Many people visit Miami from abroad and decide it’s the perfect place to own a second home. Of course, why wouldn’t it be? It’s safe, the food and shopping are great, the beaches are beautiful and the weather is even better. What makes owning real estate in the U.S. even more attractive for many people is that it is perceived as a safe-haven from political instability and rising inflation, especially for those from Latin America. However, unless appropriate precautions are taken, owning U.S. real estate can have disastrous tax consequences for non-U.S. persons.
Outright ownership. Let’s take a look at a basic scenario, a foreign investor buys a vacation home in Miami Beach for $ 1 million. The benefit of this is that if he were ever to sell the property, he would potentially be eligible to treat any gain as long term capital gain, eligible for the lower capital gain rates. However, without any tax planning, if our investor were to die, the Miami Beach vacation home would be fully includible in his U.S. estate, except for the first $60,000 of value. Assuming a $ 1 million value at death, the taxes due at the current estate tax rate would be as follows:
$1,000,000
- 60,000
= 940,000
$940,000 X 40% = $376,000
Under this basic scenario, it is quickly revealed that our investor would owe $ 376,000 in U.S. federal estate taxes if he died while owning his Miami Beach home. This is a horrible result and may force his spouse or children to sell the property simply to raise the funds required to pay the tax bill. Luckily, there are numerous alternatives to this bad result.
Using a foreign corporation. Assume our investor, instead of buying the Miami Beach property outright, created a wholly owned foreign corporation, which in turn purchased the Miami Beach property. The benefit of this structure is that the foreign corporation will protect the investor from any U.S. estate taxes at death. However, the disadvantage of this alternative arises upon sale of the property. If the property were sold, any gain would be subject to a 34% U.S. federal corporate income tax in addition to a state corporate income tax. In addition, a federal branch profits tax may also be imposed at 30%. This can lead to a total income tax rate of about 60%, which is also an unacceptable outcome.
Domestic LLC. Our investor could organize a domestic limited liability company, or an “LLC.” The investor would own a majority interest in the LLC, say 99%. His spouse, another relative or a trustee could own the remaining LLC interest. The LLC would not be classified as a corporation for U.S. income tax purposes but instead would be classified as a partnership. This avoids the imposition of federal and state level corporate income taxes and also avoids the federal branch profits tax. Additionally, the investor would potentially be eligible to treat any gain as long term capital gain, eligible for the lower capital gain rates. The interests the investor owns in the LLC are considered intangible personal property. Under the common law, the statement is sometimes made that intangible personal property follows the owner and has its situs or location for tax purposes at the domicile of the owner. Thus, at death, the investor’s executor will have an argument that the investor owned no U.S. property at death since the LLC interests should be treated as located in the investor’s home country. Accordingly, the argument would be that the $376,000 otherwise due (as in the example above) have been avoided. There is a risk, however, that in some cases this doctrine will yield to the right of the government to impose a tax.
Two Tier Partnership. While the use of a domestic LLC, as discussed above, seems like a good choice for investing in U.S. real estate, many foreign investors aren’t too happy with the idea that there is only an argument that there won’t be any estate tax inclusion of the property upon death. While there is no absolute guarantee, the slightly more sophisticated two-tier partnership structure still avoids corporate taxes and provides eligibility for lower long term capital gain rates while giving a higher promise of estate tax insulation. In this structure, the foreign investor organizes a foreign corporation, which will be treated as a partnership for federal tax purposes due to a check the box election. Once again the foreign investor would own nearly all the shares in the foreign entity, with a close relative or other third party owning about 1% of the shares. The foreign corporation and the 1% shareholder will join to organize a domestic LLC, once again with similar share divisions. The LLC will then invest in U.S. real property. The use of this two-tier partnership with direct nonresident alien ownership makes the investor eligible for lower capital gain rates on a future sale of the property and there would be no corporate taxes. Additionally, this structure gives the investor a much more assured protection from U.S. federal estate taxes upon death. Further, the foreign investor can use a non-U.S. trust to avoid having the property go through probate upon death.
Other options. Depending on where the foreign investor is from, many modifications to these structures can be made to combine the desired tax results with any tax considerations from their home jurisdictions.
Conclusion. Not every foreign investor needs to use the most complex structure for his or her U.S. real estate acquisition. Nonetheless, it is the goal of the author to inform potential investors about the tax pitfalls that exist when investing in U.S. real estate and to make sure that purchasers know that there are numerous tax-conscious acquisition structures available.
2013.04.23 USRPI Miami Tax Planning
See slideshow attached.
