Five Tax Traps for Foreign Investors

Most complications can be mitigated by pre-investment tax planning, Griffin writes.

BOSTON—The Internal Revenue Code contains numerous traps for the unwary foreign investor in US real estate or businesses. The tax law provisions applicable to nonresident foreign investors are very often quite different—and more onerous—than the tax rules applicable to US citizens and foreign residents. This article identifies some of the most common areas where nonresident foreign investors may need specialized tax advice to avoid costly mistakes. Estate Tax. An estate of a US citizen or resident is subject to an estate tax based upon the value of the worldwide property, tangible and intangible, owned by the decedent on the date of death or over which he or she has certain rights or powers. The current estate tax rate for 2015 is 40% for taxable estates in excess of a $5.34 million exemption, which is adjusted annually for inflation. A US estate may also deduct from the taxable estate a marital deduction equal to the value of property left to a surviving spouse. The amount of lifetime taxable gifts during the decedent’s life is also included in calculating the gross estate. The gross estate of a nonresident foreign investor includes all tangible and intangible property situated in the US (“US property”), in which the decedent has an interest at the time of his death, or over which he has certain rights or powers. The estate is taxed at rates 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 a nonresident foreigner is generally not allowed a marital deduction unless the surviving spouse is a US citizen. Taxable gifts are not included in the gross estate, but are separately taxed. Gift Tax . US persons are subject to a federal gift tax on gifts made of their worldwide assets, tangible and intangible. The gift tax is imposed on the donor ; donees are not subject to gift or income tax on the receipt of the gift. Taxable gifts are taxed at rates ranging from 18% (for taxable gifts not in excess of $10,000) to 40% (for taxable gifts in excess of $1 million) on the fair market value of gifts made worldwide. An annual exclusion of $14,000 per donee (for 2014) is allowed for gifts of non-trust present interests; spouses may elect to make joint gifts (split 50/50 between spouses). A lifetime exemption of $5.43 million, combined with the estate tax exception, is allowed. A nonresident foreign national is subject to a federal gift tax on gifts of real estate and tangible personal property and cash located in the United States; intangible assets such as corporate stock and partnership interests are not subject to tax. An annual exclusion of $14,000, adjusted for inflation, is allowed per donee; joint gifts with spouses are not allowed unless the spouse is a US person. Gifts to spouses are not entitled to the marital deduction unless the spouse is a US citizen, but an inflation-adjusted annual $140,000 exclusion is allowed for gifts to a non-citizen spouse. No other exemption is allowed for lifetime gifts, although gift taxes paid may be credited against the estate tax. Withholding Taxes . The tax code imposes a number of special withholding taxes on US source income received by nonresident foreign nationals. Rents, dividends, interest, royalties, and other ”fixed or determinable annual or periodic income” (“FDAP”) received by nonresident foreign nationals are taxed at a flat rate of 30% on the gross amount received determined without deductions, unless these amounts “effectively connected” with a US trade or business conducted by the taxpayer. This tax must be withheld at the source by the payor, and is not refundable. In some cases, tax treaties reduce or eliminate the withholding rates for certain classes of income. Net income “effectively connected” with a US business conducted by a nonresident foreign national is taxed at customary US personal and corporate income tax rates. A special election permits income from real estate activities to be classified as “effectively connected” and thus taxed on a net—rather than gross—basis. Income of a nonresident foreign investor in a US partnership is subject to withholding at a 39.6% rate for individuals (35% for corporations), which is creditable against taxes due and potentially refundable. FIRPTA Withholding . Income of a nonresident foreign investor from the sale or disposition of US real property interests is subject to “FIRPTA” withholding at the rate of 10% of the gross proceeds of sale. An amendment to the tax code, effective Feb. 16, 2016, increases this rate to 15% for properties other than a principal residence, and for principal residences sold for more than $1 million. This amount is withheld at the source by the buyer and is creditable and potentially refundable. The amount withheld may be greater than the capital gain tax imposed on the seller and sometimes greater than the net cash received by the investor. No S Corporation Election. Nonresident foreign investors cannot take advantage of the ”pass-through” S corporation classification, since stock ownership by such an investor will terminate the corporation’s S corporation election. Conclusion. In most cases, the severity of these tax rules can be mitigated by competent pre-investment tax planning. For a more complete discussion of this topic, please see the publication “Tax Guide for Foreign Investors in US Residential Real Estate” available on the Davis, Malm & D’Agostine, PC website . William F. Griffin Jr. is a shareholder in Boston law firm Davis, Malm & D’Agostine, PC, practicing in the business law and real estate and environmental areas. He may be contacted at [email protected] . The views expressed here are the author’s own.