Reducing or Eliminating U.S. Taxes for Foreign Property Owners

[Jennifer Hashisaki]

Now is perhaps a better time than ever to invest in U.S. real estate for both income and long-term appreciation. However, as can be expected, the U.S. seeks to tax the appreciation on these properties when they are sold and tax their value when transferred by gift or upon death. This tax burden falls heavier on foreigners, because foreigners don't enjoy certain credits and deductions reserved to U.S. persons. By planning ahead, foreign real estate investors can still minimize or eliminate some U.S. tax consequences of their investment by using offshore corporations. For those currently owning U.S. real estate in their individual names, today's depressed property values also provide a rare window for transferring their properties to a tax-efficient, foreign corporation structure at minimal cost. In any case, and for many legal reasons in addition to saving on taxes, proper planning must be completed before you sign the real estate contract.

Even if a foreigner does not file U.S. tax returns or have any business in the U.S., the mere fact of owning U.S. real estate results in a U.S. estate tax return filing requirement upon the foreigner's death. The estate of a U.S. citizen, resident or person domiciled in the U.S. ("U.S. person") includes all assets the decedent owned anywhere in the world. On the contrary, a foreigner's taxable U.S. estate only includes U.S. situs assets.[1] The definition of U.S. situs assets includes real property, but excludes some intangible property such as stock in foreign corporations.

The estate tax is currently levied on the estates of natural persons at a maximum 45% rate, increasing to 55% in 2011. U.S. persons currently enjoy a credit that shelters the first $3,500,000 of assets from taxation, as opposed to foreigners who have only a $60,000 credit. In other words, when a foreigner dies owning U.S. real estate, an estate tax is levied on the value of that property in excess of $60,000 and could result in a lien on the property if not paid. Moreover, unlike with the estates of U.S. persons, real estate passing through a foreigner's estate is generally taxed at its full market value without any reduction for mortgages and regardless of how much they paid for it. An unlimited marital deduction that essentially exempts transfers between spouses is also not available when the surviving spouse is a foreigner, unless an effective Qualified Domestic Trust ("QDOT") is created.[2]

How then can the U.S. estate tax be eliminated for foreigners holding U.S. real property? Simply put, the U.S. estate tax does not reach stock held by a foreigner in a foreign corporation that in turn owns U.S. real estate. In order to effectively transfer indirect ownership of the property upon death, the foreigner simply uses a will or trust to govern disposition of stock in the foreign corporation. Since the foreign corporation stock is not a U.S. situs asset, it is not included in the foreigner's U.S. taxable estate.

Of course, in order for such a structure to withstand IRS scrutiny, it must be properly planned, documented and maintained. Not only that, an offshore corporate structure can carry with it income tax consequences that should be weighed considering the type of property, investment horizon, intended use, etc. That being said, this offshore holding company structure has several non-tax benefits such as keeping the property outside of a U.S. probate court, as well as providing a certain degree of anonymity as to who is the ultimate beneficial owner of the property. Moreover, the foreigner can be insulated from liability from accidents that might occur on the property if properly structured and operated.