More and more Chinese investors from the mainland are investing in residential, commercial and industrial real estate throughout the United States, with a focus on the West Coast, particularly in the San Francisco and Los Angeles metro areas. Unless properly structured, these investments could result in significant U.S. tax exposure, ranging from excessive U.S. federal income taxation to imposition of the U.S. federal estate tax at a 40 percent rate.
In view of the recent decrease of the U.S. federal corporate income tax rate from 35 percent to 21 percent, many foreign individuals investing in U.S. income-producing U.S. real estate are using a two-tier foreign corporate/U.S. corporate structure to minimize U.S. income taxation and avoid U.S. estate taxation. The benefit of this two-tier structure from the U.S. federal income tax perspective is as follows:
Income Taxation: 1) rental income is reduced by expenses; 2) when the U.S. corporation sells the U.S. real estate, the gain will be subject to a 21 percent federal income tax (and state income tax, which in California is up to 8.84 percent); and 3) the U.S. corporation can transfer the after-sales cash proceeds to its non-U.S. parent in a tax-free liquidation. Takeaway: This structure results in only one level of U.S. income taxation on the investment.
Estate Taxation: The two-tier structure can avoid imposition of the U.S. estate tax on the death of the ultimate non-U.S. individual foreign owner, provided that the structure is properly formed and maintained.
- Mr. X, a Chinese citizen and resident plans to purchase a $5 million condominium in San Francisco (Condo).
- Mr. X retains a management company to lease the Condo to VIP business guests for short-term rentals of no more than two weeks per user (at a cost of $25,000 per week or $50,000 for two weeks).
- Mr. X also plans to use the Condo for personal use when he visits the Bay Area for no more than two or three months per year.
- Mr. X does not intend to become a U.S. citizen or tax resident in the future.
- Mr. X would organize a wholly owned holding company under non-U.S. law, such as in the British Virgin Islands, Cayman Islands or another attractive jurisdiction (Parent Corporation).
- The Parent Corporation would organize a wholly owned U.S. corporation (U.S. Corporation).
- All funds used to acquire the Condo would be furnished by the Parent Corporation to the U.S. Corporation.
- The U.S. Corporation would acquire the Condo for cash.
- The U.S. Corporation would enter into a management agreement with a management company for the commercial usage of the Condo.
- Mr. X would enter into a written lease agreement with the U.S. Corporation for the part-time lease of the Condo. Under the lease agreement, Mr. X would pay the U.S. Corporation a commercial rent for his occupancy comparable to the rental rate that the U.S. Corporation would charge to unrelated persons to use the Condo. The lease arrangement between Mr. X and the U.S. Corporation is necessary to mitigate U.S. tax exposure that could arise if a related shareholder were to use the rental property rent free.
DEPICTION OF THE STRUCTURE
ANALYSIS OF STRUCTURE
Income Tax Consequences of U.S. Corporation Deriving Rental Income
The U.S. Corporation will earn third-party rental income from leases arranged by the management company and from the lease agreement with Mr. X. By holding the Condo for commercial rental, the U.S. Corporation should be treated as engaged in a U.S. trade or business and entitled to deduct ordinary and necessary expenses associated with the property, including, property taxes, condo association and maintenance fees, and insurance expenses.
The U.S. Corporation should also be eligible to claim depreciation deductions because the Condo will be nonresidential real property used in an income-producing activity. A consequence of the U.S. Corporation's eligibility to take deprecation and operating expenses is that these expenses should reduce the U.S. Corporation's taxable rental income. Although the depreciation deductions would reduce the U.S. Corporation's tax basis in the property, it also would reduce the U.S. Corporation's cost basis in the Condo, thereby increasing the gain to the U.S. Corporation upon the sale of the Condo.
If the Condo were not to generate sufficient tax deductions to offset the rental income earned by the U.S. Corporation, the taxable income of the U.S. Corporation would be taxed at a combined federal and state rate of up to just less than 28 percent.
Income Tax Consequences of U.S. Corporation Selling Condo
The strategy is for the U.S. Corporation to sell the Condo. It would pay federal income tax at a 21 percent rate and state tax (up to 8.84 percent in California for an overall rate of just less than 28 percent). Once the U.S. Corporation sells the Condo and only has cash, it could liquidate tax-free into the Parent Corporation.
U.S. Estate Tax Consequences
By using a two-tier corporate structure wherein Mr. X owns the Parent Corporation and the Parent Corporation owns the U.S. Corporation, the Parent Corporation functions as a "blocker" corporation so as to avoid the imposition of the U.S. estate tax that would apply if Mr. X had owned the Condo directly, through a limited liability company (LLC) or U.S. corporation. In order for the blocker structure to be respected, it is essential that Mr. X correctly form and maintain the two-tier structure, comply with all non-U.S. and U.S. corporate formalities and requirements, and not treat the structure as his nominee.
U.S. Tax Compliance Considerations
The recommended structure will not create a U.S. income tax filing requirement for Mr. X nor will it require that Mr. X to obtain U.S. Individual Taxpayer Identification Number (ITIN).
The U.S. Corporation will be obligated to file annual federal and state income tax returns and also certain information returns. When the U.S. Corporation is liquidated tax-free into the Parent Corporation following | sale of the Condo, the distribution will be subject to information reporting in the United States.
Mr. X will need to retain a U.S. licensed certified public accountant (CPA) with experience in dealing with international clients to handle all required U.S. tax and other compliance requirements.
Chinese investors acquiring income-producing U.S. real estate should consider the planning suggestions described herein to minimize the potential U.S. federal income tax and avoid the U.S. federal estate tax. As with all investments, however, investors need to first consider the economics of a particular transactions before considering the U.S. tax effects.