Real estate opportunities in the USA for international investors

Buying U.S. real estate can be a lucrative investment. However, for a foreign person, navigating the complexities of U.S. tax laws, choosing the right holding structure, and avoiding potential pitfalls is crucial.

U.S. taxes

Estate tax

Non-citizens, non-residents of the United States (NRAs), may be subject to U.S. estate tax if they own certain U.S. property, defined as having U.S. situs, at the time of their death. For NRAs, and with respect to the U.S. estate tax, U.S. situs property includes real estate, such as apartments, land, buildings, and houses situated within the United States. Tax rates are progressive, promptly reaching a maximum of 40%, with only the first $60,000 of property value exempt from this tax.

In contrast, the U.S. estate tax may be avoided if the property is legally owned by a foreign corporation at the time of the death of the NRA beneficial owner.

EXAMPLE 1:

Roberto is a citizen and resident of Argentina and is not a U.S. tax resident since he only visits the U.S. occasionally for vacation. Roberto bought a house in Miami, Florida, five years ago for $5 million in his personal name. The property is currently valued at $8 million. He plans to keep the house for his heirs and is not planning on selling it in the near future. In this scenario, if Roberto were to die, there would be an estate tax exposure of around $3 million. Using a foreign corporation to hold title to the property may result in the avoidance of the U.S. estate tax.

Capital gains tax

NRAs are also liable for U.S. income tax on the gain generated from the sale, or other transfer deemed a sale, of U.S. real estate.

FIRPTA (Foreign Investment in Real Property Tax Act) mandates a withholding requirement when an NRA directly or indirectly disposes of U.S. real estate. Generally, and unless there is no gain on the disposition, the purchaser is obligated to withhold 15% of the gross sales proceeds and remit it to the IRS at the time of the disposition. Subsequently, the NRA seller can file a tax return to request a refund if the actual tax liability resulting from the disposition is less than the withheld amount.

If the property was owned directly (in personal name or via a disregarded entity) or by an irrevocable trust and was held for longer than one year, currently the top capital gains tax rate is 20%. If the property is held for less than a year, ordinary progressive income tax rates apply, with a maximum rate of 37%. If the property was owned by a foreign corporation, the tax rate on the gain would be 21%.

EXAMPLE 2:

Coming back to Roberto, if he were to sell the property, he would be realizing a capital gain of approximately $3 million, which would be subject to tax of around $600,000. In this case, having the property in his personal name provides the most efficient tax rate (20%); however, the difference compared to the corporate tax rate is not significant (21% corporate rate), but with the added benefit of estate tax protection.

Income tax on rental income

In the case of a rental property, U.S. income tax applies to rental income, with tax rates varying based on ownership structure and the nature and classification of the rental income, which may be elected.

The default classification would be as Fixed or Determinable Annual or Periodic income (“FDAP income”) as rental income is treated as passive investment income by default. If the real estate is owned directly by an NRA or a foreign corporation, the tax rate is 30% on the gross rental income collected via withholding, which is final.

If the income is elected to be treated as business income (defined as Effectively Connected Income (“ECI”) rather than FDAP income, ordinary income tax rates apply to the net income. The highest applicable rate is 37% for individuals and 21% for corporations, but it is applied to the net rental income. This means that the taxpayer can utilize deductions for expenses such as mortgage interest, property tax, operating costs, depreciation, and repairs.

State, local, and other taxes may apply in some cases and should also be considered.

Other considerations

Liability protection

When an NRA invests in U.S. real estate, it is advisable to establish a clear division between his or her personal assets apart from the real estate for the avoidance of potential property-related claims. One effective approach is to own the property through an entity that, by law, provides limited liability to its members or shareholders, like a U.S. LLC (Limited Liability Company).

In an example of a rental property held by an LLC, if the tenant sues due to injuries suffered on the property, the personal assets of the member or shareholder outside the LLC are generally shielded from liability.

While a U.S. LLC is effective for liability protection, it lacks estate tax protection. Thus, it is advisable to use a blocker. This might involve having a foreign corporation own the U.S. LLC, which holds the U.S. property.

Succession

Given that the property is situated in the U.S., it is essential to plan for the efficient transfer of the ownership in the event of the property owner’s passing. Transferring the title to heirs typically involves a lengthy and public process known as probate, with court oversight and substantial costs as well as time involved.

To mitigate these challenges and ensure a smoother transition of property ownership, it is advisable to hold the property through a fiduciary structure that allows for the transfer of ownership outside the U.S. probate process.

If the property is owned by a foreign corporation, local inheritance laws applicable to the corporation stock should be considered. Usually, owning the foreign corporation stock by means of a joint tenancy with rights of survivorship or through a trust will keep succession outside probate. Alternatively, a local will in that jurisdiction (if the option is available under local law) may not eliminate the probate process but should simplify it.

How we can help

While J.P. Morgan does not provide legal or tax advice, your J.P. Morgan Wealth Advisory team may assist you and your tax and legal advisors in navigating the potentially complex issues that may arise if you wish to consider the acquisition of U.S. real estate.