Once a decision to acquire U.S. real estate has been made, the next step for the foreign investor is to analyze tax and legal structures to make sure the investment is sound. This can be challenging given the complexity of the issue and variety of options available. The goal of this article is to briefly highlight the structures available to the foreign real estate investor. This should be a starting point in any discussions with a qualified accountant and attorney.
A foreign investor may acquire the property individually. This requires minimal administrative cost and is easy to maintain. While owning real estate individually is low maintenance, it does not provide the legal protection that a structure such as Limited Liability Company (“LLC”) may offer.
S-Corporations are corporations that elect to pass corporate income, losses, deductions and credits through to their shareholders for federal tax purposes. Shareholders of S-Corporations report the flow-through of income and losses on their personal tax returns and assess tax at their individual income tax rates. This allows S-Corporations to avoid double taxation on the corporate income.
However, non-resident aliens are not permitted to be shareholders in S-Corporations. In addition, investors who have rental real estate do not typically receive any significant tax advantages from S-Corporations.
For federal income tax purposes, a C-Corporation is recognized as a separate taxpaying entity. The profit of a C-Corporation is taxed to the corporation when earned, and then is taxed to the shareholders when distributed as dividends. This creates a double tax. The corporation does not get a tax deduction when it distributes dividends to shareholders. In addition, shareholders cannot deduct any loss of the corporation.
For US citizens, a C-Corporation is seldom a good option for rental real estate. But for nonresidents, a C-Corporation can be beneficial if there are concerns over estate and gift taxes. This issue should be closely examined with your tax advisor.
A partnership is the relationship existing between two or more persons who join to carry on a trade or business. A partnership must file an annual information return to report the income, deductions, gains, losses, etc., from its operations, but it does not pay income tax. Instead, it “passes through” any profits or losses to its partners. Each partner includes his or her share of the partnership’s income or loss on his or her tax return. Partnerships are very flexible entities and are often used for real estate activities.
Like other entities, foreign corporations can be taxed on a gross or net basis. However, if they make an election to be taxed on a net basis they will generally be subject to the Branch Profits Tax (“BPT”). This tax is calculated as 30% of the “dividend equivalent amount” unless calculated differently or excluded based on a tax treaty. In addition to BPT, the entity will have to pay normal income tax. The result is an incredibly high effective tax rate that will often exceed 50%. Accordingly, this tax structure is often not recommended.
The main advantage to owning real estate through a foreign corporation is that it will allow you to bypass the U.S. estate tax. The U.S. estate tax is based on individual non-resident ownership of U.S. assets, but in this case the assets are directly owned by a foreign corporation. The individual ownership of the foreign corporation shares does not constitute U.S. property. Upon a nonresident’s death, the foreign shares are merely passed to the heirs outside of U.S. estate tax.
Limited Liability Companies (LLCs)
An LLC is a business entity organized in the United States under state law. It is a hybrid form of legal structure that provides the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership. Often replacing the limited partnership, LLC’s are the universally preferred choice for holding investment real estate.
Owners of an LLC are called members. As most states do not restrict ownership, members may consist of individuals, corporations, other LLCs and foreign entities. There is no maximum number of members. Most states also permit “single member” LLCs, those having only one owner.
In business decisions or actions of the LLC, members are generally protected from personal liability. This means that if the LLC incurs debt or is sued, members’ personal assets are usually exempt. This is comparable to the liability protections afforded to shareholders of a corporation. Please remember that limited liability means “limited” liability – members are not necessarily shielded from wrongful acts.
The federal government does not recognize an LLC as a classification for federal tax purposes. A business with at least 2 members can elect to be classified as a corporation (S or C) or a partnership. While a business entity with a single member can choose to be classified as either a corporation (S or C) or disregarded as an entity separate from its owner.
Entity structure is just as important to the foreign investor as it is the domestic investor. Each structure has its own pros and cons, and is suitable to different investors. Make sure to educate yourself on the different entities and discuss the appropriateness of each with your tax professional and attorney.
About the Author
Paul B. Sundin is a CPA and tax strategist. He works with clients worldwide on real estate tax issues. You can find out more information on him by visiting www.sundincpa.com. Should you have any questions for Paul, you can reach him at 480-361-9400. Use of any information from this article is for general information only and does not represent personal tax advice — either express or implied. Readers are encouraged to seek professional tax advice for personal income tax questions and assistance.