Navigating Stormy Seas

by Keith Durkin

March, 2017

The following article was published on March 20, 2017 by CIRE Magazine.

It's no secret that the U.S. remains an attractive destination for global investment in commercial real estate. In fact, more than 90 percent of global real estate investors anticipate maintaining or increasing the size of their U.S. portfolios, according to the 2016 annual survey from the Association of Foreign Investors in Real Estate.

Florida, in particular, is a desirable location for many reasons. Many international investors choose to supplement their income by renting the commercial real estate property they purchase in Florida.

However, buyers beware. Most international investors fail to manage their affairs to mitigate three potentially adverse issues related to income tax, U.S. estate tax and probate, and creditors. With proper planning, each potentially adverse situation can be lessened.

Mitigating U.S. Taxes

The U.S. Internal Revenue Code imposes a flat 30-percent tax on the gross rental income an international investor receives from real estate located stateside. The code imposes this tax on the individual; the property manager or agent collecting rent on behalf of this owner; or the international corporation renting the real estate. The flat 30-percent tax is imposed on the gross income received, and there are few allowable deductions for international investors.

For instance, if an international investor generated U.S. rental income of $12,000 in one calendar year, then he would have to remit $3,600 to satisfy his income tax liability. To many individuals, the flat 30 percent tax is a serious impediment to international investment in U.S. property.

Global investors, however, can circumvent this flat 30 percent withholding tax by making an 871(d) election, allowing the investors to treat the rental of U.S. property as effectively connected with the conduct of a U.S. trade or business. Characterizing the income as being connected with business income exempts the income from the 30-percent flat tax. Instead, the income is subject to the same graduated income rates as U.S. citizens.

Additionally, this election allows international investors the same deductions available to U.S. citizens and to pay nearly a similar amount of income tax a U.S. citizen would pay on the rental income.

For example, assume international investors who are a married couple purchase property in Florida and receive rental income of $24,000 in one calendar year. Without the election, the couple would be required to remit $8,000 to satisfy their U.S. income tax liability. If the married couple, however, made an 871(d) election, then they would be required to remit $4,000, or 50 percent less, to satisfy their U.S. income tax liability.

Making an 871(d) election is simple. International investors must simply attach a statement to their income tax return with specific information outlined by the U.S. Internal Revenue Service.

In nearly all cases, an 871(d) election is beneficial to international investors owning rental property in the United States. Many global investors, however, fail to make the 871(d) election and, consequently, pay a higher amount of income tax.

Preventing Probate Issues

The U.S. imposes an estate tax on international investors owning property located in the U.S. The tax imposed on them is different from the tax imposed on U.S. citizens and resident foreigners.

For 2017, the U.S. IRC grants an estate tax exemption to U.S. citizens and resident foreigners equal to $5.49 million. As a result, married U.S. citizens and married resident foreigners have a combined exemption equal to $10.98 million. Assets exceeding this threshold are subject to estate tax.

The IRC imposes significantly different estate tax rules on international investors. The code allows them an exemption amount equal to $60,000. An international investor dying with an estate greater than $60,000 is subject to the estate tax rate of 40 percent on U.S. property.

Many planning options are available to global investors to considerably lower or eliminate the U.S. estate tax. The U.S. and most international countries have executed various treaties to reduce the applicability of income and estate taxes.

Each planning option is dependent on the terms and conditions of the treaty. For example, article five of the tax treaty between the U.S. and Germany provides real estate property will be subject to tax where the property is located. Article nine, however, provides shares of common stock will be subject to tax in an individual's home country.

If a German resident died owning U.S. property, then the property would be subject to U.S. estate tax. If, however, the German resident owned the property through a U.S. corporation, then such shares of stock would be exempt from estate taxation in the U.S. The same planning option, however, does not exist under the tax treaty between France and the U.S. Accordingly, avoiding the imposition of the U.S. estate tax is dependent on the international investor's domicile.

In addition to avoiding the U.S. estate tax, international owners often do not understand that the U.S. probate rules may govern the disposition of their property based in the U.S. If an international investor dies owning U.S. property, then such asset will be subject to probate.

If international investors do not prepare a will nor title the property in a trust prior to their death, then the real estate property may be disposed pursuant to applicable state law. This may produce unanticipated consequences as the U.S. property may be distributed to one or more beneficiaries that are different from the beneficiaries in the decedent's home country.

An international investor should consider a separate U.S. estate plan to distribute U.S. property. Using a different country's will to distribute U.S. property is much more costly and time consuming than having a dedicated U.S. estate plan for U.S property.

Proper planning can allow international investors to shield or lower their exposure to the U.S. estate tax and potentially adverse U.S. probate consequences. Failure to properly plan for either situation will result in substantial problems for the international investor's heirs.

Reducing Creditor Concerns

International investors rarely consider the benefits of protecting their assets by forming a limited liability company. An LLC affords vital creditor protection from inside creditors and outside creditors.

For example, an inside creditor has a judgment against the actual LLC and seeks to foreclose upon its assets. An outside creditor has a judgment against an individual and seeks to foreclose upon an individual's various assets to satisfy the judgment.

The LLC format allows for protection from both inside and outside creditors in different ways. For instance, suppose the LLC owns rental property, someone slips and falls on the rental property, sues the company, and obtains a judgment against the LLC. The creditor is an inside creditor of the company and may only enforce the judgment LLC assets. A judgment against the company would not allow the creditor to go after the owner's personal assets. This is referred to as the corporate shield.

Alternatively, suppose the owner were in a car accident, someone sued the owner, and the owner was held liable. The judgment creditor is an outside creditor of the LLC. The creditor cannot levy the assets of the company because the judgment is against the owner.

Instead, the creditor must levy the owner's personal assets. In this scenario, the judgment creditor is an outside creditor of the company.

An outside creditor cannot levy the owner's interest in the LLC. Instead, an outside creditor may only obtain a charging order against an owner's interest in an LLC. In this case, the LLC does not allow the judgment creditor to levy the ownership interest in the company; grant the outside creditor any management rights; or allow the judgment creditor to inspect the books and records of the company.

The owner is still in charge of unilaterally operating the LLC. A charging order only allows the outside creditor to receive a member's distribution from an LLC. The outside creditor could not, however, compel a distribution from the company. The owner or manager of the LLC would decide on any distribution. If, however, the international investor individually owned the real estate property, then the judgment creditor could levy the real property.

Due to its desirable location, warm weather, and diverse commercial real estate assets, Florida will continue to be a popular place for global investment. International investors should be aware of the potential income tax issues, U.S. estate tax issues, U.S. probate issues, and creditor issues that accompany investments in commercial real estate located throughout the U.S. In most cases, proper planning can reconcile all of the potential concerns.