The interest by foreign investors in United States vacation homes and the purchase of homes for rental to tenants is booming.
A foreign owner (“nonresident alien”); who wishes to stay in the United States for extended lengths of time needs to be careful to make sure they are not considered to be U.S. taxpayers that would cause them to pay tax on their worldwide income. We will explore how a nonresident alien could become a U.S. taxpayer. This generally is a result of a nonresident alien spending too much time physically in the U.S.1
Non-Resident Alien Individuals – Taxation
A non-resident alien is a non-U.S. citizen and NOT a resident alien.2
Rental Income and Sales Income
Vacation homes may be bought and sold and rented at any time and the profit from these homes will be taxed at 10% to 20%, depending upon the amount of profits earned from a sale in excess of the cost of the real estate asset. This is the case when the foreign investor owns the home as an individual directly or through a limited liability company (“LLC”).
In the event a Taxpayer becomes a “green card” holder, this is known as a permanent resident. The alien individual will become a U.S. taxpayer at the time they receive the green card. They will be taxed like U.S. citizens even though they are not citizens of the U.S. However, they do have the right to freely exit and enter the United States as they wish, the same as U.S. citizens.
The alternative to an individual’s acquisition is for the nonresident individual to own the real estate in a U.S. corporation or foreign corporation, which is taxed at 21% on income from rents or sales.
Regardless of the form, there should be only one U.S. income tax on rental income and one tax on a final sale of real estate if it is accomplished with proper planning.
Rental Income
Profits are determined by the amount of rental income collected, reduced by all of the expenses incurred as a result of ownership of the real estate and “depreciation deductions” claimed during the ownership of the rented property. “Depreciation” is an additional benefit reducing the taxes on rental income under the assumption that real property (the buildings only), not the land, is deteriorating every year and losing value. This loss of value through deterioration is often a myth since the general rule is that real estate appreciates over time. However, for tax purposes, it is assumed that this allows each real property owner to account for the possibility that the real estate is a wasting asset by deducting a certain amount each year to account for the “depreciation” that allows the owner to recoup for his cost of the asset.
Homes and other real estate assets may be rented to third parties for rental income or lived in by the owner or sold. Rental income benefits from certain tax deductions that reduce the taxable income. All expenses of renting to a third party will reduce taxable rental income.
Sale of Real Estate
When the real estate is sold, if it has not actually depreciated the “depreciation deductions”, will have reduced the value of the property for tax purposes. This depreciation will be treated as a gain since the taxpayer has benefitted from deducting his or her cost of the assets over the years.
Investors may sell their U.S. real estate at any time. The gains from the sale of real estate are subject to tax at times at lower rates of tax, depending upon the amount of profits earned from the sale.
Taxes on the profits of sale result if the property has been sold at a profit over its cost as reduced by depreciation if the property has been rented.
Taxation Pattern
Nonresident aliens who earn real estate income will be taxed on that income in the United States. U.S. Residents (“Tax Resident”) are subject to U.S. Taxation. Foreign investors who do wish to enjoy expanded stays in the U.S. may become U.S. taxpayers. If this is the case, they will be subject to the following U.S. taxes.3
Income Taxation – Tax residents are taxed on their worldwide income.
Estate Taxation – There is a net wealth tax at death based on worldwide assets of U.S. citizens and tax residents.
Gift Taxation – Gifts given by U.S. taxpayers are taxed.Furthermore, gifts of real estate made by U.S. alien nonresident individuals are taxed.The gift tax and estate taxes can be avoided completely by nonresident aliens with the proper tax planning.However, U.S. Taxpayers do not incur the estate taxes or gift taxes unless there are assets transferred in these manners exceed the amount of $11,000,000. This amount is increased every year for inflation.
Alien Individual Non Resident Investors are only subject to U.S. Taxation under the following circumstances:
Nonresident individuals are typically only taxed on their U.S. situs assets such as real estate.
1. Income Taxation. Income tax is paid only on United States source income, and limited types of income from non-U.S. sources. Rental income and sales income are from U.S. sources if it is earned from U.S. real property.
2. Estate Tax. A Foreigner will pay a (“death tax”), if he or she dies owning U.S. real estate directly. The Estate Tax is imposed on United States Situs assets only. This includes U.S. real estate, stocks and bonds and certain tangible assets. These taxes should be avoided at all costs because it is very expensive. While American taxpayers do not pay these taxes unless the amount of assets are greater than $11,000,000 when they die, that is not the same for nonresidents who can exclude only $60,000 of real estate wealth before paying an estate tax at death.
The estate and gift tax exclusion for nonresident aliens before paying U.S. estate and gift taxes is only on the first $60,000. If a nonresident alien dies owning U.S. real estate worth $1,000,000, they must pay an estate tax (as high as 40%) on $940,000.
3. Gift Tax. During life there may be a gift tax imposed on foreigners who make a gift of real and tangible personal property within the United States. (Except there is no gift tax on gifts during life on shares of corporate stock).
A foreign investor in the U.S. needs to plan how to avoid the estate tax on large acquisitions of real estate.
This can be accomplished through several tax planning vehicles. We will discuss these in this article.
Tax Residency Status
“Residency Status” for Tax Purposes differs from the “Residency Status” for immigration purposes. For income tax purposes a resident alien is a person who lives in the United States for a certain period of time during a year. A “Resident” for income tax purposes is measured by the time spent in the U.S.
A resident for estate tax purposes is an alien individual who has made the United States their permanent home.
Resident for U.S. Income Tax Purposes
U.S. residency for income tax purposes is determined by the amount of time a nonresident individual stays in the U.S. for each calendar year.
A nonresident alien can become a U.S. taxpayer by spending too much time in the U.S. under a standard that measures the amount of days the nonresident is in the U.S. over a three-year period of time. This is known as the Substantial Presence Test.
The Substantial presence test measures an alien’s presence in the U.S. over a three-year period. In the second year, prior to the year that is being considered, the days in the U.S. are counted and each day is considered as 1/6th of a day. In the first year prior to the current year each day is measured as 1/3rd of a day. In the actual year being considered, each day counts for one day.
If based on this formula, the alien has spent an amount of time equal to more than 182 days in the year being considered for residency, then the nonresident alien taxpayer is considered to be taxable like an American (worldwide income) for that year.
Exceptions to a Finding of Tax Residency
There are three exceptions to the above rules that expand the time frame that a nonresident alien may stay in the U.S. without being a tax resident.
TAX TREATY
The U.S. has tax treaties with over 60 countries. Under those tax treaties there are certain circumstances that allow the resident alien to be in the U.S. for more than 182 full days in a year and not be considered a resident for tax purposes.
THE CLOSER CONNECTION EXCEPTION
A nonresident alien who has much closer ties to their home country may be able to stay in the U.S. for 182 full days a year and still not be a U.S. taxpayer if they can prove that during that time they still had more permanent ties to their country of origin.
STUDENTS
A foreign student who has obtained the proper immigration status will be exempt from being treated as a U.S. resident for U.S. tax purposes even if he or she is here for a substantial time period that would ordinarily result in the student being taxed as a U.S. resident under any other circumstances.
This student visa not only permits the student to study in the United States, they will only pay taxes only on income from U.S. sources and not on the student’s worldwide income.
The visa also permits the student’s direct relatives to accompany the student to the United States and receive the same tax benefits.
Tax Planning for Real Estate Investment by Nonresident Aliens
The non-resident alien investor can reduce or eliminate many of the U.S. tax consequences of real estate ownership through a number of tax planning devices.
Estate and Gift Tax
A nonresident alien investor in real estate will be exposed to the U.S. estate tax and gift tax if they own U.S. property in their individual names or a limited liability company (a partnership) is established to own the real estate.
However, in the event a foreign investor owns a foreign corporation formed outside of the United States, the foreign investor will only own the shares of the foreign corporation. The investor will not own the real estate directly and personally. This is not direct ownership of real estate by an investor and will not result in the foreign investor paying any gift taxes if the investor only transfers shares of the foreign corporation that owns the real estate as a gift or if the foreign investor dies owning shares of a foreign corporation that owns U.S. real estate.4
Income Tax
There is no avoiding the U.S. income tax on gains or income from US. real estate. However, because of the depreciation deduction reviewed earlier, rental income is reduced for that deduction and the taxes on rental income are lower even though there is no actual economic loss from the depreciation. Depreciation does reduce rental income at no cost to the owner.
When the asset is sold, there is a tax on the profit or “gain” earned.
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Footnotes:
We will explore how a non-resident alien unknowingly can become a U.S. tax resident for tax purposes.
Green Card Holders
In the latter part of this Article, we will describe how nonresident aliens can avoid becoming U.S. residents. Essentially this is accomplished by the nonresident not extending their stay in the U.S. past certain time limits.
A foreign investor may also use a U.S. corporation to own real estate and avoid the gift tax since there is no U.S. gift tax on a transfer of shares in a U.S. corporation. However, there is an estate tax imposed if a nonresident alien dies owning shares in a U.S. corporation.
Contact Barrister Richard S. Lehman, United States Tax Attorney
