Tax implications of the type of entities used to buy real estate by foreign investors
The United States real estate market is one of the largest recipients of foreign direct investment and continues to attract foreign investors. There are no restrictions on who can buy properties in the U.S., and the process of investing in U.S. real estate is easy.
That said, investing in U.S. real estate comes with its share of U.S. tax implications. As a foreign real estate investor, it’s crucial that you understand U.S. tax laws and how it will affect your investment.
During the operation of the property, foreign real estate investors pay taxes on net rental income and real estate taxes on the property value. Upon the sale of the property, investors pay taxes on the appreciation of the property. In addition, if a foreign investor dies while owning U.S. property, there is an estate tax on the property’s value.
As you can see, the U.S. government loves real estate investments because the government gets a piece of the action without investing a penny. If you don’t plan accordingly before investing in U.S. real estate, you could end up paying more taxes than necessary.
What business entity is best for real estate investments?
There is no single best structure that works for all real estate investors. The best business entity for you will depend on your specific situation.
Work with your real estate team (attorney, banker, realtor, and CPA) to help determine which business entity is best for you. An experienced, knowledgeable team will be able to help structure your investment so that you can minimize your taxes.
What should you consider when choosing the best entity structure for foreign investors?
The best business entity for you will vary based on several individual factors. Again, work with your real estate team to discuss each of these points and how they will affect your decision.
The twelve most important factors to consider when choosing an entity to invest in U.S. real estate are:
1. Investor’s home country tax implications
2. U.S. tax treaty with the investor’s home country
3. Investment goals and objectives
4. Number of properties to be acquired
5. Type of real estate property
6. Intended use of the property
7. Whether the investor is financing the property or not
8. Whether the investor is moving to the U.S. or not
9. Foreign investor exposure to U.S. estate taxes
10. Foreign investor exposure to U.S. withholding tax
11. Individual compliance requirements vs. entity compliance requirements
12. Repatriation of funds
What are the most common business entities used to buy real estate?
Most foreign investors choose one of five business entities to structure their investment. The most common business entities used by foreign investors to buy U.S. real estate are:
1. Foreign individual ownership
2. U.S. corporation
3. Foreign corporation
4. LLC - Limited Liability Company
5. Two-tier corporate structure
Each of these holding business entities comes with a mix of pros and cons. In this section, we will analyze the advantages and disadvantages pertaining to income tax, capital gain taxes, withholding taxes, estate and gift taxes, tax compliance, and repatriation of funds.
You are not alone in this decision. Involve your attorney, accountant, banker, and realtor when discussing your entity structure, and lean on their expertise to make the best decision for your investment.
Foreign individual direct ownership
Income tax: A foreign investor receiving rental income from U.S. real property must pay income tax. Usually, the rental income is considered effectively connected with a U.S. trade or business, and therefore, it is taxed under the effective regime. This means that the tax is calculated on the net rental income (i.e., income - expenses).
Individual foreign investors pay income tax at graduated rates up to almost 40%. However, after depreciation and other deductions, foreign investors usually end up paying an effective tax rate of 20% or less.
Capital gain tax: Upon the sale of the property, foreign investors will pay capital gain taxes on the gain of the property (Capital gains = selling price - cost - selling expenses). Unlike corporations, individuals are eligible for favorable capital gain rates of 15% - 20%. This is a vital advantage of this ownership type.
Withholding taxes: A foreign person’s U.S. real property interest disposition is subject to income tax withholding under FIRPTA. The transferee must deduct and withhold a tax rate of 15% of the total amount realized by the foreign person on the property’s disposition. This withholding is an estimated tax on your potential capital gain taxes.
Estate and gift taxes: If a foreign investor buys U.S. real estate under their name, the real estate property will be subject to U.S. estate tax upon the death of the foreign investor. This is the main disadvantage of owning the property at the personal level.
Foreign investors are generally subject to an estate tax rate of up to 40% on the property’s value above the allowed exemption of $60,000. Executors for foreign investors must file an estate tax return or Form 706-NA.
Tax compliance: If a foreign investor owns U.S. real estate under their personal name, they must file individual income tax returns with Form 1040-NR. This requirement is another significant disadvantage of individual ownership.
Repatriation of funds: One valuable advantage of individual ownership is the repatriation of funds. After selling the property, paying the taxes, foreign investors can bring their money back to their home country without any additional U.S. tax implications. Unlike corporations, there is no double taxation when owning the property personally.
Summary: Individual ownership is the simplest and most cost-effective way of owning U.S. real estate. This structure offers lower income and capital tax rates compared to other entity options.
However, owning real estate under your name has disadvantages such as the imposition of the estate tax, the requirement to file individual income tax returns in the U.S., and the consequential lack of anonymity.
U.S. corporate ownership
Income tax: Foreign investors can also own real estate investments through a U.S. corporation. The U.S. corporation will pay federal income tax on the net rental income (rental income – rental expenses) at a flat rate of 21% plus state taxes. A U.S. corporation is recognized as a separate taxpaying entity for federal income tax purposes. A corporation’s profit is taxed to the corporation when earned and then taxed to the shareholders when distributed as dividends. This famous double taxation is the main disadvantage of a corporate ownership structure.
Capital gain tax: Upon the sale of the property, the corporation pays tax on the capital gain of the property, which is the selling price minus the cost and selling expenses. Unlike individuals, corporations do not have special capital gain rates. However, at the moment, the current low U.S. corporate tax rate offsets part of this disadvantage.
Withholding taxes: Under section 1445 of the Internal Revenue Code, the disposition of a U.S. real property interest by a U.S. corporation is not subject to income tax withholding.
Estate and gift taxes: Upon the death of one of the shareholders, the corporation will not pay estate or gift taxes. However, the value of the shares will be subject to estate and gift tax at the personal level, which is a great disadvantage of this U.S. real estate ownership type. Certain tax treaties provide an exemption to this general rule.
Tax compliance: If a foreign person owns U.S. real estate through a corporation, the corporation must file a corporate income tax return with Form 1120. The corporation, not the individual, is required to file U.S. tax returns.
Repatriation of funds: In order to repatriate the funds back home, the corporation will have to pay dividends to the owners of the corporation. The dividends will be subject to tax, creating double taxation for investors. This type of structure is not recommended for commercial property investors with large operating positive cash flows because of the double taxation upon paying regular dividends.
Summary: There are many advantages of owning real estate through a corporation. The corporation is a separate entity from the individual owners, eliminating the need to file a personal income tax return. You would not need to withhold tax in the case of a property sale, and the corporation itself does not pay estate taxes if one of the shareholders dies.
But owning the property through a corporation comes with disadvantages, too—most notably, double taxation. Shareholders are also required to pay estate taxes on the value of the U.S. corporate shares unless exempt through an estate tax treaty. Finally, you will have limited anonymity due to new information disclosures required for foreign investors.
Foreign corporate ownership
Income tax: Foreign corporations are generally not subject to tax in the United States unless they have U.S.-sourced income. U.S.-sourced income is categorized as either Effectively Connected Income (ECI) or Fixed, Determinable, Annual, or Periodical (FDAP) income.
FDAP income is taxed on the gross amount at a 30% rate by default. On the other hand, ECI is taxed on the net income principle.
By treating the rental income as ECI, you can deduct expenses and allowable deductions and only pay taxes on the net rental income. Even if a rental property is not considered ECI, a foreign corporation can make an election under Section 871(d) to treat the rental income as ECI.
Capital gain tax: Upon the sale of the property, the corporation will pay tax on the gain of the property, which is the selling price minus the cost and selling expenses. Unlike individuals, foreign corporations do not have special capital gain rates.
However, the capital gain on the sale of the foreign corporation’s stock will not be taxed in the U.S. If you sell the foreign corporation’s shares instead of the real estate, you will pay no taxes in the U.S. This is a significant advantage of choosing foreign corporate ownership as your business entity type.
Withholding taxes: A foreign corporation’s U.S. real property interest disposition is subject to income tax withholding under section 1445 of the Internal Revenue Code.
Estate and gift taxes: Upon the death of one of the shareholders, the foreign corporation does not pay estate taxes and the ownership interest of the foreign corporation is generally not subject to estate tax. Additionally, the gifting of foreign corporation stocks is not subject to U.S. gift tax either.
Tax compliance: The foreign corporation, not the individual, will be required to file U.S. tax returns. The corporation will file Form 1120-F, U.S. Income Tax Return of a Foreign Corporation.
The foreign corporation’s U.S. tax return must include Form 5472, which provides information about the corporation’s shareholders. This information is required under sections 6038A and 6038C.
Repatriation of funds: To repatriate the funds back home, the foreign corporation must pay dividends to the corporation’s owners. Like U.S. corporations, foreign corporations face double taxation in the form of a branch profit tax. The branch profit tax is 30% of a foreign corporation’s dividend equivalent amount for the taxable year, subject to treaty reductions.
Summary: The main advantage of owning real estate through a foreign corporation is that it allows the foreign investor to bypass U.S. estate tax. Additionally, selling the foreign corporation’s stocks is tax-free to a non-resident investor.
The main disadvantage of this entity is double taxation in the form of the branch profit tax. However, you may not be required to pay a branch profit tax if there is a treaty between the U.S. and your home country or if you retain the earnings in the corporation until the liquidation of the corporation.
LLC ownership (Limited Liability Company)
Limited liability companies have overtaken corporations as the most popular form of entity to hold real estate by foreign investors. Unless you make an election with the IRS to treat the LLC as a corporation, an LLC is classified as a partnership if it has two or more owners or disregarded as an entity if it has one owner.
We have already explained individual direct ownership and corporate ownership. In this section, we will limit our explanation to LLCs treated as partnerships.
Owners of the LLC are called members. However, for simplicity purposes, we will refer to the owners of the LLCs as partners.
Income tax: LLCs treated as 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 profits or losses through to its partners. Each partner (owner) reports their share of the partnership’s income or loss in their individual tax return.
Capital gain tax: Upon the sale of the property, the partnership will have to report the gain of the property. Again, capital gains are calculated with the selling price minus the cost and selling expenses.
The partnership does not have to pay tax on its capital gains. Instead, partners (foreign investors) report their share of the partnership’s capital gains on their individual income tax returns. They pay capital gain tax at special capital gain rates.
Withholding taxes: A partnership that has income effectively connected with U.S. trade or business must withhold and pay the withholding on the effectively connected taxable income that is allocable to its foreign partners.
A partnership must pay the withholding tax for a foreign partner even if the partner does not have a U.S. taxpayer identification number. A foreign corporation’s disposition of a U.S. real property interest is also subject to income tax withholding under section 1445 of the Internal Revenue Code, FIRPTA.
Estate and gift taxes: If a foreign investor buys U.S. real estate under a partnership LLC, the partnership interest will be subject to U.S. estate tax upon the death of the foreign investor. The U.S. imposes a 40% estate tax rate on U.S. assets above a $60,000 exemption threshold on assets of the deceased non-residents. This is one of the main disadvantages of owning the property through an LLC. Some practitioners believe that the interest of a partnership is an intangible asset and therefore the interest is not taxable for estate tax purposes. However, we take the position that the partnership interest is taxable for estate tax purposes.
Tax compliance: Partnerships file an information return to report the real estate investment income, gains, losses, deductions, credits, and so on using Form 1065 – U.S. Return of Partnership Income. Each partner in a U.S. partnership engaged in a trade or business will need to file a U.S. tax return to account for their share of income from the U.S. partnership. The form for this is Form 1040-NR, U.S. Nonresident Alien Income Tax Return.
Repatriation of funds: A significant advantage of partnership ownership is the repatriation of funds. After selling the property and paying U.S. taxes, the foreign investors can bring money back to their home country without any additional U.S. tax implications. Unlike corporations, there is no double taxation when owning the property through a partnership.
Summary: The main advantages of owning the real estate through a partnership is the single level of income tax (flowthrough) on all income and the favorable long-term capital gains rates available upon sale.
The main disadvantages are the estate tax implications of owning the real estate through a partnership and the complexity of the withholding requirements associated with a partnership.
Two-Tier Corporate Structure
In a two-tier corporate structure, foreign investors set up a foreign corporation whose sole asset is all the stock of a U.S. corporation. Then, the U.S. corporation buys the real estate.
Income tax: The U.S. corporation pays income tax on the net rental income at a flat rate of 21%. For federal income tax purposes, a U.S. corporation is recognized as a separate taxpaying entity. The corporation’s profit is taxed to the U.S. corporation when earned, and then it is taxed to the foreign corporation when distributed as dividends.
Capital gain tax: Upon the sale of the property, the corporation must pay tax on the capital gain of the property. A vital disadvantage of this ownership type is that corporations, unlike individuals, do not have special capital gain rates. However, currently, this does not have a significant impact because of the current low U.S. corporate tax rate.
Withholding taxes: The disposition of a U.S. real property interest by a U.S. corporation is not subject to income tax withholding under section 1445 of the Internal Revenue Code, FIRPTA.
Estate and gift taxes: Upon the death of one of the shareholders, neither the U.S. corporation nor the foreign corporation pay estate or gift taxes. The foreign corporation shareholders are not liable for estate tax or gift taxes. This structure provides for a high level of U.S. estate tax certainty, but at the cost of higher income tax rates in certain circumstances.
Tax compliance: Only the U.S. corporation will be required to file U.S. tax returns using Form 1120, U.S. Corporate Income Tax Return. Neither the foreign corporation nor the individual investors will need to file U.S. tax returns.
Repatriation of funds: To repatriate the funds back home, the corporation will have to pay dividends to the foreign corporation. The dividends will be subject to tax, creating double taxation for investors. To avoid double taxation, the U.S. corporation can retain the corporation’s earnings until the property is sold and the corporation is liquidated.
Summary: There are many advantages of owning real estate through a two-tier corporate structure. The U.S. corporation is a separate entity from the investor and the foreign corporation, eliminating the need to file a personal income tax return and a foreign corporation tax return. There is also no U.S. estate tax upon the death of the investor, because the ownership of the foreign corporation is not U.S. situs property for U.S. estate tax purposes. There is no branch profits tax because a foreign corporation did not earn the rental income. In addition, there is no tax withholding in the case of a property sale.
However, the two-tier corporation structure does impose double taxation. Dividends from a domestic corporation to a foreign corporation are subject to 30% withholding unless reduced by a treaty. In addition, the double taxation can be minimized by retaining the earning in the corporation until liquidation. Additionally, the U.S. corporation is not eligible for the traditional favorable long-term capital gains rate.
What is a property landlord?
The landlord is an individual or a corporation or an institution who rents out a real estate property to an individual or a business who is called the tenant.
What is a property tenant?
The tenant is an individual or a corporation or an institution who occupies the real estate property rented from the landlord.
What are the responsibilities of the landlord?
As the owner of the property, the landlord has the right to rent the property but at the same time the landlord has the following responsibilities:
1) Deliver the property to the tenant in rentable conditions – You must deliver the property to the tenant in accordance with state and federal rent rules. So, as a landlord, you are obligated to rent and maintain the property in good rentable conditions, good plumbing, no roof problems, and all structural part of the property should be in good conditions.
2) Maintain the rental property: you are obligated to always maintain the property. So, get ready to always answer calls from your tenant. As a foreign investor, you should hire the services of a property manager, so they take care of the property for you. You don’t want to receive a call in the middle of the night that the toilet is not working.
3) Comply with anti-discrimination laws: in the US, under the Fair Housing Act (FHA), landlords are prohibited from discriminating against tenants on the basis of race, sex, religion, ethnicity, family status, or disability. The Fair Housing Act protects people from discrimination when they are renting or buying a home, getting a mortgage, seeking housing assistance, or engaging in other housing-related activities.
4) Manage your tenant’s security deposit: as a landlord, you must follow the local laws surrounding security deposits. In simple terms, you cannot go and expend your tenant’s security deposit. Remember, the security deposit is not your money.
5) Keep records for your properties: as a landlord, you are obligated to keep all records related to your rental property. You must keep your tenant application, lease agreement, records of your rental income, records of your rental expenses. The IRS recommends that you keep your tax records for about seven years.
6) Paying property expenses: as a landlord, you are responsible for paying expenses related to the ownership and operation of the property. Some of the rental expenses are insurance, management fees, real estate taxes, utilities and others.
7) Notify tenants of changes: If you are repairing the property, you should notify you tenant before entering the property. Also, if you are raising the rent, you should notify the tenant with time. Like in any other business, communication is the key to a good relationship.
8) To be accessible: As a foreign investor, you are not close to the property, but you should be aware of what it is going on in your property. You should have a representative in the US who should be available in case of an emergency.
Property Management Company
Managing a property from another country can be difficult and frustrating. Being a landlord is a tremendous responsibility and it is not always fun. A property management company can help you manage the day-to-day operations of your property. For foreign investors, a property manager can be a life saver. The company can take all the headaches associated with managing the property. As a foreign investor, you need to work with a trusted property manager familiar with international investors to avoid potential issues associated with global investors.
Should a foreign investor hire a property manager?
As a foreign investor, you should work with a property management company to take care of your properties. Many foreign investors manage their properties on their own from another country. Yes, you don’t need a property manager to help you with your properties. However, as a global investor, we believe that your time would be better spend doing other things than fixing a toilet or collecting the rent. When looking for a property manager, it’s important to choose a trusted and competent company. In most states, property managers are regulated, and they must be licensed. So, consult with the regulatory agency of the state where you are hiring the property manager to verify that the company is in good standing, and it has not outstanding complaints.
How much do property managers charge?
The fees of the property managers depend on the responsibilities assigned to the property management company. The management fee is usually a percentage of the rent but we see many property manager charging a flat fee. Most property management companies charge a monthly fee of about 10%.
What do real estate management companies do?
A property management company deals directly with the tenant and take cares of the day-to-day operations of the property. Usually, a property management company do the following as part of their duties:
1. Rents the property
2. Collects the rent
3. Pays the bills, utilities, taxes, insurance
4. Negotiates with vendors
5. Maintains and repair the property
6. Deals with tenant’s complaints
7. Pursues evictions
8. Supervises third party services
9. Prepares internal financial statements
10. Ensures the smooth operations of the property
How to make money in real estate?
Real estate is a great investment, and you can make money two main ways:
1) Capturing the increase in the property value – by buying low and selling high, you can capture the appreciation on the property. For this to happen, you must buy and sell and the right time. You also have to maintain your property so it increases in value
2) Net rental income – you can also make money in real estate by renting your property at market value and keeping your operating expense low so there is money after paying the expenses. A good location is very important to ensure that you can secure good paying tenants.
How to increase the value of your property?
• Upgrade Your Interior Paint
• Touch Up Your Landscaping
• Modernize Your Bathroom
• Keep It In The Kitchen
• Get Energy-Efficient
• Add Updated Systems and Appliances. ...
• Add Technology.
• Make it more attractive
• Make it more efficient
• Make it smatter
• Make it bigger
• Chang windows and doors
• Add a pool
• Change flooring
• Add more square footage
• Add New Energy-Efficient Fixtures
• Keep Up With Regular Maintenance and Repairs
How to increase the income of the property?
Maintaining the property
Maintain and renovate
Real estate taxes appeal
Recordkeeping and accounting
As a landlord, you are responsible for paying taxes on the income of the property. In the US, the income tax system is xxxxx
Who must file a U.S. corporate income tax return with Form 1120?
Unless exempt under the IRS code, all US corporations must file an income tax return whether they have taxable income or not.
Yes, even if your corporation has no taxable income, the corporation must file a tax return. If you don’t file the return, you will pay penalties for not filing the return or filing late. A domestic entity that elects to be classified as an association taxable as a corporation must also file Form 1120.
When do I have to file Form 1120?
Generally, a corporation must file its income tax return by the 15th day of the 4th month after its tax year. For calendar-year corporations, the due date to file Form 1120 is April 15th.
How to request an extension for file Form 1120?
If you cannot file your corporate tax return in time, you can apply for an extension using Form 7004.
The automatic extension will be granted if you complete Form 7004, make a proper estimate of the tax (if applicable), file Form 7004 by the due date of the return for which the extension is requested, and pay any tax that is due.
As long as you fill out Form 7004 correctly, you will automatically be granted the maximum allowed extension. Generally, this will give you an additional six months from the due date to file your return.