What the foreign investor should know before acquiring real estate in the U.S.
Whether you are considering buying real estate in the U.S. or whether you are helping a foreign client who is looking to acquire property located in the U.S., there are important legal and tax issues that need to be considered before signing closing documents. An uneducated decision could result in hefty tax consequences and even time-consuming and costly legal processes.
In opposition with the process for U.S. persons, which sometimes could be straight forward, when a foreigner buys real estate in the U.S., every aspect of a transaction needs to be carefully analyzed, from determining the proper entity or entities to be used to acquire the property, to deciding how the property will be managed, and even potential considerations for when and if the property is sold.
While U.S. persons are subject to U.S. federal income and estate tax on their worldwide income and assets, foreigners are generally liable for U.S. federal income and estate tax for income received from sources within the U.S. and for property located within the U.S., respectively. As a result, when buying property in the U.S., a foreign investor needs to consider both income and estate tax issues.
One of the first considerations that a foreign individual needs to consider is how to own or title the property. Owning real estate in the U.S. directly in the foreigner’s name will certainly result in the estate of the foreign client being subject to federal estate tax upon the foreigner’s demise. Federal estate tax rates go up to 40% with a nominal $60,000 credit that can be applied towards the fair market value of such property at the time of death. Additionally, if a foreigner dies owning real estate in his or her own name, a probate process must be completed with a competent court in the U. S. before the property can be transferred to the legal heirs or even sold to an unrelated party.
Often, foreign investors acquire real property in his or her own name or jointly with another person, correcting this issue can be costly and complicated. Changing title to the property results in income tax consequences under the Foreign Investment in Real Property Tax Act ("FIRPTA"), in addition to transfer and documentary stamp taxes and approvals from the lender and the condominium association, when applicable.
For U.S. income tax purposes, both rental income and the gain from the sale of real property will be U.S. source income and thus subject to federal income tax irrespective of whether the foreign client was present in the U.S. or independently of whether such income is taxed in the foreigner’s home country. Rental income attributable to the U.S. property will receive different treatment depending on whether the foreign client is deemed to be engaged in a “U.S. trade or business” or if such rental income is a passive investment. Passive rental income will be subject to a 30% withholding tax applied to the gross income received. On the other hand, if the rental income is attributable to a U.S. trade or business, such income will be taxed at ordinary progressive rates. Additional considerations on the tax treatment of repairs, operating expenses, interest payment on mortgages, and insurance premiums, among other costs, need to be analyzed to determine the best potential outcome for the foreigner’s investment.
The careful advisor, as well as wary real estate professionals advising foreign investors, should stay informed on the important issues affecting the foreign investor. Keep an eye out for our upcoming Chronicles issues where we will be discussing other issues dealing with investments in U.S. real estate and clarifying common mistakes dealing with the application of FIRPTA.