Foreign Real Estate Investors Must Consider All US Taxes
By Brad Wagner, CPA. Wagner, Duys & Wood, LLLP, Bethesda, Maryland
Foreign inbound investors in U.S. real estate anticipate owing Federal income tax on the profits from the rental and sale of their properties. However, many do not realize that there are state and local taxes that will be incurred. This is because, many foreign investors live in countries where there is a National income tax, but no state and local tax. The state and local taxes can have a significant effect on the cash flow and internal rate of return to investors.
Let’s assume the foreign investors will structure their acquisitions with the typical blocker structure. A foreign corporate parent is set up to own 100 percent of a United States C Corporation, also known as a blocker corporation. This will block the investors from individual tax obligations and filing disclosures. The blocker corporation will either own the real estate directly or through an LLC.
Income tax. Corporate income tax is incurred on the annual taxable income from rental operations and gain on the sale of properties. Not all 50 states have the same corporate income tax laws or tax rates. Nevada, South Dakota, Washington and Wyoming are examples of states that do not have a corporate income tax. State corporate income tax rates typically range from 5% to 10%. In addition, some cities such as New York City have a corporate income tax.
The state tax rate is applied to the taxable income after any tax loss carry forwards from prior years. These are called net operating losses (“NOL”). The Federal tax rules allow an NOL to be carried forward indefinitely, but not carried back. Some states have different rules on NOLs than the Federal government. Some states allow carrybacks. Some states only allow a shorter carry forward period. Some states have NOLs apportioned in the year incurred and some in the year used.
If the blocker owns properties directly or through passthrough entities in more than one state, the taxable income must be apportioned to each state every year. Apportionment formulas are designed to allocate to a taxing state, for tax purposes, a share of a company’s income that corresponds to its business activity in the state. State formulas use one or more factors to determine each company’s overall taxable income apportionment percentage. States have different rules on apportioning taxable income. Historically, an equally weighted 3 factor formula was utilized based on revenue, property and payroll. About ten years ago, the trend was to double weight the receipts factor. Today, the trend is a single receipts factor. The apportionment rules can result in positive or negative inequitable results. Timing of sales may be used to reduce the state income taxes on the gain of a property sold. For example, if the blocker owns three properties in three separate states, and one state uses a single receipts apportionment factor, one uses a double weighted sales factor and one uses the old equally weighted 3 factor formula, it’s unlikely that the blocker will pay tax on 100% of its taxable income. If the three factor formula is used, it may be easy to manipulate it by creating payroll or eliminating payroll by using a management company. Also, the blocker can reduce the state income taxes if it sells the property in the state with the highest income tax rate in a year before the other properties are sold. This is because some of the gain will be apportioned to the other states with lower income tax rates.
For example, let’s assume a blocker owns two properties. One is in Nevada and one is in Georgia. Nevada has no corporate income tax and Georgia has a 6% income tax rate. Georgia apportions taxable income based on receipts. They do not consider payroll or property. Assume in year one, the blocker corporation sells the Nevada property for $10 million with a 1 million gain and the Georgia property has $500,000 of sales and taxable income of zero. There would be no tax in Nevada, since there is no corporate income tax there. There would be Georgia income tax of $2,880. The taxable income of $1 million would be multiplied by the apportionment percentage of 4.8% ($500,000 Georgia sales divided by $10,500,000 total sales), and this would be multiplied by the 6% Georgia income tax rate. If the Georgia property is sold in year 2 at the amount of its adjusted basis, there would be no taxable income and no Georgia tax due.
Now let’s flip the sequence in the facts above. The Georgia property is sold in year 1 for $10 million with a $1 million gain, the Nevada property has $500,000 of rental income in year one with zero taxable income and is sold in year 2 for its adjusted basis. There would be Georgia income tax in year one of $57,000. The $1 million of taxable income would be multiplied by the sales factor of 95% ($10 million divided by $10,500,000), resulting in apportioned taxable income of $950,000. This would be multiplied by the Georgia income tax rate of 6%, resulting in Georgia income tax of $57,000. These examples demonstrate the differing results in state tax based on the timing of the sales.
Some states have NOLs apportioned in the year incurred and some in the year used. Florida apportions NOLs in the year incurred. Maryland apportions the NOL in the year used. For example, let’s assume the blocker owns a property in Florida and Maryland. In each of the first 3 years, the blocker has a tax loss of $500,000, with 30% apportioned to Florida and 70% apportioned to Maryland. The Florida NOL carryforward into year 4 would be $45,000 ($500,000 annual loss multiplied by 30% multiplied by 3 years). Maryland would use the NOL carryforward of $1.5 million ($500,000 loss times 3 years). Assume both properties are sold in year 4 and the blocker has taxable income of $1.5 million, with 30% apportioned to Florida and 70% to Maryland. There would be Florida taxable income of $450,000 in year four. This would be offset by the Florida NOL carryforward of $45,000. The Florida taxable income after the Florida NOL carryforward would be $405,000, and the tax would be $22,275 based on the 5.5% tax rate. Maryland would take the current year taxable income of $1.5 million, subtract the NOL carryforward of $1.5 million then multiply it by the Maryland apportionment percentage. Therefore, there would be no Maryland taxable income or tax in the year of sale. Two very different results in Florida and Maryland based on the NOL apportionment rules.
When a property is sold some states use the gross sales price in the receipts factor and some use the net gain from the sale of the property in the receipts factor. This can have a significant effect on the apportionment percentage to a state.
Some of the states also decouple from Federal tax law on depreciation, typically decelerating it. Over the life of the property, Federal and state depreciation will be equal, but some states allow lower amounts of depreciation in the earlier years.
LLCs are flow through entities and the income flows through to the blocker corporation which pays the Federal income tax and usually the state income tax. However, a few states and jurisdictions tax LLCs, such as DC and Tennessee. In these instances, the state tax is at the LLC level, not the blocker level.
DC has a 9.2% tax on the annual taxable income of the LLC. If there is a sale of the property and a termination of the entity and it has no assets or liabilities at the end of the year, there is no D.C. income tax (other than on depreciation recapture). Use of cost segregation studies to accelerate depreciation are used in DC real estate LLCs to minimize the annual tax. This is more than just a timing difference since the sale is not subject tax upon a termination of the unincorporated business.
Tennessee has a 6% excise tax (effectively an income tax) on the taxable income of the LLC. However, the LLC members are not taxed on their share of Tennessee income. Therefore, the tax is at the LLC level, not the blocker level. In jurisdictions which tax the LLC and not the blocker, the leveraged blocker interest expense does not reduce the state income tax. The tax strategy is to maximize the debt at the property level.
Some states now assess a minimum tax on LLC, partnership and C corporation tax returns to generate revenue. These taxes apply even if the entity has a tax loss for the year. California has an $800 annual minimum tax with the filing of the LLC or C corporation return. DC has a minimum tax of $250 and if the entities’ gross receipts exceed $1 million, the minimum tax is $1,000.
Gross receipts tax. Many local counties and states have a gross receipts tax, though they may go by different names. These gross receipts taxes apply even if the entity has a tax loss for the year.
The counties in Virginia have what is called the Business License Tax. The tax is 36 cents for each $100,000 in rents each year.
Texas calls their gross receipts tax a Franchise tax. The tax is 0.75% percent of the “taxable margin” which is defined as the lower of the following three: gross receipts minus cost of sales; gross receipts minus $1 million; or 70% of gross receipts. Tenant reimbursements are excluded from gross receipts in computing this tax. If the entity has annual revenue of $20 million or less, the tax rate is 0.331%. If a property is sold, typically, the taxpayer will use the sales price of the property less transaction costs, less the adjusted basis of the property in determining revenue.
California has an annual LLC fee, which is based on California gross source revenue. It can be as high as $11,790 if the LLC has at least $5 million in annual gross revenue.
Net Worth Tax. Some of the states tax the net worth (equity) of the blocker corporation. This is typically common stock, paid in capital and retained earnings multiplied by the state apportionment factor times the net worth tax rate. For example, North Carolina has an apportioned net worth tax, which they call a Franchise tax for the privilege of doing business in North Carolina. The tax is computed three different ways, and the highest tax applies.
- The first is capital stock, surplus and retained earnings.
- The second is 55% of appraised value of tangible property in North Carolina. The blocker corporation needs to multiply the fair market value of the real estate it invests in by it’s percent interest in the deal, to arrive at this base.
- The third is the actual investment in tangible property in North Carolina.
The North Carolina net worth tax is added to the corporate income tax. The blocker corporation does not pay the higher of the two taxes.
Other taxes. State and local jurisdictions have numerous other taxes. The following is a list of the more common material taxes.
Real estate taxes. State and local counties assess real estate taxes annually based on the fair market value of the land and improvements to the property. The tax rate on the assessment is typically about one percent and is payable annually or semi- annually. The assessment can be challenged by the taxpayer if they believe it is too high. Real estate taxes are used by the counties to fund the school system, and for other public services they provide to their residents.
Personal property taxes. Many state and local counties assess a personal property tax on the cost of personal property less some stated amount of depreciation. An example of personal property would be furniture, fixtures and equipment in a hotel. A typical tax rate would be about 5 percent.
Sales tax is the amount a taxpayer pays on the purchase of personal property. The seller collects the tax and remits it to the state or local government. It is typically about five percent of the purchase price. If the purchase is from an out of state seller, the tax is called a use tax.
Transfer taxes. When a property is sold, counties levy a transfer tax based on the sales price of real estate. and a stamp tax on the amount of the mortgage.
Before foreign investors invest in US real estate they should consult their tax advisors about the state and local taxes to maximize their returns.