Tax Guide For Foreign Investors In U.S. Residential Real Estate 2019 EDITION IN THIS GUIDE I. Introduction 2 VIII. U.S. Income Taxation of U.S. Persons 10 II. The U.S. Tax System 3 A. Individual Income Tax Rates 10 A. U.S. Persons 3 B. Corporate Income Tax Rates 10 1. Basic Rules 3 C Qualified Business Income 10 2. U.S. Persons 3 Deduction for Pass-Through Income 3. U.S. Domestic Corporations 3 D. Income Tax Rates for 4. U.S. Domestic Trusts 3 Trusts and Estates 11 B. Non-Resident Aliens (“NRAs”) 3 IX. U.S. Income Taxation of NRAs 12 III. Estate Taxation 4 A. U.S. Source Income 12 A. U.S. Persons 4 1. Rents 12 B. Nonresident Aliens 4 2. Dividends 12 IV. U.S. Estate Tax Consequences of 3. Interest 12 Real Estate Ownership Structures 5 4. Gains on Sale of U.S. Real Estate 12 A. Direct Ownership By NRA 5 B. Character of U.S. Income 13 B. Domestic (U.S.) Corporation 5 1. FDAP Income 13 C. Foreign Corporation 5 2. U.S. Trade or Business Income 13 D. U.S. Domestic Trusts 5 3. Deductions from Rental Income 13 E. Irrevocable Foreign Trust 5 4. Special Rules for Corporations 14 F. Revocable or Grantor 5. Capital Gains 14 Foreign Trusts 5 6. U.S. Income Tax Returns 14 G. Partnership Interests 5 X. U.S. Income Tax Consequences of V. U.S. Estate Tax Planning 6 Real Estate Ownership Structures 15 A. Foreign Corporation 6 A. Foreign Corporation 15 B. U.S. Corporation with B. U.S. Corporation with Foreign Foreign Corporation Parent 6 Corporation Parent 15 C. Foreign Irrevocable Trust 6 C. Foreign Irrevocable Trust 15 D. Limited Liability Company with D. Limited Liability Company 15 Foreign Irrevocable Trust Parent 7 XI. FIRPTA Tax On Capital Gains 16 VI. U.S. Gift Taxes 8 A. FIRPTA 16 A. U.S. Persons 8 B. FIRPTA Withholding 16 B. Non-Resident Aliens 8 C. U.S. Real Property Holding Companies 16 VII. U.S. Gift Tax Planning 9 XII. Summary 17 XIII. About Davis Malm 18 Updated February 2019. 1 I. INTRODUCTION The U.S. income tax code contains numerous traps for the unwary foreign investor. This guide is intended to assist the foreign investor in U.S. real estate in understanding how the U.S. estate, gift and income tax rules affect his or her investment and the planning opportunities available to minimize U.S. taxes. With proper legal advice, a foreign investor should • minimize the annual U.S. income tax liability be able to: on the net income generated by his or her • avoid U.S. estate and gift taxation on his or her investment; and investment; • minimize the potential capital gain on the • avoid the 30% withholding tax on the gross income profitable sale of his or her investment. generated by his or her investment; This edition reflects the changes in U.S. income tax law made by the Tax Cuts and Jobs Act of 2017, enacted on December 22, 2017, and generally effective for 2018 and subsequent tax years. 2 II. THE U.S. TAX SYSTEM A. U.S. PERSONS For U.S. estate tax purposes, a different test is used: 1. Basic Rules Whether the person resides in and has “domicile” in U.S. persons are subject to U.S. income taxation on the U.S. A person has domicile in a country by living their worldwide income; individuals who are U.S. there indefinitely, with no intention of relocating to residents are subject to U.S. estate, gift and another country. generation-skipping transfer (“GST”) taxation on their worldwide assets. 3. U.S. Domestic Corporations A corporation organized in the U.S. (usually under Non-U.S. persons are subject to income tax only on state law) is a U.S. person. their U.S. source income; individuals who are non- U.S. residents are subject to U.S. estate, gift and GST 4. U.S. Domestic Trusts taxation only on U.S. situs assets. A trust is a U.S. person if (a) it is subject to the primary jurisdiction of a U.S. court over its 2. U.S. Persons administration and (b) one or more U.S. persons U.S. persons include U.S. citizens (including have the power to control all substantial decisions of persons with dual citizenship in the U.S. and a the trust. foreign country) and U.S. residents, regardless of citizenship. B. NON-RESIDENT ALIENS (“NRAS”) For U.S. income tax purposes, a U.S. resident A person is an NRA if he, she or it is not a U.S. includes a “green card” holder (or other lawful person. NRAs include foreign individuals, foreign permanent resident) who is present in the U.S. A corporations, and foreign estates and trusts. person is also a U.S. resident if he has a “substantial presence” in the U.S. One is deemed to have a substantial presence if he or she is (a) present in the U.S. for 183 days in a calendar year; (b) present in the U.S. for at least 31 days in a calendar year and has been present in the U.S. for an average of more than 121 days per year during that year and the two prior years; or (c) elects to be classified as a U.S. resident in certain circumstances. The tax code contains numerous exceptions for persons temporarily in the U.S. 3 III. ESTATE TAXATION A. U.S. PERSONS U.S. property included in an NRA’s estate include (i) U.S. real estate owned or under his control; An estate of a U.S. citizen or resident is subject to an (ii) corporate stock in a U.S. corporation; (iii) debt estate tax based upon the value of the worldwide obligations of a U.S. person (with exceptions for property, tangible and intangible, owned by the certain bank deposits and “portfolio interest decedent on the date of death or over which he has obligations”); (iv) interests in U.S. partnerships; certain rights or powers. The current estate tax rate and (v) interests in U.S. trusts (discussed below). for 2018 is 40% for taxable estates in excess of an Life insurance proceeds, even if paid by a U.S. $11.2 million exemption, which is adjusted annually insurer, are not included in an NRA’s estate. A credit for inflation. A U.S. estate may also deduct from the against the estate tax is allowed for gift taxes paid. taxable estate a marital deduction equal to the value of property left to a surviving spouse. The amount of The U.S. has tax treaties with several foreign lifetime taxable gifts during the decedent’s life is countries which may limit the amount of U.S. estate also included in calculating the gross estate. See tax on an NRA’s estate.* Section VI below. Massachusetts has an estate tax applicable to real B. NON-RESIDENT ALIENS estate and tangible personal property located in Massachusetts. Rates range from 0.8% to 16%; The gross estate of an NRA includes all tangible estate tax returns need not be filed if the gross and intangible property situated in the U.S. estate is $1 million or less. Other U.S. states also (“U.S. property”), in which the decedent has an impose estate or inheritance taxes (so-called “death interest at the time of his death, or over which he taxes”) on NRA estates. These tax rates are lower has certain rights or powers. than the U.S. estate tax rate, but these taxes should not be ignored when planning an investment in U.S. The taxable estate of an NRA is taxed at rates real estate. ranging from 26% to 40% of the value of estates in excess of a $60,000 exemption (the 40% rate applies to taxable estates over $1 million in value). Moreover, the estate of an NRA is generally not allowed a marital deduction unless the surviving spouse is a U.S. citizen. Taxable gifts are not included in the gross estate, but are separately taxed. See Section VI below. * The U.S. has estate tax treaties with the following countries: Australia, Austria, Canada, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Japan, Netherlands, South Africa, Norway, Switzerland, and the U.K. 4 IV. U.S. ESTATE TAX CONSEQUENCES OF REAL ESTATE OWNERSHIP STRUCTURES A. DIRECT OWNERSHIP By NRA F. REVOCABLE OR GRANTOR FOREIGN TRUSTS U.S. real property directly owned by an NRA on his death is subject to U.S. estate taxes (and any If an NRA possesses the right to revoke the trust, or applicable state death taxes). possesses any of the proscribed powers or interests in any U.S. property held by the trust on the date of B. DOMESTIC (U.S.) CORPORATION his death, he will be subject to U.S. estate taxes (and any applicable state death taxes). Shares of a U.S. corporation owned by an NRA on his death are subject to U.S. estate taxes (and any G. PARTNERSHIP INTERESTS applicable state death taxes). An investment in a partnership may be considered C. FOREIGN CORPORATION to be U.S. property if the partnership is engaged in business in the U.S. or holds U.S. assets; the tax law Shares of a foreign corporation owned by an NRA is unsettled on this issue. on his death are not subject to U.S.