United States (“U.S.”) vacation destinations in states such as New York, Florida, and California have some of the most valuable and desirable real property in the world. Wealthy visitors often decide to purchase a second or third home while on vacation without much thought. However, U.S. tax consequences should be a major consideration when choosing to purchase real property in the U.S. Those who do not primarily live in the U.S. must ask three extremely important questions regarding their US real property:
- Are you domiciled in the US for Federal estate and gift tax purposes?
U.S. citizens and individuals domiciled in the U.S. are subject to federal estate tax, at a progressive rate of up to 40%, on the fair market value of their worldwide assets owned at the time of their death, provided that their estate exceeds a designated exemption amount that adjusts each year (currently $5.49M for those deceased in 2017).
Those not domiciled in the U.S. at their death are subject to estate tax only on directly held property situated in the U.S. (“U.S.-situs property”), which includes U.S. real property. While non-domiciliaries do receive a small exemption from U.S. estate tax (currently $60,000), the remaining value of the U.S.-situs estate, including U.S. real property, could be subject to an estate tax of approximately 40% of the fair-market value in excess of the $60,000 exemption amount.
Domicile is a subjective facts and circumstances test that generally asks if you are in the U.S. with an intention to stay.
- Are you a U.S. taxpayer for Federal income tax purposes?
While the U.S. does not currently tax or impose a filing obligation on the acquisition or mere ownership of U.S. real property by a foreign person, foreign ownership of U.S. real property could someday become reportable to the Internal Revenue Service (IRS). The IRS already requires foreign persons to disclose mere ownership of a single member limited liability company (LLC) by a foreign person.
Foreign persons also have U.S. tax obligations and reporting requirements in the case of a rental or disposition of U.S. real property interests. The Foreign Investment in Real Property Tax Act (FIRPTA) imposes reporting and withholding requirements of foreign persons on the sale or transfer of U.S. real property. Furthermore, rental income earned from such property will be subject to U.S. taxation. Simply put, rental income or the disposition of U.S. real property can carry a litany of U.S. income tax obligations and reporting requirements, and potentially, significant penalties for the unwary. As such, it is critical to determine your U.S. income tax status before purchasing property, and to understand what triggers resident and non-resident taxation.
Two common ways that individuals are unknowingly “residents” for U.S. Federal income tax purposes are (1) individuals who are citizens of the U.S. but unaware (e.g., because they were born in the U.S. or one of their parents was born in the US), and (2) individuals that are residents by way of the substantial presence test. The substantial presence test is a weighted average calculation based upon an individual’s presence in the U.S. over a three-year period.
Whereas U.S. residents are subject to U.S. income tax on their worldwide income, a foreign person generally is subject to such tax only on certain U.S. source income, income related to a U.S. trade or business, or the gain from the sale of U.S. real estate. Concerning the ownership of U.S. real property, unless the NRA has engaged in income tax planning, he or she could be subject to significant income taxation on the rental and disposition (including gifts!) of U.S. real property, and, in some instances, information return reporting requirements.
- How do you/will you own your U.S. real property?
Once you have determined your federal income tax and estate tax status, it is time to consider your choice of entity or investment vehicle. Before planning can begin, it is helpful to decide whether you intend to purchase U.S. real property for personal use, business use, or hold as a long-term investment. The answer to this question can determine whether it is best to own your U.S. real property directly, through a trust, U.S. entity, or foreign entity. The U.S. income and estate tax implications of the ownership structure is critical.
Structuring your investment requires special balancing of state, federal and international laws. For example, in some instances, some foreign investors might be eligible to benefit from U.S. tax treaties that can minimize taxation provided they hold their interests directly. However, direct ownership in U.S. real property (i.e., U.S.-situs property) is subject to the estate tax regardless of whether you are a U.S. domiciliary. Additionally, because it is U.S. situs property, you cannot simply “gift” the property without being subject to federal, and sometimes state, transfer taxes. If, for example, your real property is located in Florida, transfer of the real property can trigger a local documentary stamp tax based on the value of the real property. In addition, there are state-specific non-tax issues that you must consider. For example, if you own U.S. real property located in California in your name individually, it will be subject to California probate at your death. The probate can be notoriously slow and expensive procedure in California, especially for a non-resident.
Navigating the various local, federal, and international issues can be complex. Proper structuring of your U.S. real property ownership before you buy can plan for these inevitable problems.
Foreign investors should be aware of the tax and reporting requirements associated with their investment in U.S. real property. The best time to learn about potential issues and set up a tax-efficient structure is before you purchase U.S. real property. The Duane Morris Wealth Planning Team and Tax Practice Group is ready to assist you with an investment strategy regardless of where you are in the process of owning U.S. real property.