PLANNING FOR INVESTMENT IN UNITED STATES REAL ESTATE BY THE FOREIGN CLIENT  

Non-resident aliens considering the purchase of United States real estate should understand certain basic rules of taxation as planning is essential, and it can be difficult and expensive to change the form of real estate ownership after title closes.

Estate tax imposed on all U.S. situs property

Of all the taxes affecting non-resident aliens of the United States, probably the least understood is the estate tax. The United States imposes an estate tax on all property that is considered to be "U.S. Situs" property. U.S. situs assets subject to estate tax include tangible personal property in the United States, U.S. real property, whether vacant land, a private house, or a condominium apartment, and shares of stock in a U.S. corporation, whether publicly traded or not, including shares of stock in a cooperative apartment corporation. A cooperative apartment corporation is a form of ownership almost unique to New York City. In a cooperative apartment corporation, the tenant shareholder owns stock in the corporation owning the building, and the tenant occupies the apartment under a long-term proprietary lease.

Estate tax based on date of death fair market value

Federal estate taxes are high. The tax is calculated on the total fair market value of all assets subject to tax as of date of death. Thus, if a foreigner owns condominium apartments in Miami and New York, the date of death value for determining the estate tax is the combined fair market date of death value of all the real estate. The estate tax is assessed on the total value, not just on the appreciation from date of purchase. There is no adjustment for inflation. Even if at date of death the property is worth less than its purchase price, the estate tax is based on the date of death value. Estate taxes can reach 48% on estates over $3,000,000.

Foreigners' estates are subject to tax at the same rate as American estates. The estate tax is determined by first calculating the total estate tax due based on the date of death value, and then applying a credit against the tax. The estate tax rules were recently changed to provide for an increased credit for American taxpayers and the "repeal" of the estate tax in 2010, but these changes are not permanent. Unless the law is further amended, the estate tax will return in 2011 and the exemption will return to $1,000,000. Thus, long-range estate planning for American taxpayers is uncertain.

Changes to the estate tax rules currently no benefit to foreigners

Unfortunately none of these changes benefits foreigners now. Unlike Americans, who currently have a $1,500,000 exemption from estate taxes, (which will rise to $3,500,000 in 2009) and an unlimited marital deduction for property passing to a surviving U.S. citizen spouse, foreigners have only a $60,000 exemption. Foreigners have no marital deduction unless the surviving spouse is an American citizen. A permanent resident ("green card" holder) surviving spouse is not entitled to the unlimited marital deduction. This means that for non-resident aliens everything over $60,000 may be subject to estate taxes. If the non-U.S. decedent is survived by a non-citizen spouse, it is possible to establish a special form of trust called a Qualified Domestic Trust (commonly known as a "QDOT") which postpones the estate tax until the death of the second spouse, or until the principal is distributed, but the QDOT does not avoid the estate tax.

For example, if a foreigner owned a condominium in New York with a date of death fair market value of $1,500,000 and he owned a condominium apartment in Miami with a market value of $500,000 he would have a $2,000,000 estate subject to estate tax. The total federal and state estate taxes on $2,000,000 estate, giving effect to state death credits, would be approximately $767,000.

The United States has estate and gift tax treaties with some fifteen countries, but these treaties do not change the basic estate tax rules for real estate, which is always subject to estate tax in the United States. If the decedent were domiciled in a country with which the United States has an estate tax treaty then generally shares of stock would be taxed only in the country of domicile. If the estate tax is repealed for everyone, then foreigners will benefit along with American taxpayers, but repeal is by no means certain.

States may also impose estate taxes

Many states also impose an estate tax on real estate and tangible property located in the state, but because of the credit allowed on the federal estate tax for state estate taxes, state estate taxes generally do not increase the total estate taxes payable. Since states only impose estate taxes on immovable property and tangible personal property owned by non-resident aliens, shares of stock are generally subject only to the federal estate tax.

Jointly held property does not avoid the estate tax

If title to the real estate is in joint name with right of survivorship, even if the joint owner is the surviving spouse, the entire value of the property may be subject to the estate tax unless the survivor can establish that he or she contributed to the purchase price. The Internal Revenue Code has a presumption that the first to die contributed 100% of the purchase price. Unless the survivor can establish the amount contributed by the decedent, the entire date of death value will be subject to the estate tax. If property is in the sole name of the deceased, then the entire value is subject to estate taxes.

Foreigners rarely able to claim deduction for mortgage

Many foreigners who purchase U.S. property with mortgage financing assume that the mortgage debt reduces the amount of the taxable estate by the amount of the mortgage. This is not correct. Only in the case of a non-recourse mortgage may the full value of the mortgage be deducted. Generally the mortgage cannot be deducted at all, unless the heirs or representatives of the deceased are willing to disclose the worldwide assets of the deceased on the federal estate tax return. Even if there is disclosure, there usually is only a partial credit for the mortgage debt. Most foreigners elect to forego the mortgage deduction and not disclose worldwide assets.

Need for a will for property in individual name

In addition to the question of estate taxes, there is the question who inherits the property. If property is jointly held with right of survivorship, then on the death of the first owner to die, title passes by operation of law to the co-owner. In all other cases, unless there is a will covering the U.S. assets, the property will pass either by the law of the decedent's domicile or the law of the state where the property is located. Real property (immovable property) will pass under the law of the state where the property is located. For movable property, such as shares of stock, title passes by the law of the decedent's domicile. Thus, it is theoretically possible for a person to die intestate owning a condominium in Florida and shares stock in a Manhattan cooperative apartment, and for the two properties to pass to different intestate heirs. Community property rights of a surviving spouse and the forced heirship rules of the decedent's domicile may also become an issue.

Use of corporation to own real estate

American estate and tax proceedings can be time consuming and expensive. One way to avoid the estate tax is to put the ownership in corporate form. The use of a corporation to own the real estate may allow more flexible planning techniques, since title to the property would be in the name of the corporation, but the shares of the owning company would be disposed of by will, trust or other appropriate means. Thus, it may be possible to avoid estate taxes and estate administration proceedings in the United States if property is held in a corporate structure.

Since shares of stock in an American corporation, including a privately held company or shares of a cooperative apartment corporation, are U.S. situs assets, using an American corporation whose shares are owned by the non-resident alien individual or by a revocable ("grantor") trust will not avoid the estate tax.

To shelter the property from estate taxes using a corporate structure, the real estate must be owned either in the name of a foreign corporation or by an American corporation whose shares in turn are owned by a foreign corporation. Taking title in corporate name does not affect real estate taxes, which are the same for individuals and corporations.

Title to cooperative apartments

As a practical matter, it may not be possible to hold shares of stock in a cooperative apartment in corporate name because many cooperative apartment corporations do not allow corporate ownership. Thus, a foreigner who wants to own a cooperative apartment in New York should not assume that he would be able to purchase the apartment in corporate name.

If corporate ownership is appropriate, it is essential that proper corporate formalities be observed in the formation and continuing maintenance of the corporation. This is necessary so that the Internal Revenue Service does not disregard the corporation and treat it as a sham such that the corporate assets are treated as owned by the individual shareholder. Failure to maintain the corporation could subject the underlying property to estate taxes.

Corporate ownership not always advisable

Corporate ownership is not suitable for every purchase. For one thing, the gains tax payable on sale is higher for corporations than the long-term capital gain rate applicable to individuals. In addition, there are fees to organize the corporation as well as annual maintenance fees, and in some states, such as New York, a "franchise" tax based on the value of the property, even if the property is not rented. Net profits from rental income could be subject to withholding tax on the dividends paid by the American company or to the branch profits tax (which, in effect, is a dividend equivalent tax) if the owning company is a foreign corporation. There are no withholding taxes on rental income earned by individuals.

Also, corporate ownership may not be suitable for a foreigner planning to live and work in the United States for a few years. If the property is held in individual or joint name, the owner can deduct the real estate taxes and mortgage interest on his personal tax return. When the property is sold, it may be possible to exclude entirely up to $500,000 of the net gain if the property can be considered the seller's principal residence.

Nonetheless, the more valuable the property subject to potential estate taxes, the more it is necessary to consider the use of corporate ownership, because as the value of the estate increases, the greater the estate taxes will be.

Death and taxes may be certain, repeal of estate taxes is not. Therefore, a foreigner considering the purchase of U.S. real estate should understand the planning options before signing the contract.

This memorandum is intended to provide summary information and should not be construed as legal advice. Readers should seek specific legal advice before taking action with respect to the matters discussed herein.

GRANT, HERRMANN, SCHWARTZ & KLINGER LLP
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