Individuals who are not U.S. citizens or resident aliens (“nonresident alien”) that sell real property situated in the U.S. (“U.S. real property”) at a gain are currently taxed on a net basis at graduated rates of up to 37%. If the property is held for more than a year, gains may be eligible for long-term capital gain rates, which, although subject to change, are currently at 20%. At first blush, these results are not markedly different than the consequences of a similar sale by a U.S. citizen or resident alien. Failure to inquire further, however, may have grave financial implications. The following is a non-exhaustive list of considerations related to the ownership of U.S. real property by a nonresident alien. This area of the law is deeply complex and requires a balancing of the pros and cons of each structuring alternative based on a nonresident alien’s particular situation.
- Anonymity. If a nonresident alien holds U.S. real property in her or her individual name, the local public records will reflect the individual’s name.
- Tax Return Requirements. If a nonresident alien holds U.S. real property in his or her individual name, the nonresident alien will likely be required to file U.S. federal income tax returns (Form 1040NR) at some point during ownership. If they have U.S. source income from rental activity, it will be during operations; otherwise, it will be at the time of sale of the U.S. real property. State income tax returns, generally where the U.S. real property is located, may also be required. The process of filing U.S. returns can prove difficult as the nonresident alien needs to obtain a U.S. taxpayer identification number or social security number.
- 15% FIRPTA Withholding. If a nonresident alien holds U.S. real property in his or her individual name or through a non-U.S. entity (think foreign corporation), a buyer purchasing the U.S. real property must generally withhold 15% of the gross consideration paid and remit this amount to the IRS. Note that some states require additional withholding, e.g., Colorado requires an additional 2% foreign withholding. The 15% withholding rate generally results in excess withholding, especially where the nonresident alien held the property for more than a year (20% tax rate on a net taxable income). While the seller may seek a withholding certificate from the IRS to reduce the 15% gross withholding amount, this process can be impracticable depending on the circumstances. As such, the nonresident alien would generally need to file a U.S. tax return to receive a refund, the process for which can be costly and time-consuming. Moreover, refunds may not become available for six (6) to eight (8) months following the end of the year of sale.
- U.S. Estate Tax. Nonresident aliens are subject to a U.S. estate tax of 40% with respect to that part of their gross estate that, at the time of death, is situated in the U.S. This would include U.S. real property and tangible personal property situated in the U.S., as well as certain types of intangible property, including stock in a U.S. corporation. To make matters worse, nonresident aliens currently have only a $60,000 lifetime exemption. By example, if a nonresident alien, individually, held U.S. real property valued at $1,060,000 at death, he or she would be liable for $400,000 of U.S. estate tax. Note that a state-level estate tax may also apply.
- Direct Ownership. Direct ownership by an individual nonresident alien is generally not the preferred method for holding U.S. real property given the anonymity, tax return filing, withholding and, most importantly, estate tax considerations listed above; however, it may be the simplest option to administer if the U.S. real property will not generate income during the ownership period. It will also guarantee capital gains rates if the property is held for more than one year. Should a nonresident alien decide to pursue direct ownership and / or currently hold U.S. real property directly (after thoughtfully considering the impediments listed above), the nonresident alien can seek to mitigate the estate tax burdens by acquiring life insurance (proceeds paid on an insurance policy on the life of a nonresident alien are generally excluded from the decedent’s estate). Note that if a nonresident alien holds U.S. real property through an entity that is disregarded for U.S. federal income tax purposes (many advisors recommend nonresident’s acquire U.S. real property through a local jurisdiction single-member limited liability company), certain foreign disclosure filings are required that carry a $25,000 penalties for failed and / or incomplete filings.
- Indirect Ownership. Several different options exist for indirect ownership, with the following two being the most common now that the U.S. federal income tax rate was reduced from a graduated 35% to a flat 21%.
- Foreign Blocker Structure. There are several benefits to non-resident alien persons holding U.S. real property through a non-U.S. entity taxed as a corporation for U.S. federal income tax purposes: the individual non-resident alien generally remains anonymous in public records, the individual non-resident alien need not obtain a U.S. taxpayer identification number, the corporation rather than the individual files tax returns and the individual non-resident alien does not have a taxable estate on his or her passing. Moreover, the U.S. corporate income tax rate was reduced from a graduated 35% to a flat 21%, closing the gap on the 20% capital gains rate. On the flip side, the foreign corporation will be required to file U.S. federal income tax returns annually (regardless of whether there is income) along with foreign disclosure forms that carry $25,000 penalties for failed and / or incomplete filings, personal use by a shareholder or related party should be supported by fair market rent, FIRPTA 15% withholding is still required on sale and certain additional income tax regimes apply (e.g., branch profits tax). Note also certain administration requirements will be required for the entity under this scenario (e.g., maintaining legal records, bank accounts, etc.).
- Tiered U.S. and Foreign Blocker Structure. In most situations, there are even more benefits to non-resident alien persons holding U.S. real property through a tiered structure where a U.S. entity taxed as a corporation holds U.S. real property and a non- U.S. entity taxed as a corporation is the sole owner of the U.S. entity: the individual non- resident alien generally remains anonymous in public records, the individual non- resident alien need not obtain a U.S. taxpayer identification number, only the U.S. entity taxed as a corporation files tax returns, the individual non-resident alien does not have a taxable estate on his or her passing, FIRPTA 15% withholding should not be required on sale if certain actions are taken (e.g., U.S. entity liquidated in year of sale and proceeds repatriated) and the additional income tax regimes applicable to foreign corporations (e.g., branch profits tax) are inapplicable. Like the foreign corporation situation, the U.S. corporate income tax rate was reduced from a graduated 35% to a flat 21%, closing the gap on the 20% capital gains rate. On the flip side, the U.S corporation will be required to file U.S. federal income tax returns annually (regardless of whether there is income) along with foreign disclosure forms that carry $25,000 penalties for failed and / or incomplete filings and personal use by a shareholder or related party should be supported by fair market rent. Note also certain administration requirements will be required for both entities under this scenario (e.g., maintaining legal records, bank accounts, etc.). Consideration will also need to be given to the foreign jurisdiction implications of the structure.