What You Should Know about Foreign Investment in U.S. Real Property

By Penelope L. Banks, CPA, Senior Tax Partner, Gordon, Hughes & Banks, LLP

If you are a real estate agent or attorney assisting foreign investors to purchase real estate in the United States, you should make them aware of U.S. income and estate tax requirements of ownership.

If real estate is purchased for rental, the same 14-day or 10% of rental days “vacation home” rule applies equally to foreign individuals and U.S. investors.  However, foreign landlords are subject to withholding at a rate of 30% of GROSS RENTS, unless they file for a U.S. I.D. number via Form W-7 as a person “doing business” in the United States, and file annual tax returns as a Non-Resident Alien (Form 1040NR).  The W-7 form can be obtained at www.IRS.gov or and can be submitted to any IRS office, a U.S. embassy or consulate, or  to a Certifying Acceptance Agent.  The latter designation is held by some public accounting firms, including Gordon, Hughes & Banks, LLP and can greatly facilitate obtaining an I.D. number for your client.  Form W-7 must be submitted with a tax return or information return required to be filed.

If the foreign individual elects 30% withholding, no U.S. tax returns are required.  However, the foreign landlord will save a significant amount of tax dollars by filing returns, since all of the costs to hold the rental property are deductible from the gross rental income.  These costs include interest, advertising, management fees, utilities, telephone, cost of travel to inspect the unit annually, as well as some factor for depreciation.  Landlords then pay tax on the net amount, less the personal exemption allowed U.S. residents (currently $3,400), at the incremental tax rate (currently 15% on the first $31,850). If expenses exceed income, a passive activity loss is generated which can be carried over to offset future income and/or gain on a future sale. A foreign individual may not file jointly if married, so title should be held in only one name to avoid having to file a tax return for each spouse.

Under FIRPTA, foreign owners of U.S. real estate wishing to sell their property are subject to 10% federal withholding and 2% Colorado withholding on the gross sales price.  This ensures that the government takes its “cut” before the foreign individual leaves the country.  The withholding is a deposit for taxes owed and a tax return is required to be filed by June 15th of the year following the year of sale.

FIRPTA withholding can be avoided or decreased by filing, prior to closing, Federal Form 8288-B along with documentation to prove the projected gain on sale.  The IRS then determines the actual tax, and issues a “Withholding Certificate” letter to the withholding agent stipulating the correct tax due.  As long as the seller can provide a copy of completed Form 8288-B to the title company at closing, the 10% withheld funds will be held in escrow from the date of closing until the date of receipt of the “Withholding Certificate”.  At that time, the corrected withholding amount will be sent to the IRS and the balance of the escrowed funds will be returned to the seller. Since the IRS seldom allows 100% of deductions claimed at the time of filing Form 8288-B, additional refunds may be claimed upon filing of the tax return in the following year (which is required whether or not additional funds are due or excess funds were paid).  If Form 8288-B is not completed prior to closing, the title company is required by law to transmit the withheld funds to the IRS within 20 days of closing.  The tax may only be refunded by filing Form 1040NR after December 31 of the year of sale.

Foreign individuals and U.S. citizens share many similarities, and some differences, with regard to estate considerations.  U.S. citizens have a non-taxable estate threshold of $2,000,000 as well as an unlimited marital deduction.  Foreign individuals have a $60,000 non-taxable estate threshold, and no marital deduction, based on the fair market value of their U.S. assets at date of death.  For a non-resident foreign citizen, U.S. assets include only real property held directly by the foreign individual, stock in a U.S. corporation not listed on any exchange held in the name of the foreign person, or U.S. partnership interests.  The estate tax rate starts at 26% at the $60,000 exemption and goes to 50% maximum.

If the real estate is currently valued (or expected to be valued prior to a sale or death) at greater than $60,000, couples can double the $60,000 exclusion by owning jointly.  Note that expenses, losses and debts are deductible against the U.S. estate in the ratio to which U.S. assets bears to worldwide assets, regardless of the location of debt, loss or expense.

Holding property in a U.S. corporation owned by a foreign corporation avoids the estate tax problem, and avoids the FIRPTA withholding problem.  If the corporation has a Colorado address, it also avoids the Colorado withholding problem.  Additionally, upon sale of the property, and payment of tax by the U.S. corporation, the liquidating distribution to the foreign shareholder is exempt from taxation.  Holding U.S. real property directly in a foreign corporation also avoids the estate tax problem, but the foreign corporation must elect to be treated as a U.S. corporation to avoid the FIRPTA and Colorado withholding problems.  To avoid other more complicated tax issues, the foreign corporation should hold only U.S. assets.

One drawback to corporate ownership is that tax on the gain on sale of property is not limited to a 15% maximum rate (if property is held more than 1 year) as it is with individual owners.  However, the first $50,000 net income is taxed at 15%; the next $25,000 at 25%; the following $75,000 at 34%; the balance up to $335,000 at 39%, and anything above at 34%.  Net operating losses from the rental operation each year can be carried over 20 years to offset gain on sale.  Corporate officers and directors can hold their annual meeting at the rental property and thereby deduct the cost of the trip each year.

For corporations, the foreign individual or foreign corporate owner must be disclosed on the return, as well as any transactions between the owner and the U.S. Corporation.  For clarification of these basic rules consult your tax advisor.