Tax planning for US real estate can be complicated. A plan to save on income or capital gains taxes might accidentally cause higher estate or gift taxes, and the same can happen the other way around.
It’s important to understand the rules no matter where you live. US residents have to pay taxes on all their income and assets worldwide. Non-residents, including foreign companies, also have to pay taxes. A law from 1980, called the Foreign Investment in Real Property Tax Act (FIRPTA), makes non-residents pay federal and sometimes state taxes on income and profits from US property sales.
Your residency status affects how much tax you owe, so getting advice and planning ahead carefully is a good idea.
1. Income tax and capital gains tax
Both US residents and non-residents must pay taxes on income earned from renting out US property and profits from selling it. However, non-US residents have some additional tax options:
Rental Income:
By default, non-residents pay a flat 30% federal tax on gross rental income.
Non-residents can opt to treat their rental activity as a business. This allows them to deduct expenses, reducing their taxable income, and pay taxes at graduated rates, with a maximum of 37%.
US residents are always taxed on their rental income after deducting expenses, and at graduated rates, they are taxed up to a maximum of 37%.
In both cases, losses can offset similar income if expenses exceed income or be carried forward for future tax years.
Capital Gains:
If a property is held for over 12 months, the maximum federal tax on gains is 20%, with lower rates (0% or 10%) possible for smaller gains.
For properties held less than 12 months, gains are taxed as regular income, with rates up to 37%.
Non-residents must file an annual tax return using IRS Form 1040NR to report income and pay taxes.
2. Corporations and Trusts
Tax rates for corporations and trusts are different from those for individuals.
Corporations:
If a company owns a property, it faces a 21% federal tax on its income, as per the Tax Cuts and Jobs Act of 2017.
Companies must file taxes using Form 1120-F.
Foreign Corporations and Branch Profits Tax:
A foreign corporation earning rental income from US property may face an additional 30% tax on profits sent to shareholders.
Tax treaties can reduce or eliminate this tax, but this tax applies fully if there’s no treaty. A US corporation can sometimes act as a middleman to avoid this.
Trusts:
Trusts are generally taxed at the same rates as individuals. They use Form 1040NR for filing.
For certain trusts, called foreign grantor trusts, the person who created the trust (the settlor) is responsible for paying taxes on income and gains, not the trust itself.
State Taxes:
In addition to federal taxes, state taxes on rental income or property gains may also apply, depending on where the property is located.
3. Special Withholding Tax Rules for Non-US Residents Selling US Property
Non-US residents selling property in the US must consider special tax rules.
FIRPTA Withholding Tax:
Under the Foreign Investment in Real Property Tax Act (FIRPTA), non-residents selling US property face a 15% withholding tax on the gross sales price.
The buyer is responsible for collecting and submitting this tax to the IRS within 20 days of the sale. Failing to do so may result in penalties.
Exceptions and Exemptions:
There are exceptions, such as when the sale results in a tax loss. However, to qualify for these exceptions, the seller or buyer must apply to the IRS for an exemption or a reduction in the withholding tax amount.
The IRS must approve any exemption or reduction; a valid certificate is required.
Application Process:
It’s important to apply for the exemption or reduction well before the sale is completed, as withholding tax will be applied without a valid certificate.
If an application is made, the provisional withholding amount can be placed in escrow until the IRS decision is received.
State Rules:
Each state also has its own rules for tax on property sales, many of which are similar to the FIRPTA provisions.
4. Estate and Gift Tax on US Property
Owning US property can expose you to US estate and gift taxes, which need to be carefully managed.
Domicile and Tax Rules:
US estate and gift tax obligations depend on whether you are considered a US tax resident (domiciled in the US). Unlike income tax, there’s no specific test (like the substantial presence test) to distinguish between residents and non-residents for estate and gift tax purposes.
A person who has never lived in the US but owns US property at death is considered non-domiciled for estate tax purposes.
A US citizen, even if living abroad, is still considered domiciled in the US for estate tax purposes.
Tax Treaties:
Estate and gift tax treaties may override or adjust the rules about who can tax the property and how domicile is determined.
Tax Exposure:
Generally, non-domiciled individuals will still be liable for US estate and gift tax on tangible property in the US. However, treaties may provide exemptions or higher exemption amounts for certain items (e.g., personal items within a property).
State Taxes:
In addition to federal taxes, each US state can impose its own estate or inheritance taxes. Not all staes have such taxes, but where they exist, the rules vary.
5. Implications for Non-Domiciles
Non-US domiciled individuals may face higher taxes on US property than US domiciled individuals unless a tax treaty offers additional relief.
Estate Tax for Non-Domiciled Individuals:
If a non-domiciled person (not a US citizen) passes away, their estate will only be taxed on US-based property, including real estate.
There’s a small exemption of $60,000 against the value of US property for estate tax calculations. However, estate tax rates rise quickly, reaching 40% on estates exceeding $1 million.
If heirs hold the property personally, any future capital gains will be calculated based on the property’s market value at the time of death.
Marital Exemption:
The marital exemption applies only if the surviving spouse is a US citizen. If both spouses are non-domiciled, US estate tax will apply only to the first spouse’s estate to die.
Planning and Advice:
Individuals owning US property should seek advice on whether special provisions in their will or an estate tax treaty can reduce their tax liability or increase the exemption amount.
Property Held in a Non-US Corporation or Trust:
Suppose the property is held within a non-US corporation. In that case, it won’t be subject to US federal estate tax, as the company is seen as the owner, not the individual shareholders. However, the corporation must be properly maintained (with meetings, resolutions, etc.), or the IRS may disregard its structure.
Similarly, property held in an irrevocable trust may also be outside the scope of estate tax, provided it’s considered a completed gift.
Tax Filing:
There’s no automatic withholding tax for estate taxes like FIRPTA. Instead, any taxes due should be paid by filing IRS Form 706NA.
6. Using Trusts vs. Corporations
When owning property through an entity, both trusts and foreign corporations can offer potential tax advantages, especially regarding estate tax planning. The decision on which structure to choose depends on several factors, including tax implications and legal considerations.
Trusts vs. Corporations:
- Historically, trusts were preferred due to their flexibility and lower tax rates. However, after the US tax reforms in 2017, foreign corporations have often become the preferred choice. This could change if corporation tax rates rise to 28%, as proposed by the President.
- Both structures can act as intermediaries, potentially helping shield property from estate taxes, but careful planning is essential to maximise tax benefits.
Key Considerations for Trusts:
- Settlor Control: The settlor (the person creating the trust) should not retain too much control or benefit over the property, as this could cause the property to be included in their estate at death.
- Funding the Trust: Careful attention is needed to determine whether the trust is funded with cash that then buys the property or if the property itself is transferred into the trust.
Key Considerations for Corporations:
- Proper Management: It’s crucial to demonstrate the corporation is properly managed so that it is not considered a sham by the IRS.
- Inherited Shares: If the property is held in a corporate vehicle, the heirs inherit company shares, not the property directly. The base cost of these shares will be their market value at the time of death rather than the property’s value. This can be a disadvantage if the heirs wish to sell the property, as they would incur tax on any gains.
Impact on Estate and Gift Taxes:
- Trusts and Corporations: Neither trusts nor foreign corporations provide an automatic step-up in the property’s cost basis for estate tax purposes. This could be a disadvantage if heirs wish to sell the property, as they would be taxed on any capital gains from the property’s appreciation.
- Gift Tax: Transferring property into a trust or foreign corporation may trigger gift tax, depending on the structure and jurisdiction.
Additional Reporting Requirements:
Both trusts and foreign corporations come with extra reporting requirements for US citizens or residents who inherit the property. These individuals must comply with US tax laws regarding their inheritance.
Considerations Based on Jurisdiction:
The tax rules in the taxpayer’s home country must also be considered. In some jurisdictions, using a foreign trust or corporation may not be tax-efficient and could result in higher taxes. Therefore, local tax laws should always be considered when deciding whether to use a trust, corporation, or neither.
Conclusion
Understanding US tax rules for real estate is very challenging, especially since residency status plays a big role. The best solutions usually depend on where you live, state tax laws and treaties, and their home country’s tax rules for non-residents. Getting advice and planning carefully is key.
