Historically, U.S. real estate has been a solid investment for non-U.S. persons, both as a diversification strategy and for pure returns. But the tax consequences can be severe if not structured properly.
Investment in U.S. Real Estate by a non-U.S. person can lead to rates north of 50 percent for those who do not plan and structure their investments properly. With professional help, however, investors can take advantage of the latest tax laws and cut those rates substantially.
While every investor and every deal requires unique consideration, here are four questions to consider for your clients before they invest in U.S. real estate.
How should the deal be structured?
For a non-U.S. citizen, investing directly in U.S. real estate the deal can be fraught with requirements that if not addressed properly can be very costly. The investor will have to file tax disclosures to the IRS. The Foreign Investment in Real Property Tax Act (FIRPTA) ensures high tax rates. And other liabilities may apply, such as the federal estate tax.
But there is some recourse. Investing through a U.S. corporation, known as a “blocker,” allows the corporation rather than the investor to file the disclosures and pay the taxes. Investors fund the corporation, which in turn funds the real estate deal. Done properly, this can reduce liabilities for the investor and often result in far lower tax rates.
For example, if a group of investors fund the corporation with a carefully calibrated mixture of debt and equity, the interest deduction on the debt can offset taxable income, lowering the overall tax bill. Known as a “leveraged blocker,” this structure is flexible and effective.
Another structure is known as a “splitter” structure. This structure usually works in conjunction with blockers and/or leverage blockers. A splitter structure is designed for investors who wish to invest in multiple U.S. properties. One blocker corporation is formed for each property. Through a partnership agreement, the corporate partners agree to share rewards and risks across the multiple real estate investments This allows the tax losses on underperforming assets to offset the gains on investments that do perform well, thus lowering the overall tax bill.
The splitter also can be tax beneficial when distributing sales proceeds upon disposition of the real property at a gain. For example, if the multiple properties are not sold all at one time and they were all owned by one corporation, this would subject the foreign investors to double taxation on the gain. This is because the corporation is subject to FIRPTA until it doesn’t own U.S. Real Estate consisting of more than 50% of the fair market value of its total assets for 5 years or it owns no more U.S. real estate at all. In this structure, if a property is sold at a gain, the splitter is a vehicle that allows a corporation to be bought out of the partnership (no longer owns real property) with the property sales proceeds, adopt a plan of liquidation, distribute the proceeds to the non-U.S. Investors as liquidating distributions and avoid this double taxation.
Both the leveraged blocker and the splitter are well-worn paths for non-U.S. investors to buy U.S. real estate without incurring the heavy tax consequences that come with owning U.S. real estate. How the deal is structured can make a big difference.
What do I need to know about debt transfer pricing and what can I do to avoid IRS scrutiny?
Recently, the IRS has increased their focus on transfer pricing. They see the abuse in cross-border controlled transactions used to reduce taxable income and there are large fiscal incentives to combat this abuse. In the case of the leverage blocker where the non-U.S. investors are both the shareholders and the lenders, the debt to equity ratios, interest rates and other terms must be based on what a 3rd party lender would require.
Non-U.S. Investors need to document effectively, at the loan’s inception, that the U.S. entity could have borrowed from a 3rd party lender for same amount, interest rate, loan origination, defeasance and other terms. Proper, accurate and contemporaneous documentation is key and may very well prevent an expensive tax dispute. This documentation usually requires the collaboration of experienced investment bankers, tax advisors and legal counsel. There could be material tax consequences depending on the rate and loan terms you use. It is important to choose the most favorable terms without risking trouble down the road.
Are there international treaties in play?
Non-U.S. Investors in U.S. real estate can benefit greatly from knowledge of the tax relations between nations.
Tax agreements between the United States and many countries, particularly those in the West, often contain provisions that can reduce the tax burden on U.S. real estate investments. For example, agreements between the U.S. and Great Britain, France and Germany, among other countries, stipulate that residents of those countries withhold far less in taxes on interest paid by U.S. entities than residents of countries without a treaty.
That’s an element that could impact investors under several different structures. In fact, knowledge of the treaties in place can help determine the structure of the deal, and this is another area where hiring an expert can yield major results. Before moving forward, be certain to understand the rules that will impact your investor(s) based on their country of citizenship.
What other rules apply?
Of course, investing in U.S. real estate means adhering to laws and regulations of all kinds, including those at the federal and state level in the United States, as well as any applicable statutes in the investor’s country of citizenship.
In the United States, for example, some investments may be subject to review by the Committee on Foreign Investment in the United States (CFIUS), which is authorized to evaluate transactions that bring a U.S. business under foreign ownership and control. The committee is chaired by the U.S. Treasury Secretary and has members from the departments of Homeland Security, Justice, Defense, State and others. Often, the question is whether the transaction poses a threat to national security.
In some Islamic countries, for example, Sharia Law may come into play, providing that additional requirements be met. For examples, to be compliant, structures would have to work around the payment of interest or owning any establishment that sold alcohol related to their real estate ownership.
Knowing how laws and regulations apply, and how the structure of an investment will impact disclosure and review, is simply vital. And that too is something that can greatly benefit from an experienced hand.
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