Before turning the dream into reality, real estate buyers must consider long-term goals, tax implications, and the various methods for acquiring and holding property.
International buyers of U.S. real estate might seek holiday or seasonal homes, a personal place to stay while doing business, or a home for children while studying or working in the United States.
“The first step is to determine the purpose of the property, followed by other considerations such as the age and health of the owner; the cost of the property; the likely holding period; and who will eventually inherit the property if not sold,” says Joseph Tubio, Managing Director and Wealth Advisor at the International Private Bank.
House hunters should also analyze the pros and cons of various buying structures to ensure alignment with long-term wealth goals, and should consult with U.S. and home-country tax advisors before—not after—purchasing the property.
In this episode, we will talk about the purpose, structures and tax aspects to take into consideration before acquiring the property.
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JOE TUBIO:
Welcome to our Wealth Advisory Series, where we discuss topics related to life and legacy.
Today, we will be introducing you to some of the issues and considerations for the non-U.S. person who is thinking about buying real estate in the U.S.
We will identify the benefits and drawbacks of several widely used methods of taking title and holding real estate, and touch on some of the most significant tax and other considerations.
This will be a short introduction to this topic, and is not meant to be a complete or detailed survey of the many additional legal and tax issues that one may encounter. Appropriate tax and legal advice is always suggested from the onset.
My name is Joe Tubio, and today I am joined by my colleague Ariel Fleischer to discuss this topic.
So Ariel, how does one approach this subject in a manner so that we would understand the issues at hand and the options available to address them?
ARIEL FLEISCHER:
Thank you. Buying and holding real estate in the U.S. is a topic that comes up frequently in conversations with clients, since the U.S. is often a preferred destination for a number of reasons. Some buyers seek holiday or seasonal homes; others want a personal place to stay while doing business; and yet others desire housing for children while studying or working in the U.S. So the first step would be to determine the type of property desired and its intended use.
JOE:
Therefore, first, one needs to establish the intended purpose of the property, followed by other considerations, such as: the age and health of the owner; the cost of the property; the likely holding period, and who will eventually inherit the property if not sold.
One must understand how these factors may apply in order to understand the potential risks and benefits of the different ways the property may be held.
One must consider:
- U.S. taxes, such as the gift tax and estate tax;
- Income tax that may arise from capital gains on sale;
- And other non-tax considerations, like privacy, succession, corporate compliance (if a corporate entity is used) and personal liability protection.
Let’s look at some examples and see how these considerations may play out.
ARIEL:
We worked with a family where the patriarch, a healthy 70-year-old Argentine citizen and tax resident, has bought a mansion in Palm Beach five years ago. The family spends vacation time there several times a year. The purchase price was around 5 million dollars, but the current market value is north of $10 million. He plans to keep the property as the family’s yearly gathering place, and does not plan to sell it during his lifetime.
We can see here that his objectives are well defined. He bought the house in his personal name. Is that the best option under the circumstances?
In the first quarter of last year 2020, in light of COVID, he was concerned about possible health consequences, and the holding and passing of the house became more relevant.
JOE:
Okay, let’s analyze your case and his concern. We have mentioned a number of considerations, but usually the U.S. estate tax is a major factor in choosing the way the property should be held. The U.S. estate tax applies to non-U.S. persons on assets having U.S. situs owned at death. The maximum tax rate of 40% is quickly reached after $1 million worth of value.
For this client, if he were to pass away owning the house, and assuming he did not own other assets having U.S. situs, his estate would be subject to approximately $4 million dollars in taxes. The heirs would be entitled to the house, subject to the tax bill being paid. We have seen cases where the taxable asset had to be sold in order to raise the cash needed to pay the tax bill.
What better option may be available in this case?
ARIEL:
In order to avoid the estate tax, the use of an entity, such as a foreign corporation, as the ownership vehicle, may have a totally different result.
If this client had bought the house in the name of a foreign corporation where he owns the stock and the proper formalities are followed, then at his death, he would not own the U.S. property; therefore, the property should not be part of his U.S. taxable estate. Assuming the foreign corporation stock does not have U.S. situs, it is not subject to U.S. estate tax. Obviously, one must also ensure that there is no estate or inheritance tax in the country where the corporation is organized due to the death of the shareholder.
In this example, the benefit of choosing the right holding structure is obvious, as it could result in tax savings of approximately $4 million. So, put into perspective, if the house value increased and reached $20 million at the time of death, then the approximate tax bill would be $8 million at today’s rates.
JOE:
Let’s elaborate a bit more on this family. This client’s son prefers Miami over Palm Beach. He wants to buy a small apartment in Key Biscayne that he found at a very competitive price. He mentioned that he may sell the property if it were to appreciate 20% or more, so he would presumably only hold it for a few years. The son is young and in good health.
In his case, the exposure to the estate tax is less obvious and less significant. So, instead of creating a corporation to hold a $1 million dollar apartment, he is considering term life insurance, as it may be an effective and inexpensive mitigant to cover the potential estate tax on the property if he were to die prematurely. For him, the plan is to sell the property in a few years, so life insurance, in annual payments, might be a good solution.
ARIEL:
In the son’s example, it may be fine to hold the property directly in personal name.
Alternatively, it may be held by means of a simple holding vehicle that has the same tax consequences as if it were held in personal name, such as:
- A single member U.S. limited liability company, considered a disregarded entity for tax purposes; or
- A revocable trust, considered a pass-through entity.
The important point here is that none of these methods of ownership provide protection against the U.S. estate tax, but they may provide a method of succession of the property outside of probate, which would otherwise occur if held in sole personal name. The avoidance of probate should also be an important consideration.
After solving for the estate tax, there may be benefits to holding the property directly:
Possibly a lower capital gains tax rate on sale.
If the son sells the apartment after one year, and the property was held for investment, the gain on the sale is taxed at the U.S. long-term capital gains tax rate, currently at a maximum rate of 20%.
Alternatively, if sold by a foreign corporation, the applicable corporate tax rate is currently 21%, but historically has been at 35%, and is likely to increase again.
The son would also avoid expenses of organizing and maintaining more complex vehicles, such as corporations, partnerships or trusts.
Lastly, if held under a Limited Liability Company, the company may protect the shareholder’s personal assets from claims against the company, since the shareholder’s liability is limited to his capital contribution.
For example, we have seen cases of apartment units with ruptured pipes causing water damage to other units of the building while the owner was absent.
JOE:
Going back to the father’s case, where protection against the potential estate tax is important due to the high value of the property and the older age of the owner (or where life insurance may be too expensive), a foreign corporation is more appropriate:
To summarize the benefits:
(i) a relatively low corporate tax rate, currently of 21% on the gain from the sale;
(ii) the estate tax protection, already mentioned; and
(iii) Liability protection for the shareholders of the corporation, which may come in handy if they decide to rent the property to a third-party, non-family member.
Again, the 21% corporate rate is not guaranteed into the future, but neither is the 20% rate for individuals. Both rates are projected to increase during the Biden Administration.
It is important to note that there are may be other additional complexities from corporate ownership. After all, a foreign corporation is a separate legal person. State, local taxes and other taxes may apply in some cases, and should be discussed thoroughly with tax counsel.
Hand-in-hand with tax, corporate ownership requires that corporate formalities be followed, and carefully observed, meaning that the corporation must be treated and respected as the separate legal entity it holds itself out to be, or the desired benefits may be lost.
Ariel, what about this issue of corporate formalities?
ARIEL:
The issue of corporate formalities comes up frequently. Most commonly is the free use of the corporate property, often unaware of the requirements and consequences.
One specific client from Costa Rica has a daughter, recently accepted to business school at NYU. The client mentioned that the daughter would live in the apartment the client owns in Manhattan.
Let’s review this case. The client owns a $20 million apartment on the Upper East Side. The daughter will live there on a continuous basis while attending university. The property is owned by a foreign corporation and the client is the sole shareholder.
If the daughter lives in the property that is legally owned by the corporation, complex issues arise if she does not pay fair rental value for the use of the property; on the other hand, a different set of complex issues can arise if she pays rent for the use of the property. It is critical to have tax advice on the family’s use of any property held by the corporation.
In addition, the corporation may be disregarded as far as the estate tax protection it was intended to provide. In other words, if the client were to die, the IRS may determine that the corporation does not exist, and the property may be subject to estate tax as if it were directly owned by the decedent.
But another alternative could be to own the property through a different holding vehicle: a trust. Please comment on the use of a trust in this case.
JOE:
Trusts are also used as holding vehicles for real estate; and may be the best fit in some cases. An irrevocable trust (whether domestic or foreign) when properly drafted may avoid the application of the U.S. estate tax. However, the trust must be used carefully to ensure that the anticipated tax treatment of the trust, the settlor and the beneficiaries are met. For example: If the person who creates the trust, mother in this case, is also a beneficiary of the trust, with a potential to enjoy the use of the property, depending on the facts, there is a possibility that the tax authorities may consider that she is the continuing owner of the property. In such case, the property may become part of her taxable estate upon death, resulting in estate tax.
The typical advice clients receive is that anything that is placed in an irrevocable trust should no longer be available to the grantor to enjoy.
However, for the daughter who is studying in the U.S., as the beneficiary designated to enjoy the use of the trust property, it is possible to establish the trust in such a way that she may occupy the real estate without having to pay rent to the trust, without U.S. income tax consequences to the trust or the beneficiary.
So this would meet the desired objective for the years she is studying, and other family members may also enjoy use of the property if so provided.
And finally, a trust is taxed at the same capital gains rate as an individual on the sale of the property, historically lower than the corporate rates we discussed.
ARIEL:
I agree that the irrevocable trust strategy usually works best if the intent is to maintain the property (assuming it’s held for investment) for the use of the family for long periods of time (even for several generations), so that the grantor’s family enjoys the use the property as set out in the trust agreement.
But in all cases, there are other considerations that should be planned for. One common mistake is to buy the property in personal name before setting up the optimal holding structure. When utilizing either a foreign corporation or an irrevocable trust as the title holder, the corporation or the trust should purchase the property from the beginning.
If a client already owns the property in personal name, the transfer of the property to a foreign corporation may result in a taxable transfer as a sale under U.S. tax law. The tax laws of the owner’s country of residence also may treat the transfer as a deemed sale.
Also, a transfer of U.S. real property to an irrevocable non-grantor trust may result in a taxable gift under U.S. gift tax rules.
These adverse consequences may be able to be avoided with proper planning beforehand. It is important to get the right advice before getting started.
We are almost out of time. Joe, what takeaways can we leave our listeners with?
JOE:
We can safely say that here is no one-size-fits-all solution. Each family has different objectives, and, therefore, the appropriate holding vehicle should be selected according to the particular case. However, the following three takeaways can serve as a good reminder when thinking of buying a property in the U.S. First, one should define the objectives for the property, like the purpose, the intended use and the holding period. Second, one should analyze the pros and cons of the possible structures under consideration to ensure that there is a fit and alignment with the person’s objectives—in consultation with U.S. and home-country tax advisors; and third, do both of these things before actually purchasing the property, and not afterwards.
ARIEL:
To our listeners, thank you. The Wealth Advisory Team at the J.P. Morgan Private Bank is here to help you plan and structure your wealth, with an eye on your global holdings. We believe this kind of thorough and thoughtful planning can help preserve your legacy, and pass on your vision for generations to come.
That’s all for this episode. Thank you for listening to our Wealth Advisory Series on topics of life and legacy.
