Taxation for Foreign Real Estate Investors

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June 10, 2021
By Kenneth Yaakov Kastner, CPA

If you are a non-US person living outside the US and are considering investing in US real estate it’s important to understand taxation for foreign real estate investors.  It’s equally important to remember that the information is not a substitute for personal tax advice. Each investor should seek personalized advice from a qualified US tax professional. That being said, It is no secret that many foreign investors find the US real estate market to be an attractive target for their investment funds.[1] There are multiple variations of real estate investments, including commercial real estate properties, multi-family syndication’s, single-family rentals, fix and flips, plots of land, and self-storage facilities, among others — let’s dive into the issues facing typical investors.

 

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Table of Contents

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Structure Planning

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Avoiding Double Taxation

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Estate Tax

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Entity Formation

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Purchasing A Rental Investment Directly

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ITIN & Tax Returns

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Reporting Rental Income on Schedule

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Purchasing a House Using a Single-Member LLC

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Purchasing a House Using a Multi-Member LLC or LP

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Purchasing a House Using a US Corporation

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Purchasing a House Using a Foreign Corporation

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Investment as a Loan

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State and Loacal Tax Cosiderations

Structure Planning

Before committing to any deals, investors should consider the various legal entities that are available for holding their investments. The most common entities used by foreign investors (leaving aside direct investment as an individual) are limited liability companies (“LLCs”), limited partnerships (“LPs”), US corporations, and foreign corporations.

There are many pros and cons to each type of holding structure. Two of the main considerations at the heart of these structures are the avoidance of double taxation (in the US and the foreign country of residence) and the mitigation of adverse estate tax implications.

Avoiding Double Taxation

When considering the various structure options and tax planning strategies, it is important to be minded toward the taxation rules in one’s country of residence. Many countries tax their residents on worldwide income, which could lead to the double taxation of income without proper planning.

Furthermore, the country of residence may calculate the income using methods that are different from the US tax code. For example, accelerated depreciation using cost segregation, and like-kind exchanges (better known as 1031 exchange) are tax deferral strategies accepted in the US, but not necessarily accepted in other countries. If not planned carefully, this can also lead to double taxation.

For this reason, it’s crucial to consider both the domestic US rules that available to prevent double taxation, such as the foreign tax credit, as well as a relevant tax treaty’s provisions designed to prevent the double taxation of income. In this regard, LLCs can sometimes be particularly tricky because certain foreign countries treat LLCs as regarded entities for tax purposes, while the US treats LLCs as disregarded or flow-through entities.[2] This mismatch can lead to the unavailability of foreign tax credits, in which case treaty provisions should be explored in order to restore the tax efficiency of the investment.

Estate Tax

Before deciding on a structure, you should also consider the estate tax, which potentially applies to non-US persons holding US property. When a non-US person dies, the estate must pay up to 40% estate tax on the value of all its US assets (except for the first $60,000 per person).[3] Holding your investment through a foreign corporation is a common method for eliminating estate tax risk, but the overall income tax implications (including foreign country corporate taxation) need to be weighed against such benefit.

Additional methods to mitigate the exposure to estate tax include trusts (if formed correctly), life insurance (the insurance company would pay the estate tax), US debt (liabilities offset assets for estate tax purposes), and investing together with additional family members (diversifying the risk).

Entity Formation

Once you have chosen the ideal structure, you should an experienced real estate attorney to help you form your new entity. You can form the entity in any state, but it often makes practical sense to form the entity in the same state as the real estate property itself, thereby avoiding having to report to two separate states. In many states, the formation documents are called Articles of Organization, and certain states allow you to apply for a new entity online.

In order to form an entity without having an actual business office in the state, you will be required to appoint a Registered Agent to serve as your official contact point with the state.

You will also want to have an operating agreement or a shareholders’ agreement, depending on the type of entity, which is usually prepared by a licensed attorney.

The tax classification of your entity will be straightforward if it is incorporated as a corporation or formed as a partnership, since the tax classification will match the legal classification. However, when forming an LLC, be aware of the different possibilities. The LLC will be classified by default as a disregarded entity if it has only one owner, and it will be classified as a partnership if it has two or more owners.[4] There is also an option to elect to treat an LLC as a corporation.[5]

With this background in mind, we now turn to the most common investment structures and their tax and reporting implications.

Foreign Individual Purchasing A Rental Investment Directly

In a scenario where the investor opted not to invest through any type of entity, the residential real estate investment property (e.g., a house) is listed under the name of the individual and any gross rental income is subject to federal income tax withholding of 30% (or lower based on the relevant tax treaty).

This withholding can be avoided if the foreign person provides the payer (renter or property manager) with a completed and signed Form W-8ECI. This establishes that the individual is electing to treat the rental income as active business income, or more technically, so-called effectively connected income (“ECI”) with a US trade or business (“USToB”). Under this treatment, the rental income is subject to progressive income rates, ranging between 10% and 37% (as of 2021) after deducting all allowable expenses.[6]

Otherwise, you can submit a W-8BEN to the payer, which signifies that you are treating the rental income as passive income, or more technically, so-called “fixed, determinable, annual or periodic” (“FDAP”) income. Under this treatment, the rental income is subject to a flat 30% tax that must be withheld from your rental payments.[7]

ITIN and tax returns

A foreign individual is required to report to the IRS annually and pay tax on any rental income (less expenses) from a US property, on Schedule E of the Form 1040NR, which is the income tax return filed by non-resident non-US citizens (referred to technically as “nonresident aliens”). This form is

due by June 15th of the following year (for calendar year taxpayers) with the option to file for a 6-month extension. If filed properly, the extension

will automatically be granted, however the extension is only for the tax return. If there is any tax owed, it must be paid before June 15th.

In order to file a tax return, a foreign individual must first obtain an individual taxpayer identification number (“ITIN”) from the IRS. The application is called Form W-7, and it should be filed together with the first tax return (Form 1040NR), unless an exception applies. There is an identification process in which the IRS wants to verify the identity of the applicant, generally by examining their original, valid passport. Assuming an applicant is not present in the US and does not wish to send his original passport via mail to the IRS, there are alternatives.

The most practical alternative for applicants is to meet with a certified acceptance agent (“CAA”) of the IRS, who is authorized to perform the identity verification. A list of CAAs located all over the world can be found on the IRS website.[8]

Other alternatives include:

  • Obtain a certified copy of the passport certified by the issuing agency of the passport. This means that only the issuing agency (typically the relevant government office) is acceptable for the IRS when providing a certified copy for the purpose of attaching it to an ITIN application.
  • Although a notary CANNOT be used for this purpose, the IRS will accept a certified copy of a passport certified by the notary service INSIDE a US Embassy. Check with your local US Embassy if they provide this service.
  • A passport is the only stand-alone document accepted by the IRS for this purpose, however, on the instructions of Form W-7 there is a list of other accepted identification documents. If two of those documents are attached to the application (as described in the instructions), then a passport does not have to be included.
  • Physically visit an IRS office inside the US and present them with your original passport for identification together with your completed application and attachments.[9]

Reporting rental income on Schedule E

Whenever a taxpayer has rental income activity, Schedule E is attached to the Form 1040NR. Each rental property must be presented separately on the schedule. Typical types of expenses appear on the schedule, however, taxpayers are not limited to those examples, and other expenses may be added on a line called “other” (details of the other expenses must be listed on a separate page).

It is important to differentiate between regular ongoing expenses (such as management fees, utilities, and insurance) and capital expenses (such as the purchase of the house, renovations, and furniture). Capital expenses are not allowable in full in the year of the expense, rather a certain portion is allowed per year, in accordance with depreciation rules.

For example, if a residential home was purchased for $100,000, and 10% of that is allocated to the land situated under the house (which cannot be depreciated), the remaining $90,000 is depreciated over 27.5 years,[10] meaning each year the allowable expense would be approximately $3,273. A higher amount can potentially be taken as an expense based on a cost segregation study.

Sale of the property and FIRPTA

Upon sale of the property, the gain on the annual tax return is calculated as the difference between the sale price and the adjusted purchase price. The adjusted purchase price is lowered by the amount depreciated over the years. The remaining gain is taxed at capital gain tax rates ranging between 0% and 20%.[11] In addition, the amount depreciated is “recaptured” and taxed up to 25%.[12]

The sale will be subject to the Foreign Investment in Real Property Tax Act (“FIRPTA”),[13] a law from 1980 which requires a buyer of real property to withhold taxes from the seller at the time of the sale, if the seller is a foreign person. Barring exceptions, the withholding amount is 15% of the sale price.[14] For example, if a foreign person sells a US real property for $200,000, the buyer must withhold $30,000 and send the funds to the IRS using Form 8288 and 8288-A. The foreign seller will be able to claim the amount withheld as a refundable credit on the annual tax return.

The withholding is fully or partially avoidable if the foreign seller requests a withholding certificate from the IRS before the closing date of the sale. This request is submitted using Form 8288-B with documentation showing that the actual tax owed will be less than the withholding amount.[15]

Foreign Individual Purchasing a House Using a Single-Member LLC

This scenario is identical in terms of reporting to that of a foreign individual purchasing a house directly, with one major addition – the LLC is required to file an annual informational return on Form 5472. This form is due by April 15th each year (for calendar year taxpayers) and is filed by fax or mail together with a pro-forma Form 1120. Failure to file this form on time can result in a very heavy $25,000 penalty for each violation.[16]

The purpose of Form 5472 is to report any and all monetary and non-monetary transactions between the LLC and its foreign owner, and vice versa. Such transactions also include any contributions to the LLC or distributions from the LLC with regard to the formation or dissolution of the LLC or for any other reason.

In order to file this form (or to request an extension), the LLC must first obtain an employer identification number (“EIN”) from the IRS. The owner of the LLC is required to apply for this number using Form SS-4.

It is important to note that a single-member LLC is considered to be a disregarded entity (unless reclassified as a corporation using Form 8832).[17] Therefore, the LLC is not considered a US entity and will not protect the owner from FIRPTA withholding. A Form W-9 (declaration of a US person) should not be filed for a disregarded entity owned by a foreign person.

Foreign Individual Purchasing a House Using a Multi-Member LLC or an LP

When two or more people own an LLC, the default classification is a partnership, which is a flow-through entity, meaning the partners, not the partnership, are the taxpayers.[18] The partnership (whether a multi-member LLC or LP) files Form 1065 annually and reports the rental income activity on Form 8825 (similar to Schedule E for individuals), and provides Schedule K-1 to each partner. Schedule K-1 shows the net gains or losses for each partner based on each partner’s ownership percentage in the partnership. The foreign partner then reports this information on the Form 1040NR and pays any taxes due, in an identical manner as described above.

In addition to Form 1065, the partnership is required to withhold taxes on behalf of each foreign partner on a quarterly basis, and report the withholding annually on Form 8804. Subsequently, the partnership must provide each foreign partner with Form 8805 (showing the amount withheld for each foreign partner) so that they can claim the refundable credit on their annual Form 1040NR tax return.

The amount of withholding is the highest possible tax bracket in a certain category, depending on the type of income derived by the partnership. For example, withholding for ordinary income for an individual partner would be 37%, and capital gains would be 20%.

The filing deadline for Form 1065 and Form 8804 is generally March 15th (for calendar year taxpayers) with an option to receive a 6-month extension. If a partnership keeps its books and records outside the US, it can file until June 15th with an option for a 3-month extension.

Penalties for late filing start at $205 per month or partial month (as of 2020), and are multiplied by the number of partners listed in the partnership.[19]

When a US partnership sells real estate, FIRPTA withholding on the sale price will not apply since the partnership is not a disregarded entity, rather, the partnership itself will ultimately withhold taxes for each foreign partner based on the actual gains.

Foreign Individual Purchasing a House Using a Multi-Member LLC or an LP

When two or more people own an LLC, the default classification is a partnership, which is a flow-through entity, meaning the partners, not the partnership, are the taxpayers.[18] The partnership (whether a multi-member LLC or LP) files Form 1065 annually and reports the rental income activity on Form 8825 (similar to Schedule E for individuals), and provides Schedule K-1 to each partner. Schedule K-1 shows the net gains or losses for each partner based on each partner’s ownership percentage in the partnership. The foreign partner then reports this information on the Form 1040NR and pays any taxes due, in an identical manner as described above.

In addition to Form 1065, the partnership is required to withhold taxes on behalf of each foreign partner on a quarterly basis, and report the withholding annually on Form 8804. Subsequently, the partnership must provide each foreign partner with Form 8805 (showing the amount withheld for each foreign partner) so that they can claim the refundable credit on their annual Form 1040NR tax return.

The amount of withholding is the highest possible tax bracket in a certain category, depending on the type of income derived by the partnership. For example, withholding for ordinary income for an individual partner would be 37%, and capital gains would be 20%.

The filing deadline for Form 1065 and Form 8804 is generally March 15th (for calendar year taxpayers) with an option to receive a 6-month extension. If a partnership keeps its books and records outside the US, it can file until June 15th with an option for a 3-month extension.

Penalties for late filing start at $205 per month or partial month (as of 2020), and are multiplied by the number of partners listed in the partnership.[19]

When a US partnership sells real estate, FIRPTA withholding on the sale price will not apply since the partnership is not a disregarded entity, rather, the partnership itself will ultimately withhold taxes for each foreign partner based on the actual gains.

Foreign Individual Purchasing a House Using a US Corporation

In this scenario, a US corporation owns the property and the corporation is also the taxpayer. Corporate tax is a fixed 21% rate for all types of income (as of 2021), and the annual tax return form is called Form 1120. A corporation needs to have an EIN in order to file. The filing deadline for a Form 1120 is April 15th (for calendar year taxpayers) with an option to get a 6-month extension of time to file. Even with an extension, any tax due must be paid by April 15th.

The foreign individual will most likely not have to file a personal tax return, and therefore will not need an ITIN either. When the corporation distributes dividends to the foreign owner, it is the corporation’s responsibility to withhold taxes at the correct amount (based on the relevant tax treaty). If a corporation does not withhold the correct amount of tax for any reason, the individual may file a personal tax return to pay the remaining tax or to request a refund.

As opposed to an individual taxpayer, a corporation can be penalized for filing a late tax return even if it does not owe any tax. In this case, the minimum penalty for filing more than 60 days late is $435 (as of 2020).[20]

A corporation is also required to disclose personal information, such as the names and addresses, of any foreign shareholders who own 25% or more of the corporation.

Furthermore, the corporation must attach Form 5472 to its annual tax return if a 25% foreign owner had any reportable transactions with the corporation. As opposed to the Form 5472 required by a Single-Member LLC, a reportable transaction for a corporation does not include contributions and distributions. An example of a reportable transaction for a corporation would be a loan between the owner and the corporation. As mentioned above, failure to report this form on time or filing an incomplete form can result in a $25,000 penalty for each violation.

Foreign Individual Purchasing a House Using a Foreign Corporation

Similar to a US corporation, a foreign corporation with US rental income is also taxed at the 21% corporate rate. However, unlike a US corporation, a foreign corporation must also calculate “Branch Profits Tax” (“BPT”).[21] This extra tax is designed to compensate for the fact that the US will not receive dividend tax from the foreign corporation, by treating the US activity of the foreign corporation as a US subsidiary of the foreign corporation and taxing the repatriation of profits from the US activity at 30% tax, or as dictated by a treaty.

A foreign corporation files annually using Form 1120-F and the rules of Form 5472 for a US corporation apply to a foreign corporation as well.

The deadline for filing the annual tax return is June 15th (for calendar taxpayers) with an option for a 6-month extension.

Investment as a Loan

One additional aspect for foreign investors to consider is to structure their real estate investment as a loan, or partially as a loan to a US debtor.

The US tax code exempts a foreigner from paying US tax on interest income when the loan is structured in a specific manner. This exemption is known as Portfolio Interest Exemption (“PIE”).[22] Some of the criteria are as follows:

  • The Lender is a Foreign Person/ Entity and the Borrower is a US Person/ Entity
  • The loan is registered and it can only be transferred to a different lender if properly registered
  • The Lender does not own 10% or more of the Borrowing Entity
  • The loan is substantially a loan (set interest amount, set maturity date, etc.), as opposed to equity where the returns on the investment are based on performance.[23]

If qualified, the foreign lender is not required to obtain an ITIN or file a US tax return.

The loan is also exempt from estate tax.

State and Loacal Tax Cosiderations

In additional to the federal income tax and reporting requirements, foreign investors should consider the state and local tax and reporting implications of their investment.

  • Each jurisdiction sets its own rules for collecting income tax. Therefore, the tax rates and deadlines vary from state to state.
  • The following nine states currently (2021) do not impose income tax on individuals: Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming.
  • Although there is no individual income tax, some of these states might impose income tax and/or various filing requirements on corporations or partnerships. Each scenario must be carefully analyzed before reaching any conclusions.
  • For foreign investors in US real estate, every type of tax structure and every type of income can have different tax rates, different forms, different withholding obligations, different reporting obligations, different deadlines, and different penalties.
References:

[1] For a recent article describing the continued popularity of US real estate investments, see Jennifer A. Kingson, Foreign Investors Poised to Flood US Real Estate Markets, WWW.AXIOS.COM, https://www.axios.com/foreign-investors-real-estate-biden-b1a57dc4-b54a-407e-9bdd-020cb8cc370d.html (last visited Jan. 10, 2021). [2] As an example, the United Kingdom treats LLCs as opaque (not transparent) for tax purposes. See HMRC internal manual, International Manual, Foreign entity classification for UK tax purposes: List of Classifications of Foreign Entities for UK tax purposes, WWW.GOV.UK, https://www.gov.uk/hmrc-internal-manuals/international-manual/intm180030 (last visited Jan. 10, 2021). [3]  A credit of $13,000 is available to the estate of a nonresident alien decedent. I.R.C. §2102(b)(1). The effect of this credit is to shelter the first $60,000 of taxable estate from the estate tax. [4] Treas. Reg. §301.7701-3(b)(1)(i)-(ii). [5] Treas. Reg. §301.7701-3(c). [6] I.R.C. §871(b). [7]  I.R.C. §871(a). [8] See Internal Revenue Service, Acceptance Agent Program, WWW.IRS.GOV,  https://www.irs.gov/individuals/international-taxpayers/acceptance-agent-program (last visited Jan. 10, 2021). [9] See Internal Revenue Service, Instructions for W-7, WWW.IRS.GOV, https://www.irs.gov/instructions/iw7 (last visited Jan. 10, 2021). [10] I.R.C. §168(c). [11] I.R.C. §1(h)(1)(B)-(D). [12]  I.R.C. §1(h)(1)(E). [13] See Omnibus Reconciliation Act of 1980, Pub. L. No. 96-499, §2599, 2682 (1980). [14]  I.R.C. §1445(a). [15] Treas. Reg. §1.1445-3. [16] Treas. Reg. §1.6038A-4 [17] Treas. Reg. §301.7701-3(b)-(c). [18] Treas. Reg. §301.7701-3(b)(1)(i). [19] see Internal Revenue Service, Instructions for Form 1065, WWW.IRS.GOV, https://www.irs.gov/instructions/i1065 (last visited Jan. 10, 2021). [20] See Internal Revenue Service, Instructions for Form 1120, WWW.IRS.GOV, https://www.irs.gov/instructions/i1120 (last visited Jan. 10, 2021). [21] I.R.C. §884. [22] I.R.C. §871(h). [23] Id.

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