The Taxing Business of Buying U.S. Real Estate
Foreign investors can minimize the tax hit on property purchases but good advice and a lot of paperwork is needed.
If you live in Tel Aviv and want to buy a home in Miami for your daughter while she goes to University, you have a lot more to think about than finding a nice neighborhood. That’s because buying U.S. property places you squarely in the U.S. tax system, adding big costs to your purchase. That’s hardly surprising news if you’re from the U.S., but it’s a shock to lots of non-U.S. residents.
Mainly, those costs have to do with taxes. The most onerous for non-U.S. residents is the inheritance or estate tax, a levy that doesn’t exist now in Israel, for instance. The U.S. charges a 40% inheritance tax on the value of any asset owned by a non-U.S. resident over $60,000 at the time of the owner’s death. So, if you buy a $1 million home, the U.S. government will charge your heirs 40% of $940,000 (plus appreciation, if any) or $376,000. That’s hardly small change. That is why Dov Weinstein cautions that “efficiently managing any estate taxes is imperative to ensure the preservation of wealth for future generations.”
There are other potential taxes as well. Say you buy an apartment in Manhattan as an investment, and you rent it. You will have to pay tax on the rental income at U.S. ordinary income tax rates of up to a maximum of 39.6%. And if you sell this investment property after one year, the tax on your capital gains may be as high as 20%.
As you might expect, there are several strategies for minimizing potential tax hits. The problem is Israeli investors — particularly those in the first generation to accumulate wealth — often wrongly think they can solve the problem on their own. A common strategy is to appoint a “nominee,” such as one of their children, to act in their place as the buyer. The strategy may be common throughout Israel for avoiding the intrusion of probate courts, or avoiding liability, but it doesn’t work in the U.S. (and often not in Israel either).
Instead, it is recommended non-U.S. buyers buy property through some type of legal structure, like a foreign-owned limited liability corporation (LLC) or a trust. Both can buffer the tax hit. Which structure you choose (we’ll detail these options further down) will depend on where you buy the property — there are U.S. state and local taxes to consider as well as federal taxes — how long you hold it, and its value, among other things specific to your own situation.
For a long-term property investment, one option is to create a foreign company — i.e. via Israel or off-shore in the British Virgin Islands — that in turn forms a U.S. LLC to buy the real estate. Since a foreign company ultimately owns the property, the U.S. government can’t assess an inheritance tax. The structure is a legal means for non-U.S. buyers who want to cut their tax bills.
Buying property through a foreign corporation doesn’t absolve you from paying U.S. taxes. Corporations have to pay a capital gains tax of 35% on the increase in their property’s value when it is sold, while an individual would only pay a capital gains tax of 20%. The upside for a corporation is the after-tax gains on the property sale can be distributed tax-free to the foreign parent company as the U.S. LLC is liquidated.
A more flexible option may be to create a family trust structure and to use the trust to form a U.S. LLC to buy the property. The U.S. government doesn’t levy estate taxes on trusts, and, if your heirs sell the property, they will be treated as individuals and taxed on only 20% on the property’s capital gains. Another plus of a trust owning your property is that it allows your beneficiaries to live in the property rent-free. That’s a benefit that’s not available to corporate owners of real estate. A trust also can be used to make other investments, giving a family more flexibility in managing their assets.
The upfront cost of setting up a trust can be higher than the dual-company approach — from $2,000 to $10,000 or more for a trust, and about $2,500 or more to set up a U.S. corporation (considering related tax matters and legal advice too), but the annual fees for doing each is about the same and often can be very little.
The long arm of U.S. tax law is more like an eight-arm octopus as surprising fees appear to dart out of nowhere. Among these are the gift tax, levied, say, if your father buys you an apartment and puts it in your name, and FIRPTA, the Foreign Investment in Real Property Tax Act, which requires someone who buys property from a non-U.S. resident to withhold 10% of the sale price for taxes. And there’s more.
The point is to seek assistance and find out what the potential taxes and other costs may be. There’s no magic formula, no right way or no wrong way. You just have to analyze the various options and figure out what works best for you. One strategy that is guaranteed to fail is doing nothing, figuring the U.S. government won’t notice.
As Dov puts it, “The cost of compliance is much cheaper than the cost of non-compliance.”
