Best Practices for International Investors in US Commercial Real Estate
Investors from around the world are attracted to the opportunities that the US economy has to offer. Why do they choose the US among other countries? For starters, the stability of the US economy provides foreigners a safe haven for their investments, unlike any other place. In our recent webinar, Kenneth Kastner, US Tax Advisor, and Abe Mastbaum, Tax Counsel at Barton LLP, went into depth on this topic and discussed why commercial real estate, in particular, interests foreign investors.
Panelists addressed topics such as:
- Estate tax awareness
- Double taxation prevention
- ITINs and tax returns (compliance)
- FIRPTA optimization
- Simplifying complex tax terms
Abe Mastbaum is a Tax and Capital Markets Counsel at Barton LLP. He began his career as a CPA, and spent several years at a large investment bank doing transaction structuring and derivatives, real estate, and mergers and acquisitions. Later on in his career, he decided to go to law school and get his license, which has led him to tax and capital markets counsel at Barton LLP, where he provides financial training and consulting services to various international investment banks, ratings agencies, private equity/hedge funds, and industry regulators.
The Double-Taxation Issue
Taking a step back to understand how double taxation works, it’s important to understand that most countries tax their residents on their worldwide income. If you have investments in other places in the world, your home country typically taxes on income you have wherever that may be. When it comes to investing in US real estate, the US will want to tax that income, as well. Because both countries have the right to tax, you may get caught up in double taxation. The question is: how can you avoid this when it comes to real estate? Here’s two examples:
- Double Tax Treaties (whichever country has the higher tax rate, you pay that instead of paying double)
- Being taxed as a US Trader business
Going off of the second point, when you’re dealing with real estate investments in the US, the question that consultants grapple with is whether or not the activity rises to be a trader business. The term that’s used with this is effectively connected income. Essentially, you have to determine whether or not your investment in US real estate rises to the level of being an active trader business and generates effectively connected income. That’s critically important; if it’s passive or non-business related, the income that’s generated from the property is subject to a flat 30 percent withholding tax, without any offset for expenses. Therefore, the alternative is to be taxed as a US trader business, where the owner of the property subjects themselves to the US tax regime, where they’re able to deduct all of the expenses associated with the property.
If you’re a passive investor, and wouldn’t qualify, you can achieve the same result by making an election that puts you in the same shoes as if you were engaged in trader business. This is under section 897 of the internal revenue code, and is done by filing a statement with your tax return.
Advice for Navigating Implications
Mastbaum provided a few examples for how he structures transactions in a way that addresses major issues:
- Deal with the taxation of the property during its ownership- May or may not be withholding taxes associated, but if there is business-generated activity, he gives guidance on proper tax returns and hands them off to competent CPAs to be in good hands for filing needs
- Disposition of the property- Upon the disposition, there’s typically the capital gains tax that has to be dealt with, and there’s a law in the US called the foreign investment real property tax act (FIRPTA), which imposes a withholding obligation at the time of sale of the property. So, if there’s a foreign owner of the property selling to a US buyer, there will be a withholding of some of the sale’s proceeds (typically 15% of the gross sales price depending on the circumstance)
Current State of Play
Estate tax awareness:
The key to dealing with estate tax if you’re a foreign party: make sure that nothing in the US is transferring at the point of death.
There’s a concept within US real estate property interest that says if you own a property interest within the country, that is the item that is going to subject you to the estate tax. Therefore, you want to structure it in a way where you own something that is not considered a real property interest.
Mastbaum’s preferred structure is through the use of a US blocker structure, where the foreign owner or corporation would own a US corporation, which would be the owner of US real estate. If the foreign party dies owning the foreign corporation and nothing in their estate is in the US, it would not trigger that estate tax.
Options for smaller scale investors:
Kastner added that if we’re talking about smaller investors or those just starting off, they might not want to take this route. Instead, taking out a life insurance policy could be a good option. Though it doesn’t eliminate the estate tax, insurance will cover the “big hit” amount that comes after you pass; it won’t cover the exact amount of the estate tax, but it will provide some sort of coverage.
Another option is to spread out the investment with a few different family members, with each family member having that small exemption. Though they’ll each have to file their own tax return, you’re spreading out the exposure and risk. This is a way to get around it for smaller scale investors.
Changes to the tax code under the Biden Administration?
In terms of US estates, Kastner believes there won’t be too much of an effect when it comes to foreign investors. However, the talk of Biden reducing the exemption for US citizens is definitely something for people to keep in mind when structuring an investment, and understanding the exposure. Kastner’s advice: Education is the best method; not necessarily to decide for the client or investor, but for them to understand because there isn’t one size fits all.
From Mastbaum’s perspective, “this is a year that clients hate and estate lawyers love” because of the worry that rises and uncertainty as to what’s going to happen until later in the year. However, he agreed with Kastner that he expects limited action to be going on from the foreign side. Domestically, changes in the step-up in basis could occur, but again, it’s hard to entirely predict what the outcome will be.
If you are interested in learning more or have any questions, please do not hesitate to contact us.
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