Wag the Tail, Not the Dog: Critical Decisions for Foreign Investors in U.S. Real Estate

By Cindy L. Spetalnick, CPA, Tax Principal at Gumbiner Savett Inc.: The four most common ownership options for foreigners acquiring real estate in the United States.

There are numerous options for structuring an investment in U.S. real estate. Determining the optimal structure is case specific, depending upon the goals, objectives and income tax situation of the particular foreign investor. In advising nonresidents, we generally assess a number of important factors including risk, economic impacts and income tax legislation, including tax treaties, in both the United States and the home country.

The four most common ownership options for foreigners acquiring U.S. real estate are: 1) direct ownership by a foreign individual; 2) investment in a U.S. limited liability company; 3) investment in a foreign corporation; and 4) investment in a foreign corporation and a domestic L.L.C.

Direct Ownership: While direct ownership may result in favorable U.S. federal capital gains tax rates, this option generally will expose the nonresident to U.S. estate tax and will result in U.S. federal and state individual income tax return filing requirements. Transfers of U.S.-owned real estate will frequently result in U.S. withholding tax on the transfer price pursuant to the provisions of the Foreign Investment in Real Property Tax Act (FIRPTA). Furthermore, direct ownership subjects the owner to unlimited legal liability with respect to the property.

U.S. Limited Liability Company: Ownership through a domestic LLC provides limited legal liability, but does not mitigate U.S. estate tax. Federal and/or state returns may be required by the LLC, in addition to the individual’s filing requirements, depending upon whether the LLC is treated as a partnership or a disregarded entity. A transfer of the ownership interest in the U.S. LLC may result in U.S. withholding tax under U.S. FIRPTA rules. The tax treatment of the U.S. LLC in the nonresident’s home country must also be considered.

Foreign Corporation: Where a foreign corporation is used as the ownership vehicle, the favorable U.S. capital gains tax rates available to individuals will not apply. U.S. corporate income tax and, potentially, branch profits on the corporation’s undistributed U.S. profits, are applicable. On the plus side, this structure prevents the application of U.S. estate tax and provides the shareholder with limited liability.

Double Entity: The double entity approach is often used in large real estate holdings when a U.S. real estate fund has already been established as a domestic L.L.C.  Accordingly, the foreign investor might decide to avoid risks associated with U.S. estate tax compliance and/or the personal income tax filing requirements.  A foreign corporation is established to own the U.S. entity, thus giving up potentially favorable U.S. capital gains rates in order to eliminate U.S. estate tax issues.

Investing in U.S. real estate is an attractive proposition for many nonresidents, assuming the acquisition is properly structured in advance. However, if the right foundation is not in place, the result could be unanticipated tax consequences or unnecessary legal liability.