The US real estate market offers abundant investment options and attractive opportunities for foreign investors. However, achieving success in US inbound investments requires a clear understanding of US tax law and its implications.
All income related to an underlying US real property asset is taxed in the US. To ensure maximum returns, investors must be knowledgeable about potential tax liabilities before committing to an investment.
Rentals
Rental income from properties located in the US is subject to a 30% withholding tax on gross rental income. If the rental income is sourced from rental activity classified as “active rental income” it is taxed within the US, but not on the gross amount. Rather, it is taxed on the net income amount, at the graduated marginal tax rates applicable to the taxpayer based on their income bracket.
If the rental activity does not meet the “active rental” income threshold, there is an option for the foreign owner to elect to treat the activity as active in order to obtain the benefit of the reduced tax rate. The impact of such election would have to be considered prior to making the election.
Sales
Sales of US real property results in capital gains income that is subject to US tax. At the time of the transaction proceeds from the sale of US real property are subject to 15% withholding of the gross amount. This amount withheld could far exceed the actual tax liability due because the withholding is on the total proceeds not the gain. In a case where the tax withheld exceeds the actual amount due, the foreign investor would have to file an income tax return to claim a refund for the excess taxes withheld. There is an option to obtain a withholding exemption from the IRS, but this process can take up to several months and delay a transaction.
If the foreign seller is an individual, then the capital gains income may be taxed at the lower long term capital gains tax rate available to individuals.
Indirect investment
Foreigners do not usually invest in US real property directly. Typically, they choose to invest through a legal entity, like a partnership or an LLC. Partnerships and LLCs are transparent for US tax purposes; they are considered pass-through for U.S. tax purposes, where income is taxed at the investor level rather than at the entity level. Therefore, if foreign individuals invest directly in a partnership or LLC whose underlying asset is US real property, they will be required to file individual income tax returns in the US and pay their US taxes related directly to this income.
A key consideration for structuring an investment would be to ensure that the rental income would be taxed as low as possible in the US considering the benefits of various available elections. Another key consideration is to make certain that any taxes paid in the US related to income in an LLC or partnership structure, would be creditable in the investor’s home country.
Go corporate
Investing in the US real estate market through a partnership or LLC offers certain protections but can be less efficient and may create delays in cash flow due to the withholding rule that would apply. Another alternative is to invest in the US through a corporate vehicle. This can be through a foreign country holding company or through a US holding company. If the real estate is held through a corporation, whether it is domestic or foreign, the income will be taxed at the standard corporate tax rate of 21% plus any state and local income taxes that would apply in the district where the real estate is located.
Investing in US real estate through a corporate vehicle introduces an extra level of tax in the form of a dividend withholding tax. The real estate tax is taxed at the corporate level at a rate of 21%, and then it is subject to a 30% withholding when the earnings are distributed (or deemed distributed in the case of a foreign corporation). If there is a treaty in place between the US and the country of residence of the foreign investor, then this dividend withholding tax can be significantly reduced or, in some circumstances, even eliminated entirely.
US vs foreign corporation
When comparing the benefits of investing through a US Corporation or a foreign corporation there are several factors to consider. From a cash flow perspective, it is usually beneficial to structure the investment through a US corporation because:
- There would be no withholding at source
- The investor has more control over the timing of tax submission
- The investor would avoid having taxes over withheld
Alternatively, the benefit of using a foreign corporation as an investment vehicle is that the stock in the foreign corporation is not considered US situs property and would avoid US estate taxes. Conversely, stock in a US corporation, even when held by a foreign person, would be considered US situs property and be subject to the US estate tax.
As demonstrated, in addition to the income tax implications, there are oftentimes estate tax implications to consider when designing a structure for US investment. Another factor that is often considered is the foreign investor’s ability to easily and efficiently reinvest earnings in the US market.
Do it through debt
After considering these complexities, it is no wonder that some investors choose to go a more simplified route by investing in US real property through bona fide debt instruments. This method is efficient and often does not attract US taxes. However, this approach limits the investors’ profit potential because in order to be considered debt, and possibly exempt from US taxes, the nature of the transaction must be true debt with a fixed rate of return.
Compliance
Once a structure is implemented, it is essential to understand the US tax compliance requirements. The IRS has robust requirements related to reporting entities and activities with foreign owners. Failure to comply with these requirements can result in significant penalties of $25,000 or more. Thus, even when an efficient structure is in place, inadequate compliance could ultimately lead to significant and unnecessary costs.
This material has been prepared for informational purposes only, and is not intended to provide or be relied upon for legal or tax advice. If you have any specific legal or tax questions regarding this content or related issues, please consult with your professional legal or tax advisor.
