The high net worth foreign client who buys a home in the United States for personal use has potential exposure to federal income taxes on rental income produced by the real estate, to federal income taxes on the sale of the real estate, to federal gift tax and possibly the federal generation-skipping transfer ("GST") tax if she gives away interests in the real estate, and to federal estate taxes and possibly to GST taxes if she dies owning the real estate.
This article discusses how the U.S. tax rules apply to foreign owners of U.S. homes and suggests an ownership structure that permits the foreign owner to retain full control over the property during her lifetime while minimizing the exposure of the home to U.S. taxation.2
Tax principles applicable to foreign owners of US Real estate
A. Income Tax
Rental income paid for the use of a foreign owner's U.S. real estate is subject to U.S. income tax either at the 30% rate applicable to U.S. source periodic income or the graduated rates applicable to income effectively connected to a U.S. trade or business (the same rates applicable to U.S. citizens and resident aliens).
If the foreign owner owns the U.S. real estate through a foreign corporation, the tax rates applicable to corporations could apply if the rental income is effectively connected income. In addition, the rental income may be subject to the branch profits tax. If the foreign shareholder is permitted rent-free use of the real estate, there is a possibility that the IRS could take the position that the corporation has imputed rental income.
If the U.S. real estate is sold, any gain will be subject to U.S. income tax.
When the foreign owner dies, U.S. real estate held in her name should receive a basis adjustment to fair market value under section 1014 of the Internal Revenue Code (the "Code"). If the real estate is held in a corporation, the corporate shares, but not the real estate, will receive the basis adjustment.
B. Transfer Taxes
Gifts of U.S. real estate made by a foreign owner are subject to U.S. gift tax and possibly to U.S. GST tax. Similarly, if a foreign owner dies, her U.S. real estate will be subject to U.S. estate tax and possibly to U.S. GST tax. If the real estate is subject to a non-recourse debt at the time of the gift or death, only the net value will be subject to the gift or estate tax.
If at the time of the gift or death, the foreign owner's U.S. real estate is held in a foreign corporation, there should be no U.S. gift or estate tax, assuming the Internal Revenue Service does not disregard the foreign corporation as an entity without a business purpose.
Suggested structure for foreign individual ownership of US Home
If the goal of the foreign individual is to minimize income taxes on her U.S. home during her life, to assure her full control over the property during her lifetime, to minimize the estate tax cost if she dies owning the property and to secure a fair market value basis adjustment for her heirs, the preferred form of ownership is likely to be a revocable trust subject to a significant debt that is nonrecourse as to the individual.
Here is a description of how a structure of this kind could work for a foreign individual (A) who wants to purchase a condominium apartment in Miami. The purchase price is $5 million.
Step 1 – A establishes a foreign irrevocable trust (Trust 1) for the benefit of her issue and funds it with a nominal amount of cash from her foreign assets.
Step 2 – A establishes a foreign revocable trust (Trust 2) for A's benefit and the benefit of her issue. Trust 1 is a beneficiary of Trust 2 and will receive all the property in Trust 2 on the death of A. A funds Trust 2 with $500,000 cash.
Step 3 – A establishes a foreign irrevocable trust (Trust 3) for her benefit and the benefit of her issue. She funds it with $5,000,000 from her foreign assets.
Step 4 –Trust 2 borrows $5,000,000 from Trust 3 on a nonrecourse basis. Neither A nor Trust 2 is liable on the loan.
Step 5 – Over time, Trust 2 makes payments on the loan, using its $500,000. As the condominium apartment increases in value, A makes additional gifts to Trust 3. Trust 2 may borrow additional funds from Trust 3 secured by the condominium, on a nonrecourse basis, and use the funds to make distributions with these funds to Trust 1.
The expected U.S. tax results are as follows:
1. No U.S. gift tax will be imposed on A. She will make no gifts that are taxable in the U.S.
2. No rental income will be imputed to A on account of her use of the condominium or on account of its use by any other person. If the trust rents the apartment to a third party, A will have U.S. source income taxable either at a 30% rate, or, if treated as effectively connected income, at graduated rates determined by Code section 1.
3. The interest paid by Trust 2 to Trust 3 will not be subject to U.S. income tax because neither Trust 2 nor Trust 3 is a U.S. person.
3. If the Trust 2 sells the condominium during A's lifetime, A will pay tax on the gain at capital gains rates.
4. When A dies, if Trust 2 owns the condominium, its value, reduced by the amount of the nonrecourse debt will be included in her U.S. gross estate. So long as the amount of the debt is substantially the same as the value of the condominium, the U.S. estate tax on this asset will be minimal.
5. On death, Trust 1's basis in the condominium will be equal to its value on the date of A's death, unreduced by the debt to which it is subject.
- This article is adapted from excerpts of the forthcoming edition of CARLYN S. MCCAFFREY & JOHN C. MCCAFFREY, STRUCTURING THE TAX CONSEQUENCES OF MARRIAGE AND DIVORCE.
- The foreign owner of U.S. real estate might also be concerned with federal reporting requirements (see for example, the International Investment and Trade in Services Survey Act, 22 U.S.C. 46, sections 3101-3108), with state regulation of foreign real estate ownership and state and local income, franchise and transfer taxation. The state and local costs of owning and disposing of real estate can be very significant.