Restructuring foreign investment in U.S. real property

Editor: Howard Wagner, CPA  

The lower individual and trust tax rates on capital gains that were in effect before the enactment in December of the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, usually dominated tax planning and structuring for foreign investors. A passthrough structure was the preferred route, despite the cost and complexity of setting it up. However, the TCJA has given a windfall benefit to foreign investors and developers in U.S. real estate due to the drop in the corporate tax rate from 35% to 21%. The new 21% income tax rate applies to all U.S. corporations, whether the owners are domestic or foreign.

The ability to change from direct or trust ownership to a corporate holding structure, generally available on a tax-free basis, makes this route very attractive, and it can be implemented before a contemplated sale. The following is a list of reasons to now consider corporate ownership instead of ownership through a passthrough structure.

Do the numbers

Individual and trust rates on long-term capital gains at the federal level are unchanged at 20% for nonresidents.

Corporations do not enjoy preferential long-term capital gain rates — the top federal tax rate on all income is now 21%. In some states, the corporate tax rate is actually lower than the top individual rate (e.g., 8.84% vs. 13.3%, respectively, in California).

The low federal capital gains rate, compared with the new federal corporate rate, makes deciding which is preferable a close call. However, in high-tax states such as California, where the corporate tax rate is significantly lower than on individuals and trusts, the overall corporate holding structure comes out far ahead. In states where there is no income tax, e.g., Florida or Nevada, this is not a factor.

The new $10,000 cap on the federal deduction for state taxes now can result in a partial disallowance of state income and/or property tax on a foreign owner’s federal return.This is a valuable deduction to lose. However, state taxes are still deductible on a corporation’s federal income tax return. This is a significant factor where taxpayers own property in high-tax states.

Lower corporate tax rates

As a result of the TCJA, corporate tax rates are now significantly lower than individual and trust rates when the income is from development activities. Gains from active development generated by a foreign investor or trust or an investment fund with foreign investors is now taxed at 37%, the same as the top ordinary income tax rate for U.S. individuals. It is often a challenge to figure out whether real estate gains are ordinary or capital. This depends on the holding period and development activities. This uncertainty is eliminated entirely if the activities are conducted in a U.S. corporation. Due to the same 21% tax rate that applies to all categories of income, whether capital gain or ordinary, the corporate structure can save up to 16 percentage points off marginal rates and help avoid a potentially high-risk audit. This makes the corporate structure, in many instances, a far superior option.

Favorable formation costs

Formation costs can be significant for complex passthrough ownership trust or partnership structures for nonresidents. However, formation of a U.S. corporation is typically a routine exercise that incurs a fraction of the cost. Corporate structures avoid all the nuances of passthrough entities that can often discourage foreign investors from buying in the United States.

Fewer tax filings

Annual income tax filings and related compliance costs are similarly much less for corporations. Foreign ownership, direct ownership, or ownership though trusts often can require the foreign owner to file personal income tax returns. This can be avoided using corporate ownership.

Confidentiality

Using a U.S. corporation to own real estate can eliminate complicated disclosure requirements for the ultimate beneficial owner.The foreign beneficial owner or trust will not need to apply to the IRS for a U.S. tax identification number (TIN). Passthrough structures often require the ultimate owner to obtain a U.S. TIN.

Avoiding withholding taxes

Withholding taxes on operating income or on the sale of property that typically apply to foreign owners of partnerships and trusts can be complex and costly. However, there is no withholding tax on the sale of U.S. property, or at the partnership level on behalf of foreign owners that invest through a U.S. corporation. This vastly simplifies the tax payment process for both the investor and for many investment funds.

Gifting

There is only a $15,000 exemption for a foreign person’s gift of any U.S. tangible property. Gifts of intangible property are generally exempt. Stock in a U.S. corporation is considered intangible property. The gift tax can be eliminated if an owner wanting to gift U.S. property does so via a gift of stock in a corporation.

Estate tax exemption

The U.S. estate tax exempts foreign owners from tax only on the first $60,000 of U.S.-situs assets. The estate of a foreign owner with a direct interest in U.S. property will be subject to tax on the value of U.S.-situs property exceeding $60,000. The rates increase from 18% to 40% of the value over $1 million. Using the gifting approach noted above, the estate tax exposure can be avoided. The estate planning implications for aging foreign parents that own shares in a U.S. corporation, which is considered to be U.S.-situs property, need to be reviewed when dealing with U.S. real property. Moving one’s property into a U.S. corporation is certain to simplify the planning process.

Possible tax-free transfer into a corporation

Even if there is substantial built-in gain on U.S. investment properties, a foreign investor can transfer his or her property into a U.S. corporation tax-free under existing, long-standing statutes. If the corporation is liquidated in the same year the property is sold, and the proceeds are distributed, there is no second-level branch profits or dividend withholding tax.

Actions to take

Foreign owners and trustees with direct or indirect interests in U.S. real property via limited liability companies or partnership interests need to consider contributing their ownership interests into a U.S. corporation to take advantage of the lower corporate tax rate and simplified filing procedures.

The drop in the top corporate tax rate from 35% to 21% is a windfall opportunity for foreign investors. Advisers should consider whether their foreign investor clients should restructure their property investments using corporate ownership alternatives. The final decision on whether to invest in U.S. real property via a corporation or alternative structure is based on each taxpayer’s particular facts and circumstances and should be reviewed with a tax adviser.

EditorNotes

Howard Wagner is a partner with Crowe LLP in Louisville, Ky.

For additional information about these items, contact Mr. Wagner at 502-420-4567 or howard.wagner@crowe.com.

Unless otherwise noted, contributors are members of or associated with Crowe LLP.