Structuring foreign investment in U.S. real estate

By William F. Rucci, CPA, MST, CGMA

Of all the business opportunities available in the United States to international investors these days, perhaps no asset class is drawing more attention than real estate.

Despite some appreciation in prices and the recent strengthening of the US dollar, savvy investors from all over the world continue to be bullish on American real property. Buyers are acquiring single family homes and condominiums, multi-unit residential developments, commercial buildings and office complexes. States seeing the most action are Florida, California, Arizona and Texas, with many other states receiving at least some degree of interest from foreign buyers.

The latest report from the National Association of Realtors shows that international sales of residential real estate reached $92.2 billion for the twelve months ending March 2014, a robust 35% increase over the previous period. Canadians continued to be the most active buyers, followed by foreign nationals from China, Mexico, India and the UK.

Why all the interest? Simply stated, the large pool of attractive properties, the still-affordable prices and the relative safety of US real estate as an investment class are combining to produce a fairly low-risk investment environment. The US remains a premier location for international investors seeking security, profitability and respect for property rights.

The devil is in the details

Less simple is choosing the investment structure that best navigates all the legal and tax complexities. There are more than 7,000 taxing authorities in the United States, from the Internal Revenue Service down through all fifty states to the thousands of local jurisdictions. Each has its own rules for taxation and registration – the only thing in common among them is their lack of consistency and coordination. For example, taxes conferred by individual states are not covered under US federal tax treaties or exemptions.

While some foreign investors may decide to hold a piece of US real estate directly, many opt to structure it as a business entity for the added legal protection that such a choice provides. But the state in which the entity is created does not necessarily have to be the state in which the real estate is located.

Delaware is a popular place for business entities because of its owner-friendly rules protecting the rights of shareholders. But the decision to incorporate there is more about maximizing investors’ legal protections than it is about maximizing tax efficiencies.

A tale of two tax regimes

When it comes to structuring the purchase of income-producing properties for tax purposes, it is important to know that there are two US federal tax regimes that apply to foreign investors, based on whether the property generates ‘passive’ income or ‘effectively connected’ income.

Passive income is any fixed, determinable, annual or periodic income derived by a foreign investment or business activity, and is subject to 30% tax withholding on a gross basis unless reduced by applicable tax treaty.

Effectively connected income (ECI) is income that can be shown to be connected to a trade or business, and is taxed on a net basis at the graduated tax rates that apply to any US citizen, resident or entity. In almost every situation, it is in the international investor’s best interest to make this net election when structuring an income-producing real estate transaction in the US.

Another important detail in American tax law is the potential impact of FIRPTA – the Foreign Investment in Real Property Tax Act – on the sale of US real estate by foreign owners.

Before the law was passed in 1980, capital gains taxes could be effectively avoided on the sale of property owned by non-resident aliens through legal structuring that configured the transfer of the asset as a corporate stock transaction rather than the sale of real property.

FIRPTA closed this loophole in order to ensure that any disposition of US real property interests by foreign investors or their corporations remained subject to US tax. The law further required that the buyer of such property deduct and withhold 10% of the purchase price on the federal government’s behalf (although under certain circumstances the buyer can petition the IRS to waive this requirement).

Use local guidance to choose the best option

There are hundreds of ways to structure the purchase of US real property by a foreign investor. Each has its own legal and tax pros and cons. Some of the more familiar choices include:

• Direct investment – the investor owns the property personally, or through a single member limited liability company (SMLLC);

• LLC taxed as a partnership – in this set up, the business profits and losses flow through direct to the partners and are taxed accordingly;

• US Corporation – a corporate entity is established in the US to buy, hold and dispose of the property;

• Foreign corporation – an entity is established in the investor’s home (or other foreign) country to buy, hold and dispose of the US property;

• Two-tiered corporation – the property is owned by a US corporation, which is in turn owned by a foreign corporation set up by the investor.

This two-tiered option is a popular choice for many international investors because it provides protection both in the US and in the home country. It also offers the greatest opportunity to reduce overall tax exposure. True, the structure is more expensive to create and maintain, but if the entity’s portfolio is large enough, the tax savings can more than offset the cost of set-up and tax filing requirements in multiple jurisdictions.

Filing tax returns in the US may be viewed by some international investors as an unfair and disagreeable burden, but those who choose to structure their US real estate holdings to avoid such filing requirements will likely pay more in tax in the end.

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Bill Rucci is president and partner of  Rucci, Bardaro & Falzone P.C. He is chairman of Russell Bedford International, a leading global consortium of CPA firms, and heads the organization's North American Tax Services Group.

Mr. Rucci can be reached at (617) 321-6065, and at billr@rbfpc.com