Foreign Nationals in the U.S. Real Estate Market - Know Your Ground
By R. Scott Jones, Esq.
The luster of the real estate market in the United States shines even more brightly for investors in current market conditions. While the appeal for foreign investors may have leveled off somewhat with the strengthening of the U.S. dollar in the last year against a number of currencies, some brave investors believe that certain markets still look historically attractive.
Indeed, foreign nationals present in the U.S. temporarily may also be attracted by the capital gain exclusion available on real estate eligible to be treated as one's principal residence, that permit owner-occupiers to exclude up to US$500,000 on a married filing joint basis. Even on a revenue basis, the deductibility of mortgage interest and real estate taxes (subject to Alternative Minimum Tax restrictions) is a further compelling reason for some.
It is important for foreign national investors in U.S. real estate to plan carefully, however, in order to avoid a series of tax and legal traps. This article seeks to outline the key planning issues and junctures that the sensible investor should consider depending upon a number of factors. These include the type of asset, who it is intended for, the period of planned ownership, the financing arrangements, the intent of the investor himself as to his own residence position, and the intended usage of the real estate.
There is a lot to think about!
The process for the foreign investor starts early and is informed by a number of estate and gift tax considerations that do not apply to domestic purchasers. The standard form approach of real estate purchase contracts for individual and joint purchase of real estate can be a trap-in-waiting. Ideally, professional advice should be sought well in advance of any transaction. In the real world, however, this often does not happen!
At minimum, at the initial contract stage, it is important to modify the language to build maximum flexibility as to the ultimate owner and the form of title at closing, as this may have an impact on various tax considerations.
So, what are the issues?
First, there is an important distinction to be made.
The tax traps associated with the purchase of U.S. real estate may impact nonresidents for estate and gift tax purposes and/or those nonresident for income tax purposes. These are not the same. It is very common for an individual to be regarded as resident for income tax purposes (based on days physically present in the United States, for example) although still considered non-resident (aka "non-domiciled") for estate and gift tax purposes. The domicile notion is indicative not of physical presence but where one intends one's permanent home to be (i.e., in this case, outside the United States).
Now for the sticker-shock, since there is really no other way to describe it in certain instances.
The taxable value of assets held by an estate tax non-resident at death can seem surprisingly high to the ill-informed. Such a non-resident is subject to tax on all U.S. "situs" assets, absent any exclusions that may be available under a relevant Estate Tax Treaty that the deceased taxpayer's home country may have with the United States.
The exemption amount available to such a taxpayer for estate tax purposes is a mere $60,000 at the federal level, with no legislative plans to increase the amount. Compare this to the $3.5m available to the U.S. Citizen or other resident for estate tax purposes!
The issue is compounded by the tax rates applicable to taxable assets. The excess over $60,000 in taxable assets (i.e. after the exclusion) is taxed on a progressive scale from 26- 45%. This is in addition to any State taxes that may be applicable.
Real estate investments are not the only U.S. assets subject to U.S. estate taxes. Equity investments in U.S. corporations and U.S. mutual and pension funds are also typically included. In some cases, Estate & Gift Tax Treaties can assist in reducing or eliminating exposure to tax on such investments. However, important to note is that there are less than twenty such Estate and Gift Tax Treaties (unlike the 65 plus Income Tax Treaties) and despite such Treaties, U.S. real estate investments often remain exposed to U.S. estate tax.
As if to compound the problem, recourse mortgages on such real estate are also generally not fully deductible against the value of the asset in determining the net taxable estate. Estates of non-residents are allowed a deduction for recourse debts only to the extent of the ratio of U.S. assets to worldwide assets (which, in turn, requires disclosure of worldwide assets to the IRS for such determination). A non-recourse mortgage (one in which the mortgage liability attaches only to the asset) may, if available, avoid this issue of apportionment and be fully offset against the value of the property.