Foreign investors often look to the United States as a secure place to invest in real estate. A weak U.S. dollar and lower valuations on real estate have increased the attractiveness for foreign investors. Furthermore, there are little restrictions in the United States for foreigners to own real estate.
The following is a synopsis of U.S. Federal income and estate tax implications for foreigners owning U.S. rental real estate. As always, this is only given as a background and does not supplant the need for a good tax accountant or attorney.
Direct Ownership:
Direct ownership of real estate is the least complex structure. There are two tax methods of taxation for direct investment in U.S. real estate by foreigners. These are as follows:
Method 1: The method by which rental income will be taxed depends on whether or not the foreign person who owns the property is considered “engaged in a U.S. trade or business.” Ownership of real property is not considered a U.S. trade or business if it consists of merely passive activity such as a net lease in which the lessee pays rent, as well as all taxes, operating expenses, repairs, and interest in principal on existing mortgages and insurance in connection with the property. Such passive rental income is subject to a flat 30 percent withholding tax (unless reduced by an applicable income tax treaty) applied to the gross income. Thus, there are no deductions for real estate taxes, operating expenses, repairs, depreciation, interest, insurance premiums, etc. The gross income and withheld taxes are reported on Form 1042-S, Foreign Persons U.S. Source Income Subject to Withholding by March 15 of the following calendar year. The payor must also submit Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons, by March 15.
Method 2: If the foreign investor is engaged in a U.S. trade or business (such as developing and managing the property), the rental income will not be subject to withholding and will be taxed at ordinary progressive rates. Expenses such as mortgage interest, real property taxes, maintenance, repairs and depreciation are deducted in determining net taxable income. The nonresident should make estimated tax payments for the tax due on the net rental income, if any.
Foreign individuals and foreign corporations can elect to have their passive rental income taxed as if it were effectively connected with a U.S. trade or business (method 2). Once such an election is made by attaching a declaration to a timely filed income tax return, there is no obligation to withhold even in a net-lease situation. Once made, the election may not be revoked without the consent of the IRS.
Ownership via a U.S. Corporation:
Foreign investors may choose to own real estate through a U.S. corporation. Under this scenario, the corporation is taxed on its net income at progressive rates, (up to 38 percent). Profits distributed in the form of dividends to foreign investors are subject to a flat 30 percent tax (unless reduced by a tax treaty). Since dividends are not deductible for U.S. corporations, it is preferable to finance these entities with debt. Interest expense is deductible for U.S. corporate tax purposes. However, restrictions apply and the interest is only fully deductible if the corporation maintains a 1.5 to 1 debt to equity ratio.
Sales of shares in the corporation are subject to capital gains tax, typically with a 10 percent withholding rate.
Ownership Through a Foreign Corporation:
Net income on foreign corporations is taxed at progressive rates, up to 38 percent. In addition, a foreign corporation is subject to the branch profits tax. The branch profits tax is a flat 30 percent of after tax earnings that are not reinvested in the United States. The purpose of the branch profits tax is to equalize the tax rates that foreign corporations pay as U.S. corporations pay. The overriding difference is that for foreign corporations, this tax is applied regardless of whether profits are distributed in the form of dividends.
A nonresident’s sale of shares in the foreign corporation is not subject to U.S. capital gains. Furthermore, upon death, the shares are not subject to U.S. estate taxes.
If you would like more information on this topic, please contact Jamie Downey at 800-849-6022 or jmdowney@downeycocpa.com.
