FEATURE ARTICLE, JUNE 2006

TAX PLANNING FOR FOREIGN INVESTMENT
Knowing the right tax plan can help attract foreign investors to a domestic project.
Richard S. Lehman, Esq.

Lehman

From that perspective, they would see that even in today’s market, United States real estate is at bargain basement prices and regarded as a safe haven for investors from Europe, the Middle East and South America. With that in mind, domestic real estate professionals — developers, brokers, tax consultants and attorneys — should view this market with great interest, recognizing that it could provide outstanding opportunities if properly cultivated.

The current global economy and political climate has resulted in U.S. real estate becoming one of the most sought investments among foreigners. There are several factors contributing to this.

First is overall safety. The United States is still regarded as the safest country in the world and the most stable in terms of politics and investment. This is in sharp contrast to other parts of the world where terrorism, political unrest and a lack of regulations and laws threaten investors and whole economies. The current situation in France, Venezuela and the Middle East are a few of the most recent examples of environments where fear motivates accumulated wealth to find a home in hard assets in the U.S.

Second, there are an increasing number of global multi-millionaires who have made and are continually increasing their fortunes in their own countries, but now need a safe haven to diversify and protect what they have accumulated.

Third, U.S. real estate is regarded as affordable when compared to similar properties in Europe, Japan, the Middle East, and South America. Combine this with a weak dollar, and domestic real estate is a bargain when seen through the eyes of investors from many parts of the world.

U.S. tax laws are very favorable to foreign investors, providing, at times, for the payment of tax-free interest by U.S. taxpayers to foreign investors, tax free capital gains or capital gain tax rates of 15 percent.

The problem with many of these foreign investors is that they make mistakes because they are often driven by fear and lack a real understanding of the “American Experience” as a real estate investor. Often they are too quick to purchase these perceived inexpensive affordable assets. 

A key component of insuring a successful U.S. real estate investment is for the foreign investor to assemble a team of independent professionals; all with separate fiduciary duties owed only to the foreign investor; who can objectively look at the situation, ask the tough questions, challenge each other, and come up with proper solutions. A mistake in any link in the chain of professionals can ruin all of the work of the others.   

Tax planning is perhaps one of the most important (and least understood) aspects of assisting a foreign investor. What follows is a very short course in the taxation of foreign investors in real estate and an example of the use of the tax planning tools that may apply only to a foreign investor.

Non-resident alien individuals will generally pay U.S. income tax only on income earned from U.S. sources and will pay U.S. estate taxes on real property and tangible personal property they own in the United States.

U.S. taxpayers pay tax on their worldwide income.

A Non-resident Alien Individual is any citizen of a country other than the United States who is not a U.S. Tax Resident for U.S. income tax purposes. An alien is considered to be a U.S. Tax Resident if the alien has a green card representing permanent residency or the alien has a substantial presence in the U.S. due to the length of time the alien may physically be in the U.S.

There is also a difference in the way the U.S. taxes owners of corporations that own U.S. real estate, depending upon whether the owner of the real estate is a Foreign Corporation, (a corporation not organized under the laws of the United States) or a Domestic Corporation (organized in one of the states of the United States).

Let’s call both Non-Resident Alien Individuals and Foreign Corporations foreign investors.

There are tax similarities and tax differences between the foreign investor and the U.S. investor in U.S. real estate.  The U.S. and foreign investors are similar in that they both pay capital gains rates on profit from the sale of U.S. real estate that is held for investment. That means that Non-resident Alien Individuals and U.S. individuals can pay as low as 15 percent on long-term capital gains. Domestic and Foreign Corporations also pay tax on the sale of capital assets however there is not a lower rate for capital gains earned by corporations. Thus domestic and foreign corporations could pay a Federal income tax on capital gains as high as 35 percent along with state corporate income taxes that may range between 5 percent and 10 percent of additional taxes.

The major negative difference in taxes applies only to foreign corporations that may earn profits in U.S. real estate. Unlike domestic corporations, foreign corporations that earn profits from U.S. investments could pay an additional U.S. tax known as the Branch Profits Tax of 30 percent on undistributed and reinvested U.S. profits. This could be in addition to state income tax, Federal income tax (35 percent) plus 30 percent Branch tax.

The balance of the major differences between classifications favor the foreign investors in both the interest of tax fairness and to promote foreign investment in the U.S.

Foreign investors can earn tax-free interest income generated from U.S. real estate profits through the use of Portfolio Interest Loans. Generally a Portfolio Interest Loan is a loan from a foreign investor to a U.S. person (includes U.S. individuals, domestic corporation, partnership, trusts etc.); so long as the foreign investor creditor does not own 10 percent or more of the U.S. debtor entity.

A foreign investor that sells stock in a Foreign Corporation that owns U.S. real estate is not taxable on the sale of shares of stock in that foreign corporation.

Foreign investors that form a corporation to own U.S. real estate can avoid a second tax on distributions of corporate profits by liquidating the corporation after it has paid the U.S. corporate tax.

The differences between the U.S. investor and foreign investor can result in well planned lower taxes for the foreign investor or significantly higher taxes when mistakes are made.

The following shows three very basic tax structures that take into consideration several of the different types of tax concerns depending upon the nature of the real estate and the Foreign Investor.

The ownership of U.S. real estate directly by a Non-Resident Alien or the alien’s use of a limited partnership or limited liability company to own U.S. real estate is shown as Foreign Investor No. 1. This generally provides the best income tax results because partnerships and most limited liability companies Pass Through Entities pass all of their U.S. tax attributes to their individual owners directly. The long-term capital gains rate for a Non-resident Alien Individual will be a maximum of 15 percent.

However, Individual ownership or Pass Through Entity ownership has several drawbacks. The conduct of the real estate business through anything other than the typical corporation will not accomplish the goal of Foreign Investor anonymity. A great deal of foreign investors do not want to file U.S. income tax or information returns and do not want their direct ownership of U.S. real estate to show up on the public records.

Furthermore, ownership of United States real estate by a Non-resident Alien could subject that ass\t to U.S. estate taxes on his or her death.

Therefore the ownership of U.S. real estate in this fashion is more suitable to a younger Non-resident Alien, not overly concerned with estate taxes, who is investing principally for capital gains from appreciation. A parcel of raw land or a second home might be suitable for individual ownership by a Foreign Investor.

Foreign Investor No. 2 is more desirous of avoiding U.S. estate tax and/or not disclosing ownership or getting caught up in the U.S. income tax system. Foreign Investor No. 2 has formed a foreign corporation to hold the investor’s U.S. real estate.

However, by using a Foreign Corporation, the foreign investor’s entity must pay a Federal tax as high as 35 percent; as compared to the 15 percent capital gain rate paid by a non-resident individual owner. Many states have their own income tax that applies to corporations doing business in that state. Furthermore, the foreign corporation owned by Foreign Investor No. 2 could be subject to the 30 percent Branch Tax if it does not quickly liquidate after a sale and distribute its profits.

This entity also is more suited to a capital gain investment as opposed to an income producing property since the entity’s ordinary income could be subject to the Branch tax. If the Real Estate can be sold all at one time, the foreign corporation can be liquidated to avoid the Branch Tax and any other tax on the distributions of the assets to the shareholders.

Foreign Investor No. 3 has established the most flexible vehicle of all but it too has its drawbacks. Foreign Investor No. 3 has established a foreign holding company to be the 100 percent owner of a Florida corporation. This method also would work with a company based in any other state.

Foreign investors who are involved in the active real estate business, such as ownership of income producing property or development property, may as a general rule, invest in the this fashion.

This structure can eliminate at least two of the three taxes that the foreign investor might face. Since the direct investor in real estate is a domestic corporation, it need not pay any Branch tax on its profits. Since the foreign investor owns only shares in a foreign corporation, there is no estate tax upon his or her demise. The income tax, however, is generally unfavorable as compared to individual ownership; since the corporate rates on capital gains can be as high as 35 percent plus state taxes.

Furthermore, distributions to shareholders of profits from a corporation, after it has paid its U.S. corporate taxes, may be considered as dividends that are subject to a second tax by the U.S.

Often with proper tax planning, the tax barriers of corporate ownership of real estate can be significantly reduced.

Finally, it is very important to keep in mind that this has been a discussion of the general rules affecting foreign investors. Many foreign investors will be citizens of a country with a Tax Treaty with the United States. These Tax Treaties, if relied on by the foreign investor, will generally provide a similar though better tax environment for the foreign investor than the rules discussed here.

Richard S. Lehman, Esq., of Boca Raton, Florida, specializes in federal tax law focusing on tax planning, document drafting, tax controversy, both civil and criminal, and litigation strategy in the areas of Federal income, estate and trust taxation.

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