in terms of gift and estate planning.

Then we’re going to try to tie it all together. Mark will go through some different planning techniques you might want to try. A quick look at the California state and local tax issues and then some takeaways at the end where we’ll try to tie it together.

So as a background, you can look at slides three and four. They give you the kind of the size of the market, why foreigners invest in U.S. real estate. These are not tax-driven, they’re simply economic issues. And in the United States, the tax regime is very important in terms of how you own and deal with real estate. It’s very, very tax-driven and if you don’t plan for it properly, one doesn’t plan for it properly, you can end up tripping into the 40% income tax or tripping into the 40% estate and gift tax, and that leaves a lot of money on the table. And then, of course, it has a significant impact on the yields you get from your investment.

So, let’s see, now we’re on the slide … let’s go to slide eight. This is kind of some background in terms of U.S. income tax, generally. The individual rates for federal, these are all federal tax rates, range between 10 and 39.6 plus there’s also the self-employment tax or net investment, NIIT tax, which may apply. There are reduced rates on long-term capital gains that if you’re a U.S. resident, it probably puts you at about a 25% net rate taking into account the net investment income tax, NIIT tax. Corporate rates, U.S. federal again, range between 15 and 35%. There is no rate differential for long-term capital gains for corporations. They pay at a constant rate.

Our U.S. international tax rules are that … sit at the bottom of slide eight. U.S. taxpayers are taxed on their worldwide income, and this doesn’t mean U.S. taxpayer, it doesn’t necessarily mean you’re a citizen. If you’re a green card holder, if you’re a resident, we’re going to tax you on your worldwide income. Foreign taxpayers are taxed in certain circumstances on certain U.S. related income.

I briefly mentioned this net investment income tax. This is a 3.8% tax that’s of concern to U.S. residents, but if you’re a non-resident alien, you don’t have a presence in the U.S., you can probably avoid being liable for these two taxes. I guess somebody had a good lobbyist on this one.

Now the basic structure for international tax for foreigners as it relates particularly to real estate I guess in, a sense, that this is the subject today. Number one, we have what the concept of what’s called effectively connected income. That is income connected with a U.S. trade or business. Or if you have a permanent establishment under a treaty. And the tax is a rate, it was noted earlier, up to 39.6%. What exactly is a trade or business? It’s a factual question, and there’s all kind of litigation on the issue, and it’s very, very fact-specific. It’s a lot of time difficult to tie down to bright-line what is a trade or business. Obviously, if you’re selling thousands of computers, that’s a business. But when you’re holding real estate, and you want the property, that gets a little more dicey in terms of is it a trade or business or not.

If they don’t get the non-resident alien under the ECI regime, we have another part of the internal revenue code that’s called FDAP, fixed, determinable, annual, or periodic income. This is income that’s from rents, royalties, interest, all these types of fixed income that aren’t necessarily tied to business activity. There’s a flat 30% withholding rate on that income that may be reduced by a treaty. It doesn’t typically cover gain on sales by foreigners. Most usually of stock.

And then with respect to real property, there’s a different regime that can get you depending on how you structure your ownership. You are entitled to make an election in the internal revenue code section 871(d) to treat your real estate asset as a business and then be subject to the general reporting regime, which is generally not there because from most standpoints in U.S. real estate, there really isn’t any net income on an ongoing basis because due to shelter from interest, and depreciation, or whatnot, most real estate doesn’t end up generating net taxable income for quite a while. So even though you saw those rates, they are generally applying to zero depending upon how you have structured your purchase of the property.

There are also some significant reporting requirements. I guess that goes to slide eleven. There’s FATCA, which is really aimed at money laundering and illicit use of money, but like everything else that the treasury get an authority for, it’s broader, and they use it to try to get all kinds of information about people who are not otherwise here. There are proposed regulations under internal revenue code section 6038A that essentially treats owners of disregarded entities, these are typically wholly owned LLCs that normally are disregarded from the owner from a tax standpoint, but the treasury has decided more and more they’re not quite comfortable with that and certainly with foreign-owned disregarded entities, they’re essentially treating them like an entity that requires reporting about the owner et cetera.

And then in particular, there are reporting requirements that apply to New York City and Miami, Dade County that I understand from Mark may actually be expanded because these were apparently the principal cities where money laundering was going on, but we have so many cities I doubt that money launderers really limit themselves to those two. So all this relates to maintaining records so that you can comply with these rules.

And with that, I guess I will transfer to Dave who will now begin to address how we deal with the 40% problem.

David Spence:

Thanks, Art. So my area of interest in the law has to do primarily with transfer taxes. And these become particularly important in the cross-border scenario because under U.S. law, transfers, gratuitous transfers, meaning transfers that are not in exchange for consideration, are not considered income to the recipient. And so there is a significant opportunity for planning in particular as it relates to cross-border families and cross-border friends even. And so what we have here on this slide is just an overview of U.S. transfer taxes as they apply to non-resident, non-citizens.

And what I’d like to highlight for you here is that there are really four key components. Number one is gift tax under the U.S. taxing regime, and we’ll talk some more about that later. There is a tax on your right to give gratuitously. So it is a tax on the giver, not on the recipient. But for non-resident, non-citizens, of course, how is the United States government going to tax the giver if they don’t have a connection to the U.S.? And so the answer is that a gift of property with U.S. situs is going to be considered a taxable gift under the U.S. tax law regardless of the fact the giver is not a resident or a citizen of the U.S.

The same thing is true with respect to a bequest of the device at death. So in other words, if I am a citizen and resident of China, and I die, and I leave my assets to my children who live, fill in the blank another country, the U.S. government may in fact still tax my estate to the extent I have given assets that are considered to be U.S. situs assets. And we’ll talk more about that.

In addition to the estate or the gift tax, there is something called the generation-skipping transfer tax, which is a tax on my right to transfer to a grandchild or to an unrelated person who is more than 33 and a half years younger than me. So anyway, and that generation-skipping transfer tax is at similar rates to the gift and estate taxes. And it is an addition, so it ends up being a double tax essentially. In some cases, greater than a double tax on gifts that skip a generation.

And then the fourth row on this slide I just wanted to point out that there are special considerations for gifts to a spouse. So generally, if I want to take care of my spouse, I make a gift of property to her. Since I’m a U.S. citizen, generally there’s no gift tax on that transfer. However, for non-resident, non-citizens there can be a gift tax applicable on a transfer to a spouse to the extent that it exceeds a certain amount. In this case, $148,000 for 2016.

The most innocuous, the most simple of familial transactions can actually subject a person to a U.S. gift tax if they’re not wary.

And at this time, I think that covers our initial overview of the transfer taxes, and I’ll pass it to Mark.

Mark Mullin:

Thanks, Dave. Well, for now, I’m going to go over the relevant entity tax basics. That is the relevant entity income tax rules for holding real property as a foreigner. And then I will turn to the FIRPTA rules, which are rules that specifically apply to foreign investment in U.S. real property. And then we will return to transfer taxes with Dave.

So the very basics of entity taxation, which I’m sure most of you are familiar with, is that disregarded entities and partnerships, the owners are taxed on the income that the entity earns directly. Whereas in a C-corporation, the corporation itself pays the tax and then that money is divided to the shareholder. The shareholder pays an additional tax. Those are the basic tax regimes of the U.S. There are more specialized ones, but we will not be delving into those.

Now generally under domestic income tax rules, it’s preferable to hold your real property in a partnership. There are several advantages you get. You can get long-term capital gains rates on disposing of real property in a partnership. Not in a C-corp if you refinance, you can pull that cash out of a partnership tax-free. You can’t do that in a C-corp. And you can even flow through losses via a partnership, although there are many rules that limit your ability to do that. But that’s still better than a C-corporation where you do not have that ability at all.

About the only thing that might seem advantageous about a C-corporation is that the owners aren’t really going to be taxed during the ownership phase in a C-corporation unless you distribute dividends. Whereas in a partnership, the partners will directly be paying tax on any net income earned by the partnership, however as Art was saying earlier, real estate tends to have very little net income during the ownership phase because of the number of deductions that you will get.

It’s generally going to be preferable as an income tax matter; we will see later on in the structuring section when you might want to use a corporation instead or if you indeed will as a foreign investor.

Arthur Rinsky:

Mark, do you mind on that slide on the top on the long-term capital gains rates, just quickly refresh peoples’ memory from the earlier slides about how significantly different the rates are?

Mark Mullin:

These are big rate differentials under the federal tax. As a non-resident alien since you’re generally going to avoid the 3.8% net investment income tax, that will be about 20% on a long-term capital gain versus up to 40% under ordinary income. So this is a big differential we’re talking about.

Arthur Rinsky:

And the corporation, the best you do is 35%.

Mark Mullin:

Yes, exactly. In a corporation, you’re stuck. You don’t get that nice 15-20% savings comparing it to the corporation or an individual.

Next, we’re going to go through something that is a bit more complex, but it does have relevance to structuring as a foreign investor in U.S. real property. This is going to be the branch profits tax. The easiest way to explain this tax is to explain the hole in the system that it’s trying to patch. So under the basic corporate example in the far left, a foreign person is going to invest through a foreign corporation, which in turn owns a U.S. corporation, which in turn owns a U.S. trade or business.

Now starting from the bottom on example number one, you’ll see that the U.S. trade or business earns money. The U.S. corporation is then taxed under domestic tax rules. Then moving up, we’re going to have that U.S. corporation give a dividend to the foreign corporation and will be under that FDAP tax that Art mentioned earlier, withholding tax on that dividend. And then that foreign corporation can dividend that money to the foreign person. That’s outside the U.S. tax system.

Now, what if we did this a little bit differently and we lived in a world where there is no branch profits tax? Well moving to example number two, we have the same structure except you’ll see that there’s no U.S. corporation. There’s just kind of a transparent gray hole where the corporation was.

So starting from the bottom, while the U.S. trade or business earns income, it will be taxed under the ECI regime, which Art mentioned earlier. Then moving up, you’ll see that there is no withholding tax because there’s no U.S. corporation to pay a dividend. Then moving on up, we’re still going to be like example number one, and we’ll be outside the U.S. tax system when the foreign corporation makes a dividend.

So you can see that if there was no branch profits tax, you would prefer not to have a U.S. corporation as a foreign corporation. Foreign corporations would actually have a distinct advantage over U.S. corporations in that the second layer of tax that U.S. corporations have to face would be optional to a foreign corporation. Congress did not like this and wanted to make things even, so they invented the branch profits tax.

So the branch profits tax works like this. So we’re going to go under the example number three. It’s the same structure as example number two, but starting from the bottom. We’ll again have the foreign corporation taxed on U.S. trade or business earnings. And then moving up, there’s going to be no withholding tax, but instead right at this point is where the branch profits tax comes in to make things fair and even. What the branch profits tax does essentially is it makes a simulated corporation for dividend purposes. So it runs a calculation to determine what the dividend would have been if there was a U.S. corporation and it taxes that amount. The important thing to keep in mind for structuring foreign investment into U.S. real property is that the branch profits tax will only trigger if a foreign corporation has a net profit in a U.S. trade or business. No other kind of foreign taxpayer will run into the branch profits tax.

Arthur Rinsky:

You might also mention the strange way they compute the equivalent dividend amount in your chart.

Mark Mullin:

Yeah, it is unusual. And I put this up here because it is quite a strange thing. Basically, the dividend equivalent amount is your tax base for the branch profits tax. It equals your effectively connected earnings and profits minus your increase in U.S. net equity. So your effectively connected E&P is going to be your earnings that are considered attributable to a U.S. trade or business, and your U.S. net equity is your amount that is deemed reinvested in the U.S. trade or business at the start and end of the year. So you’re going to take the amount of reinvestment at the end of the year and subtract from that the amount of net reinvestment at the start of the year. And that’s going to be all together combined to determine your dividend equivalent amount.

Arthur Rinsky:

So the real problem with this is if you don’t invest efficiently in the U.S. business, it accelerates what would have been a dividend. You can’t control that.

Mark Mullin:

Yeah. You have less control than you do if you have a U.S. corporation because if you had a U.S corporation, you have to declare a dividend before you’re going to be taxed on that dividend. Under this system, you might just be imputed to have a dividend equivalent even though you just are holding this money and not really doing anything with it. So you have less control over the timing of your tax.

I had an additional section on trusts just to know they exist. We’re not going to go into them in this presentation really, but trusts do have a special tax system. You can use them without any real tax negative consequence if you plan correctly. And in fact, they can have some special features like they can have long-term capital gains even though the beneficiary, say a corporation, might not be able to. But we’re not going to go into them further. That’s going to be a more complex concern that we simply do not have time for.

So now I will move onto the FIRPTA and related tax rules, which are the tax rules that apply specifically to foreign investment in U.S. real property. So before FIRPTA, long ago in a magical age, a foreign person, with the right amount of planning, dispose of their U.S. real property without incurring any U.S. tax liability. There would be some ways they could fall into the U.S. tax system, but by investing through an entity, by and large, it was optional for a foreign investor to pay U.S. tax on their U.S. real property.

Now Congress didn’t like this. There’s not much more American property than American real estate, and so America should get the tax, that would seem to be the thinking. And the way that they decided to do this was FIRPTA, the Foreign Investment in Real Property Tax Act of 1980. The basic feature of FIRPTA is that income from the disposition of a U.S. real property interest is effectively connected income. It’s ECI, which is that system that Art noted earlier. You do not have to have a trade or business; it just is ECI.

Congress was also afraid that foreigners might not pay this ECI. They might take the money and run. So they added a 15% gross withholding tax. So as a buyer, for buying a U.S. real property interest, the default presumption is you have to withhold 15% of the purchase price that you paid toward real property, and you have to pay it over to the IRS. Now, this is not the final tax due. It’s an advance payment that will be credited against the final tax due by the seller. So you can have overwithholding pretty frequently or underwithholding at other times. This gross withholding amount, by the way, was recently increased.

Now there are exemptions from FIRPTA withholding. If there’s an affidavit of nonforeign status by the seller, there’s a nonrecognition transaction, or if it’s a qualified foreign pension fund, there’s no need to do the withholding.

So as I said before, FIRPTA applies … it makes the disposition of a U.S. real property interest into ECI. So what is a U.S. real property interest? Generally speaking, it’s a non-creditor interest in real property, U.S. real property, either directly or through an intermediary entity. For these purposes, real property is land, certain natural products, certain improvements of land, and personal property associated with the use of real property. So you can see it’s actually a very broad term.

One of the more interesting features is that it includes stock in a real U.S. real property holding corporation. Now, what’s that? A U.S. real property holding corporation is a U.S. corporation where more than 50% of its assets measured on a fair market value basis are U.S. real property interests at any time during a five year period preceding the sale of the stock. So you can sell a corporation, and it will be considered a U.S. real property interest under this regime.

Now if a U.S. real property holding corporation disposes of all of its U.S. real property interests in a taxable transaction, its stock is no longer a U.S. real property interest, and then you can dispose of that stock without worrying about FIRPTA.

The real takeaway I want you to take away from this slide is that these are broad terms and it is very possible to have an accidental U.S. real property holding corporation. For instance, imagine the retailer, which owns most of the buildings its stores are in. And say that these building and the land under it happens to be the most valuable asset, more than 50% of the value of that corporation. Well, that is a U.S. real property holding corporation, and a foreigner who sells stock in that corporation may, in fact, be taxed under FIRPTA. In fact, will be taxed.

Arthur Rinsky:

Mark, isn’t another takeaway that if you’re going to own property in a corporation that’s generally, we need to think through before you do it, you don’t want to own more than one property in the corporation?

Mark Mullin:

That is another, actually yes, that’s a huge takeaway. If you’re foreign, and you want to invest in U.S. real estate through a U.S. corporation, which will often be optimal, you only want one property per corporation because once that property is sold, you can liquidate that corporation without falling into FIRPTA because, as you guys may or may not know, a liquidation of a corporation is treated as a sale. So as we’ve noted earlier, a sale does not fall under the FDAP withholding tax, and it’s actually going to be there’s no effectively connected income, so it’ll just escape the U.S. tax net.

Arthur Rinsky:

So you’ll pay the corporate tax, but there won’t be an additional tax when the money comes out to you?

Mark Mullin:

Exactly. So you’re going to be able to have one layer of tax even though you’ve held the property through a U.S. corporation. And that’s going to be very key for planning.

As I’ve noted earlier, FIRPTA includes a withholding mechanism. 15% of gross withholding under section 1445, which is due 20 days after the transfer date. The interesting thing is that U.S. partnerships have their own withholding regime. So if a U.S. partnership has ECI and allocates it to a foreign partner, that foreign partner there’s going to be … that domestic partnership has to withhold a tax equal to the net ECI allocated to the foreign partner times that partner’s highest statutory rates. And this withholding is done quarterly rather than 20 days after any transaction.

So why am I telling you this? Well, the interesting features are that section 1446 preempts section 1445 where both apply. So you have a choice as a foreign investor as to what sort of withholding you want to do. Many people find section 1446 withholding to be preferable because the withholding is done on net ECI rather than on a gross income basis. So there’s less chance of a severe overwithholding. But there are disadvantages too, so this is something to consider during your structuring.

Another important thing it comes to like-kind exchanges. If you’ve invested U.S. real property, you’ve definitely heard of section 1031 and like-kind exchanges. Under this, a property that is like-kind can be exchanged for other property of like-kind, and there will be no recognition. There will be no transaction unless you include cash, or liability assumption, or other boots. The interesting feature here is that U.S. real property is only like-kind to other U.S. real property and foreign real property is only like-kind to other foreign real property. That prevents you from using section 1031 to get out of FIRPTA by the way.

So as you do your planning and as we recommend the structures later in this program, or rather go through them, you’re going to have to set up these structures. And one way you might do that is, for example, if there’s a partnership, you might try and contribute your U.S. real property interests to that partnership or to the corporation in question. You might be familiar that most contributions if planned and structured correctly are tax-free under the U.S. tax law, but that’s not the case under FIRPTA. FIRPTA, well the general rule is that those nonrecognition provisions are overruled unless you meet certain criteria. Specifically, written up here, the foreign transferor must receive as USRPI in exchange for the transferred USRPI. The USPRI received in the exchange would be subject to U.S. tax upon its disposition, and the foreign transferor has to comply with certain filing requirements.

There are also other regulatory exceptions that broaden the scope of the FIRPTA and the nonrecognition rule even further. So you have to consider those in planning. Additionally, there’s section 367 and 7874, which apply to cross-border transactions to also create pretty harsh tax effects if you don’t plan for them. And there’s actually an interesting interplay here. One of the regulatory exceptions under FIRPTA, if you follow it, will likely end up with you triggering 7874. To give that in non-tax terminology, that’s going to be an inversion and you’re going to end up … what the exception is if you put a U.S. real property holding corporation into a foreign corporation under 351, you could end up triggering 7874 where that parent foreign corporation will be deemed to be a U.S. corporation for U.S. tax purposes because you’ve committed an inversion.

Now the FIRPTA regulations kind of encourage you to do that. Don’t listen to them. That’s a trick. Don’t let them get you.

So now we’re going to move back to Dave for the federal transfer tax considerations.

David Spence:

Thanks, Mark. I’m confused already.

Mark Mullin:

That’s the right response.

David Spence:

So again, I gave you a short overview of the federal transfer tax considerations in this context, and we want to come back to the transfer tax issues and get into a little more detail because as I mentioned earlier, when we’re talking about a lot of time closely held business interests are family held interests, and that’s where you commonly will see planning strategies involving transfers, gratuitous transfers, uncompensated transfers between family members or even between close friends. And particularly because of the fact that under the U.S. transfer tax regime, transfers for no consideration are generally not considered income for purposes of the federal income tax. So you avoid all of those income issues when you transfer without consideration and sometimes friends, you know, make gifts to each other.

So what we want to do is take a minute and get a little deeper into the transfer tax considerations. And so let’s start with this one. I want to start with just a general overview of the U.S. gift and estate tax as it applies to U.S. citizens or domiciliaries. Now, that word “domiciliaries” becomes an extremely important word in the context of the U.S. transfer tax system. For federal income tax purposes, all we care about is residents, and there are lots of bright-line tests around whether someone is a resident for U.S. income tax purposes. Where they present in the U.S. a certain number of days? Do they have a green card? And so on and so forth.

For U.S. gift and estate tax purposes, there is no bright-line test. The test is essentially a, “We, the IRS, are going to look into your heart and determine what your true intention is with respect to the United States of America and whether it is your intention to stay here forever and die here and be buried here or whether you intend to just stay here for a while, make your money, and leave.” And there are pluses and minuses to both of those obviously.

So as you can see from the chart, for a U.S. citizen and this is also applicable to anyone who is deemed to be a domiciliary, meaning anyone who has no plans to leave the U.S. ever, there is an exemption from the U.S. transfer tax. That’s gift and estate taxes and the generation-skipping transfer tax incidentally of just short of $5.5 million currently. So that it works out to $10.9 million for a married couple. And that’s a really nice exemption. In addition to that, I can make gifts to my children for their birthdays of up to $14,000 per year or $28,000 between my wife and I. And in addition, upon my death, I can pass my estate because I’m a U.S. citizen, to my spouse without any estate tax consequences. If my spouse were not a citizen of the U.S. but was just living here and even if my spouse is a U.S. domiciliary, so maybe my spouse was born in China and immigrated here when she was three, but has never gotten U.S. citizenship, maybe she doesn’t even speak Chinese. It doesn’t matter. The fact that she is a non-citizen affects how much I can give to her without any estate tax.

Arthur Rinsky:

So even if she has a green card-

David Spence:

Yep. A green card doesn’t solve this problem. And so it’s interesting because to my knowledge, and I’ve been in the tax business in one form or another since 1986, Art longer than that, and this is the only area of the tax law that I’m aware of where citizenship matters as compared to simply residency or domicile. And so it is important to understand that if my spouse is not a U.S. citizen, I cannot just give her without tax consequences. And so we need to look at those.

Okay.

Arthur Rinsky:

Is there a downside to being a domiciliary? Does that subject you to- ?

David Spence:

Of course. And that brings us … Thank you for the softball. That was a softball pitch. That brings us to our next slide, which is … Here are some comparative numbers in this chart for how it affects those who are not U.S. domiciliaries. So as you can see, in the lifetime gift tax exemption column, instead of $5.45 million for gift tax exemption, there is a zero gift tax exemption. So that means if I am a non-U.S. domiciliary, if I live in Japan and I am a citizen of France, then I cannot make a taxable gift without paying a tax.

Arthur Rinsky:

Of U.S. situs property?

David Spence:

Of U.S. … well, we’re getting there. And so this is, as you can see at the top of the chart, mentions this is all applicable to U.S. situs property, and that’s the second real point of analysis because the question of what constitutes U.S. situs property is not what you would think it would be necessary. But the key pieces I want to point out here is that there is an estate tax exemption of $60,000. It’s barely enough. If I have enough money to be making gifts, significant gifts that I care about gift tax or significant inheritance that I care about inheritance tax, $60,000 might as well not be there. It just makes the calculation more expensive.

But I do have an annual … So I can give up to $148,000 to my non-citizen spouse without any gift tax. Now interestingly, let’s say I live in China, but my wife is a U.S. citizen, I can give my wife $1 billion-

Arthur Rinsky:   Unlimited.

David Spence:

-and it is not subject to gift tax because I get a marital deduction because she is a U.S. citizen. And so the key to the marital deduction is no marital deduction on gift tax if it’s a non-U.S. citizen spouse, you do get a $148,000 exemption. Upon my death, I can leave as much as I want to my citizen spouse, but if I have a non-citizen spouse regardless of my domicile or my citizenship, if my spouse is a non-U.S. citizen, even if she has a green card, I cannot give my estate to her without estate taxes unless I do it through a special type of trust called a qualified domestic trust. And that’s really only a deferral technique.

So that brings us to the question of what is U.S. situs property? And that takes us to this next slide. So the key here is that if I’m a non-U.S. citizen, non-U.S. resident, I will be taxable on gifts of U.S. situs property or upon my estate to the extent it consists of U.S. situs property, but the question is what constitutes U.S. situs property?

So number one, if I write a check, and this is not included really in this chart, but if I write a check on a U.S. bank account to anyone and let’s say I live in China and I have a bank account with Bank of America in San Francisco and I write a check on that Bank of America account to anyone in the world as a gift, I have made a taxable gift.

Arthur Rinsky:

Suppose I write that check in British pounds-

David Spence:

Okay. If I write that check drawing on HSBC Bank branch in Hong Kong, then I have made a gift of British pounds. I’ve made a transfer of property not located in the U.S. Now, let’s contrast that too if I die and I leave to my children my Bank of America account containing $100 million, from my lips to God’s ears, and I leave $100 million bank account not effectively connected to a U.S. trade or business, it’s just my personal savings account I have at Bank of America in San Francisco, I’m a citizen and resident of China, I die, I leave that bank account to my children who happen to be going to school at San Jose State, and guess what? No estate tax because that bank depository account is considered not located in the U.S.

Arthur Rinsky:

For estate tax purposes?

David Spence:

For estate tax purposes only upon my death. If I try to give it away during my lifetime, there’s going to be a big gift tax. So it’s very, very confusing. And so one has to look at every gratuitous transfer separately and analyze the rules. It is not-

Arthur Rinsky:

Intuitive.

David Spence:

Compare that to let’s say I have a brokerage account. I have a Morgan Stanley brokerage account. In that brokerage account, I have $100 million in Apple stock. I am still a citizen and resident of China, my children are going to school at San Jose State, and if I make a gift of that Apple stock during my lifetime, that Apple stock is an intangible asset, and as an intangible asset, it is specifically exempted not considered property in the U.S. It is specifically not subject to U.S. gift tax. If, however, I die and leave that Apple stock to my children through my estate, guess what? Big estate tax. So it’s exactly the opposite of the currency rules, the depository account rules. So it’s just simply not intuitive, and one has to look at the rules.

So let’s look briefly here at the asset types that I’ve got in this chart. So obviously real property, if I own a house in San Francisco and I leave that to my children, that real property is located in the U.S. If, however, I have that real property owned by a corporation, which is incorporated in the U.S., guess what? If I give that to them during my lifetime, no gift tax. If I leave it to them at my death, there will be an estate tax. If, however, I wrap that U.S. corporate stock in a foreign company, a foreign corporation so that all I own as a Chinese resident and citizen is a foreign corporation, which owns U.S. corporate stock, which owns U.S. real estate. I have converted that real estate into an intangible, which I can give away during my life free of gift tax and which is not considered U.S. property for purposes of the estate tax. So I’ve avoided both of those.

Now, that brings us partnership interest, and LLC interests disregarded entities, and so forth. The law here is, as I like to call it, it’s an unfinished symphony. So what we really have here is some real unknowns in terms of partnership interests and disregarded entities. My personal thoughts on this are that a partnership interest especially a legitimate partnership interest that can be shown to be a true sort of, even if it’s a family business, but it has real substance to it, I would argue that a partnership interest is, in fact, an intangible asset, which can be given away during my life free of gift tax. Disregarded LLC interest, it’s not entirely clear, and so as a planning point, I would avoid those types of interests to avoid that issue until we have some more settled law.

Okay. And I’m running out of time here, But I’ll just … So I’ve got just a little gift tax discussion here. Again, and this is just really illustrating what I mentioned before, which is if I make a gift of U.S. property, I’m going to have a taxable gift. If I make a gift of an intangible that wraps around a U.S. property interest, then that could be a non-taxable gift if I give it during a lifetime.

And to add to that, we have to consider the generation-skipping transfer tax. Let me give you an example, I have a client who came to me recently, which is the estate of a non-citizen, non- resident, and they had a brokerage account in the U.S. in which they named a payable on death designation to their grandchildren who live in the U.S. Oops. They made a mistake because they just doubled their transfer taxes because now it is a transfer between grandparent and grandchild and there is no exemption for the GST tax. So one of the things that we are considering doing is having the grandchildren disclaim that interest so that it will pass to their parent, the son of grandma and then have the son make gifts if he so chooses over the coming years. Since he’s a U.S. citizen and resident.

Arthur Rinsky:

They have no GST exemption?

David Spence:

No GST exemption for non-citizen, non-residents.

Arthur Rinsky:

So the takeaway is-

David Spence:

Don’t do it.

Arthur Rinsky:

-don’t give to grandchildren.

David Spence:

Yeah. Don’t do it in that fashion. Don’t make a gift of any taxable asset. So, if, however, grandma had, instead of dying, had just given that stock to her grandchildren-

Arthur Rinsky:

Then it would have been situs where she is.

David Spence:

-then it’s situs where she is, and it would not have been subject to tax. And even better, if she had given it to a trust located in Delaware or South Dakota or some similar place for the benefit of her issue, it might never be subject to U.S. estate tax because no one ever owns it. That’s a topic for a different day.

Okay. I think I can hand it off at this point to … back to Mark.

Mark Mullin:

Alright. Thanks, Dave. So we’ve given you a huge information dump of just about everything relevant … planning as foreign investment into U.S. real estate. And it’s a lot to handle, so we’re going to try and crystallize this all a little bit by running through some structures and looking at the different tax consequences these structures have.

To begin with, we’re going to have a foreign person who owns their real estate through a foreign corporation. So what’s going to be the outcome of this under the various tax rules we mentioned? Well, there is U.S. tax system exposure for the foreign corporation, not for the foreign person himself though or herself. The foreign corporation cannot get capital gains; the special capital gains rate on the disposition of real property. Corporations are not entitled to that. There’s not going to be withholding tax on repatriation of funds from the foreign corporation to the foreign person. As you might remember from those branch profit slides, that’s just outside of the U.S. tax system.

Now, is there a U.S. tax-free disposition of the entity? Yes, actually. If the foreign person sells this foreign corporation, it’s not effectively connected income, and it’s not FDAP. And those two facts mean that that foreign person can sell this foreign corporation free and clear of U.S. tax consequences.

Arthur Rinsky:

So can you give an example of that?

Mark Mullin:

Yeah. Like, you know, this person could sell this foreign corporation to really anyone in the world, or they could even liquidate it, and they’re not going to be hit with U.S. tax for that. The interesting thing is if the real property is sold, they will be hit with it, or the foreign corporation will be hit with the tax. In fact, it will also be hit with the branch profits tax to make up for the fact there’s no U.S. corporation between the foreign corporation and the real estate.

So that seems like a nice tax thing. Of course, most buyers are going to want to buy your real property. They’re going to want that step up in basis that means they’ll get an increased depreciated later. So if you do manage actually to sell the corporation, the buyer may not really like that they have a foreign corporation.

Arthur Rinsky:

Right because then they have to figure how to get it out of the corporation and bring it back.

Mark Mullin:

Yeah.

David Spence:

And in the meantime do all the reporting they need to do for the foreign corporation.

Mark Mullin:

Yeah, so no one’s really going to want to buy this foreign corporation in most circumstances. Maybe if they’re foreign themselves, they might be interested. But a nice thing here as you may remember from what David just went through, so there’s no exposure to U.S. gift or estate tax. This foreign person, when they die, they have non-U.S. situs property, and the foreign corporation is intangible. Between those two facts, they have entirely escaped the U.S. transfer tax system. So overall, not a great income tax result, but a very reliable and good transfer tax result.

Now, what if we, instead of the foreign corporation, have a U.S. real property holding corporation? Well, there’s going to be U.S. tax system exposure for that U.S. corporation, of course. And that foreign person too actually because that U.S. corporation stock in that is going to be a U.S. real property interest. So you’ll see a little lower than the U.S. tax-free disposition of entity, if the foreign person sells this, they will be taxed in the U.S. under the FIRPTA rules. It will be considered a U.S. real property interest, and it will be effectively connected income. They will be hit with that 15% withholding on that.

There are, again, no capital gains. There is going to be a withholding tax on any dividend from the U.S. corporation. There is not a branch profits tax because this is a U.S corporation, not a foreign corporation. There is exposure to U.S. estate tax for this foreign person as David mentioned earlier. If this foreign person dies holding this stock, there will be an estate tax on this amount.

Arthur Rinsky:

So their tax rate could be up to 39.6?

Mark Mullin:

Yeah, for the amount … yeah, when they sell it.

Arthur Rinsky:

Right.

David Spence:

And 40% on the estate tax.

Mark Mullin:

Yeah. I mean they should be able to get capital gains I believe on the stock sale, but not on the-

Arthur Rinsky:

But the stocks there would be of a U.S. real property holding corporation, right? So wouldn’t it be 39 … wouldn’t they pay 39.6?

Mark Mullin:

I think, well, my-

Arthur Rinsky:

If they only have one asset, maybe they could get it to 20?

Mark Mullin:

Yeah, definitely. So the big thing that comes here is that if this U.S. real property holding corporation sells its assets, and say this U.S. corporation has a single item of real property, after that sale, the U.S. corporation is no longer a U.S. real property holding corporation, so that stock could be sold or liquidated without U.S. tax consequences by the foreigner.

Now here’s actually sort of the best overall … If you’re going to do the corporation structure, which again has some bad income tax consequences, this is probably the best overall. There’s no U.S. tax system exposure for the foreign person. I mean there’s no capital gains rate, but you went into corporations really, so that’s sort of … you did that to yourself. There is a withholding tax on repatriation of funds from the U.S. corporation on the one hand, but we’ve avoided the branch profits tax, which as we noted earlier, is the worst tax because you can’t control the timing of your tax. There’s a U.S. tax-free disposition of the foreign corporation because it’s not a U.S. real property interest. And you’ve escaped the U.S. estate tax and gift tax. And again, you can use the cleansing exception from the previous slide.

So overall, this is the best way you can structure if you want to go the corporate route. And why might you do the corporate route? Well, basically because you have certainty on the transfer tax issues. You know that you’re going to escape the transfer tax system.

So what if we instead structure it without a corporation where you just have direct ownership? Well, this foreign person is in the U.S. tax system. They might not have very much net income during the ownership phase because real property throws off tons of deductions, so their net income should be low. Unlike all the corporate examples that we just went through, you will get capital gains. Hurray. There’s no withholding tax because there’s no corporation. And the U.S. asset, the real property, is going to be a U.S. real property interest, so that will be ECI when sold and there will be a withholding tax. There’s no branch profits tax. There won’t be for the remainder of these slides because they will not involve any corporations. Specifically foreign corporations. But there is, this is terrible from a transfer tax perspective, just absolutely as bad as it gets, you have exposure to the U.S. estate and gift tax. This foreign person can’t gift this without probably very sizable tax consequences since real property is very high in value and they can’t die while holding this with some serious tax consequences.

What if they do it through a disregarded entity? Well, generally you can see that all the tax results are the same actually like the previous slide. I’ll go back and forth so you just sort of can see that nicely. Except for two things, which is no one really knows what kind of U.S. estate and gift tax exposure this foreign person has. Generally, the feeling I get is that people wouldn’t count on this who are estate planners. There’s something just weird about a disregarded entity being regarded for tax purposes.

David Spence:

And I think you have, if we’re talking about a U.S. LLC, you have certainly a better chance of avoiding U.S. gift tax, but I think you have no chance of avoiding U.S. estate tax with a U.S. LLC.

Mark Mullin:

Yeah.

David Spence:

You may have a chance of avoiding U.S. estate tax if you have a foreign LLC depending on a lot of as yet undetermined law.

Arthur Rinsky:

You mentioned earlier with the U.S. LLC that’s disregarded, now there are reporting requirements that may make you tell them more about you than you’d like to tell them.

Mark Mullin:

Yeah.

David Spence:

That’s right.

Mark Mullin:

So maybe just stick with the foreign one or, actually even better, try using a partnership. Again, we have the same income tax results as in the previous slide, but everyone is pretty much more comfortable than a partnership interest is, in fact, an intangible that will get out under the gift tax rules and if this is a foreign tax partnership, that this should escape the U.S. estate tax rules. An important thing to remind you of that we went through earlier is that under the withholding tax rules if you use a U.S. partnership, you can do section 1446 withholding instead of section 1445, which is often more favorable.

David Spence:

And let me just point out that even with a foreign partnership, the U.S. estate tax is not that … I’m not super comfortable with that because the statute is only clear about foreign corporations, not about foreign anything else.

Arthur Rinsky:

From an estate tax standpoint, and I shouldn’t assume that’s always dangerous, a lot of this depends upon the value because you think that if you only have, let’s say, four or five million dollars of property, that’s all you have in the U.S. You’re a U.S. domiciliary, you might say, “Oh, yeah. Okay. I’m here. I got a basis step up. I leave the $5 million property to my heirs, and when they sell, they don’t pay any tax.” So it’s very facts specific.

David Spence:

Yeah, and if I claim to be a U.S. domiciliary, that’s great except now I have to report to U.S. government my worldwide assets. When I have clients come in, and we start talking about this, what I need to know is, “What are your worldwide assets and what are your U.S assets?” And then we can make an argument as to whether they’re a U.S. domiciliary or not. And sometimes it’s not entirely clear, and you have to sort of make your argument based on, “Well, you know, I’m a member of a country club in England. Does that help me?” “Yeah, that helps you. That makes you look like a non-U.S. resident, a non-U.S. domiciliary.” So it’s always clear.

Mark Mullin:

And then the next structure we have up here lets you combine the foreign tax partnership, which gives you a better estate tax argument, the better argument that it’s a non-U.S. situs property. And then you get to still have the U.S. tax partnership with gives you that 1446 withholding. Otherwise, same income tax results. Same general gift tax.

We’re running out of time, so I will just breeze through the earnings stripping. The general idea here is you can use loans to financial entities in a very … You have to dodge a lot of anti-abuse rules to do this, but if you do this right because interest often has zero percent U.S. withholding, you can get money out of the U.S. tax-free. You have, yeah, earnings stripping rules, anti-conduit rules, which are not discussed on the slides, but this is sort of the general structure of what you would do to get out money tax-free under the U.S. income tax system. This would be very good for a rent, for instance.

We’re going to breeze through California state and local tax considerations. Just sort of ignore them because I’ll mention them in this last slide, which is what is the takeaway? What should you have gotten from this whirlwind tour through the crazy tax rules that govern foreign investments in real property? Well, the best way to be certain to avoid transfer tax is to invest in U.S. real property through a foreign corporation. You do have very negative income tax results from doing that. You have no capital gains, and you can have a repatriation tax.

The best income tax is to use flow-through entities, and maybe there’s a chance, and it depends on your comfort, that you can still argue that you are okay under the transfer tax rules. If that’s the case, that would clearly be the best structure. It’s just that no one knows for sure that that would work under the transfer tax rules.

Earning stripping, which I mentioned, which is the use of interest to get money out of the U.S. tax-free. It can create further tax efficiencies. And you should consider your preferred withholding between the different sections. I also make a note that intangibles can create further tax efficiencies. I mean that from a California state perspective. California state intangibles. So like interest on that, for instance, will often not be sourced to California if you plan it right. So that’s a way to avoid California state income taxes.

And the other thing you should do besides knowing what the best tax structure is is you should be careful when doing your structuring because there is a pitfall. California, when you’re moving around property within entities that you own or largely own, you can trigger reassessment under California property tax. You can have a deed transfer tax. So you need to pay attention to those rules and see what might happen during your structuring.

And as noted earlier, there’s the FIRPTA section 367 and 7874 rules also to give you more to worry about. And I think that pretty much covers all there … as much as we could.

David Spence:

It covers our time.

Mark Mullin:

Yeah, it covers our time, for sure.

Arthur Rinsky:

I think the bottom line is before you acquire real estate, you really need to sit down with a tax and estate planner and figure out how you want to acquire it.

David Spence:

That’s right.

Arthur Rinsky:

That, to me, is the takeaway.

Mark Mullin:

Yeah, that’s the best way to avoid the structuring issues, and it’s the best way to plan for your ultimate tax goals.

David Spence:

And ideally before you make the purchase.

Arthur Rinsky:

Right. That’s why I said before.

Mark Mullin:

Yeah, save everyone the headaches. Well, we’ve gone a little over so we don’t really have time for questions but thank you very much for attending … Yeah, thanks for attending.

 

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