Tax Planning, U.S. Real Estate Ownership by Nonresidents (2018 Update)
Questions involving Non-Resident, Foreign Persons owning U.S. Real Estate is a common question we receive — since we represent many clients from abroad who have U.S. Real Estate Investments.
Non-Resident Alien & U.S. Real Estate
We think it is important that foreign national, non-residents with ties (especially real estate) in the U.S. understand the basics of estate tax and planning (especially the limited exemptions) beyond mere FIRPTA issues, twofold:
- Many people are understandably confused about Foreign Person, Non-Resident U.S. Estate Tax responsibilities; and
- It oftentimes leads to IRS Foreign Reporting and Voluntary Disclosure issues.
Since U.S. Estate Tax rules vary depending on the type of property/asset/account the foreign national invests in, we will focus on Real Estate — since that is the most common investment.
Estate Tax on a Foreign Person’s U.S. Real Estate
Not only is southern California a wonderful place to live, it is a great place to invest. Southern California has a low inventory of housing, and it is known worldwide as a great investment.
For purposes of Estate Tax, a Foreign Person/Non-Resident generally includes a person who:
Is a Non-U.S.Citizen/Non-Legal Permanent Resident who does not meet the Domicile Rule for Estate Tax purposes.
U.S. Residency – Income Tax vs. Estate Tax
While the United States has the right to tax U.S. persons on their worldwide income (aka Income Tax) as well as their global estate assets (Estate Tax), the analysis is different.
While U.S. Citizens and Legal Permanent Residents are taxed on their worldwide income and international estates, the U.S. Estate Tax rules for Non-Citizens/Non-Permanent Residents are somewhat different than Income Tax rules.
U.S. Income Tax Rules
A person (individual, not business) is considered a U.S. person when they are either:
- A U.S. citizen
- Legal Permanent Resident (aka Green card holder)
- Foreign national meets the Substantial Presence Test
U.S. Estate Tax Rules
For Estate tax, the analysis is a bit different. A U.S Citizen/Legal Permanent Resident is subject to U.S. estate tax whether or not they reside in United States or outside the United States, and whether or not the property is located in United States or outside of United States (Subject to different Estate Tax Conventions and Estate Treaty rules).
For Non-Citizens, non Legal Permanent Residents, the Domicile Test is used in lieu of the Substantial Presence Test. The Domicile test is different than the Substantial Presence Test. While the Substantial Presence Test is essentially a “a Counting Days test,” the Domicile Test is a more “totality of the circumstances test.”
A Domicile is the country a person resides, with the intent to remain in that country.
Estate Tax on a Non-Resident’s U.S. Real Estate Investment
Typically, a non-resident (non-U.S. Person) purchases the U.S. Real Estate for various different reasons.
These typically include:
- Purchasing homes in order to bring money to the U.S. (for a subsequent home sale and liquidity)
- Purchasing a home for a child attending school in the United States
- Investing in a REIT (Real Estate Investment Trust)
- Purchasing a second home or vacation home
- Purchasing a rental property to generate U.S. sourced income which may be tax-free in their country of residence
Estate Tax – The Hidden Tax
When people think of estate tax, they tend to think of the common U.S. person rules, which includes a major gift and estate tax exemption.
The gift and estate tax exemption is combined into one “bucket” (unlike GST “Generation Skipping Tax” which has a separate bucket), and currently it is set at $11,180,000.
In addition, the annual gift exclusion amount is $15,000 (increased from $14,000).
For a person who is a foreign national, non-U.S. Person (aka non-U.S. Citizen or Resident) who does not meet the domicile test, the Gift and Estate Tax exclusion is only $60,000.
That’s correct: the estate and gift tax exclusion for non-U.S. persons is literally not even 1% of the U.S. Person gift and estate tax exemption. This can cause a major (unnecessary) headache for many of our clients.
Foreign Resident U.S. Estate Tax Example
David Sr. is a non-U.S. person and resides in Taiwan. David Jr.. was admitted to USC, and David Sr. decides that since he and his family will be visiting David Jr. often, it would be easier for David Sr. to purchase a home (they have a significant net worth).
He purchases a $2M home in nearby Santa Monica, so his family can visit David, and enjoy sunny California. David’s children are all U.S. Citizens (his wife is a U.S. Citizen). David had no intention of placing the home into David Jr.’s name, since he thought it would be too much responsibility for David Jr. .
In addition, due to certain local tax rules, David did not want to place the U.S. residence into his spouse’s name.
Unfortunately, David died suddenly due to complications with a surgery. The only asset David Sr. had in the U.S. was the home. Since the home was in David Sr.’s name, when he died, the U.S. situs asset will be taxed at the current U.S. Estate Tax Rates (40%) and only $60,000 of the home value would be exempt.
That leaves 40% tax on the remaining difference.
How Could the Result Have Been Different?
Aside from establishing a QDOT, forming a foreign corporation (which has other pitfalls) or other unnecessary tax planning scenarios, all David had to do was purchase the home in a different person’s name who was a U.S. Citizen, such as his spouse or child (U.S. Citizens).
David could have gifted the money to a U.S. person, and the U.S. person would file a Form 3520.
Even if the other person (a U.S. Citizen) had died suddenly instead, and the asset was under his or her name, there would be no estate tax (unless the entire estate was worth significantly more) — since a U.S. person is taxed on their worldwide estate subject to various convention and estate tax treaty rules.
But the Spouse and Children are Not U.S. Residents?
While they do not live in the U.S.,they are U.S. citizens, so the mere fact that they live or ‘resident’ outside of the United States does not make them “Foreign Residents” for estate tax purposes. Since the wife and children are U.S. Citizens, any one of them would have received the benefit of the full $11,180,000 exemption.
It is a double-edged sword: One the one hand, the U.S. gets to tax the wife and children on worldwide assets (whereas it can only tax David Sr., a non-U.S. Person for Estate Tax, on his U.S. situs), but unless his wife or children are worth more than than the exclusion amount, there would be no U.S. Estate Tax.
Other Common Related Issues to Watch Out For
Since David’s wife and children (all U.S. Citizens) have not been filing their U.S. Tax Returns properly. Like many of our clients, they thought there were different Tax and Reporting rules, since they reside outside of the U.S., only have passive income (they have no earned income), and pay tax in their current country.
Now, they have the IRS to deal with.
IRS Foreign Account, Assets and Investment Reporting
Since the rest of David Sr.’s brood are U.S. Citizens, they should have been disclosing their foreign money to the IRS, including:
- Bank Accounts
- Financial Accounts
- Investment Accounts
- Real Estate
- Foreign Business
Since the family was not properly reporting, they may find themselves subject to IRS fines and penalties unless they properly get into compliance.
With that said, there are many IRS Amnesty Programs in place that may assist them win reducing or eliminating these penalties.
IRS Offshore Penalty List
A Penalty for failing to file FBARs
United States citizens, residents and certain other persons must annually report their direct or indirect financial interest in, or signature authority (or other authority that is comparable to signature authority) over, a financial account that is maintained with a financial institution located in a foreign country if, for any calendar year, the aggregate value of all foreign financial accounts exceeded $10,000 at any time during the year. The civil penalty for willfully failing to file an FBAR can be as high as the greater of $100,000 or 50 percent of the total balance of the foreign financial account per violation. See 31 U.S.C. § 5321(a)(5). Non-willful violations that the IRS determines were not due to reasonable cause are subject to a $10,000 penalty per violation.
FATCA Form 8938
Beginning with the 2011 tax year, a penalty for failing to file Form 8938 reporting the taxpayer’s interest in certain foreign financial assets, including financial accounts, certain foreign securities, and interests in foreign entities, as required by IRC § 6038D. The penalty for failing to file each one of these information returns is $10,000, with an additional $10,000 added for each month the failure continues beginning 90 days after the taxpayer is notified of the delinquency, up to a maximum of $50,000 per return.
A Penalty for failing to file Form 3520
Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts. Taxpayers must also report various transactions involving foreign trusts, including creation of a foreign trust by a United States person, transfers of property from a United States person to a foreign trust and receipt of distributions from foreign trusts under IRC § 6048. This return also reports the receipt of gifts from foreign entities under IRC § 6039F. The penalty for failing to file each one of these information returns, or for filing an incomplete return, is the greater of $10,000 or 35 percent of the gross reportable amount, except for returns reporting gifts, where the penalty is five percent of the gift per month, up to a maximum penalty of 25 percent of the gift.
A Penalty for failing to file Form 3520-A
Information Return of Foreign Trust With a U.S. Owner. Taxpayers must also report ownership interests in foreign trusts, by United States persons with various interests in and powers over those trusts under IRC § 6048(b). The penalty for failing to file each one of these information returns or for filing an incomplete return, is the greater of $10,000 or 5 percent of the gross value of trust assets determined to be owned by the United States person.
A Penalty for failing to file Form 5471
Information Return of U.S. Persons with Respect to Certain Foreign Corporations. Certain United States persons who are officers, directors or shareholders in certain foreign corporations (including International Business Corporations) are required to report information under IRC §§ 6035, 6038 and 6046. The penalty for failing to file each one of these information returns is $10,000, with an additional $10,000 added for each month the failure continues beginning 90 days after the taxpayer is notified of the delinquency, up to a maximum of $50,000 per return.
A Penalty for failing to file Form 5472
Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business. Taxpayers may be required to report transactions between a 25 percent foreign-owned domestic corporation or a foreign corporation engaged in a trade or business in the United States and a related party as required by IRC §§ 6038A and 6038C. The penalty for failing to file each one of these information returns, or to keep certain records regarding reportable transactions, is $10,000, with an additional $10,000 added for each month the failure continues beginning 90 days after the taxpayer is notified of the delinquency.
A Penalty for failing to file Form 926
Return by a U.S. Transferor of Property to a Foreign Corporation. Taxpayers are required to report transfers of property to foreign corporations and other information under IRC § 6038B. The penalty for failing to file each one of these information returns is ten percent of the value of the property transferred, up to a maximum of $100,000 per return, with no limit if the failure to report the transfer was intentional.
A Penalty for failing to file Form 8865
Return of U.S. Persons With Respect to Certain Foreign Partnerships. United States persons with certain interests in foreign partnerships use this form to report interests in and transactions of the foreign partnerships, transfers of property to the foreign partnerships, and acquisitions, dispositions and changes in foreign partnership interests under IRC §§ 6038, 6038B, and 6046A. Penalties include $10,000 for failure to file each return, with an additional $10,000 added for each month the failure continues beginning 90 days after the taxpayer is notified of the delinquency, up to a maximum of $50,000 per return, and ten percent of the value of any transferred property that is not reported, subject to a $100,000 limit.
Fraud penalties imposed under IRC §§ 6651(f) or 6663
Where an underpayment of tax, or a failure to file a tax return, is due to fraud, the taxpayer is liable for penalties that, although calculated differently, essentially amount to 75 percent of the unpaid tax.
A Penalty for failing to file a tax return imposed under IRC § 6651(a)(1)
Generally, taxpayers are required to file income tax returns. If a taxpayer fails to do so, a penalty of 5 percent of the balance due, plus an additional 5 percent for each month or fraction thereof during which the failure continues may be imposed. The penalty shall not exceed 25 percent.
A Penalty for failing to pay the amount of tax shown on the return under IRC § 6651(a)(2)
If a taxpayer fails to pay the amount of tax shown on the return, he or she may be liable for a penalty of .5 percent of the amount of tax shown on the return, plus an additional .5 percent for each additional month or fraction thereof that the amount remains unpaid, not exceeding 25 percent.
An Accuracy-Related Penalty on underpayments imposed under IRC § 6662
Depending upon which component of the accuracy-related penalty is applicable, a taxpayer may be liable for a 20 percent or 40 percent penalty
Possible Criminal Charges related to tax matters include tax evasion (IRC § 7201)
Filing a false return (IRC § 7206(1)) and failure to file an income tax return (IRC § 7203). Willfully failing to file an FBAR and willfully filing a false FBAR are both violations that are subject to criminal penalties under 31 U.S.C. § 5322. Additional possible criminal charges include conspiracy to defraud the government with respect to claims (18 U.S.C. § 286) and conspiracy to commit offense or to defraud the United States (18 U.S.C. § 371).
A person convicted of tax evasion
Filing a false return subjects a person to a prison term of up to three years and a fine of up to $250,000. A person who fails to file a tax return is subject to a prison term of up to one year and a fine of up to $100,000. Failing to file an FBAR subjects a person to a prison term of up to ten years and criminal penalties of up to $500,000. A person convicted of conspiracy to defraud the government with respect to claims is subject to a prison term of up to not more than 10 years or a fine of up to $250,000. A person convicted of conspiracy to commit offense or to defraud the United States is subject to a prison term of not more than five years and a fine of up to $250,000.
We Specialize in Reporting Foreign Assets
We have successfully handled a diverse range of Foreign Income, Account and Asset Reporting cases. Whether it is a simple or complex case, safely getting clients into compliance is our passion, and we take it very seriously.
Unlike other attorneys who call themselves specialists but handle 10 different areas of tax law, purchase multiple domain names, and even practice outside of tax, we are absolutely dedicated to Foreign Income, Account and Asset Reporting.
No Case is Too Big; No Case is Too Small.
We represent all different types of clients. High net-worth investors (over $40 million), smaller cases ($100,000) and everything in-between.
We represent clients in over 60 countries and nationwide, with all different types of assets, including (each link takes you to a Golding & Golding free summary):
- Foreign Mutual Funds
- Foreign Life Insurance
- Fixing Quiet Disclosure
- Foreign Real Estate Income
- Foreign Real Estate Sales
- Foreign Earned Income Exclusion
- Subpart F Income
- Foreign Inheritance
- Foreign Pension
- Form 3520
- Form 5471
- Form 8621
- Form 8865
- Form 8938 (FATCA)
Sean M. Golding, JD, LL.M., EA – Board Certified Tax Law Specialist
Our Managing Partner, Sean M. Golding, JD, LLM, EA is the only Attorney nationwide who has earned the Certified Tax Law Specialist credential and specializes in IRS Offshore Voluntary Disclosure and closely related matters.
In addition to earning the Certified Tax Law Certification, Sean also holds an LL.M. (Master’s in Tax Law) from the University of Denver and is also an Enrolled Agent (the highest credential awarded by the IRS.)
He is frequently called upon to lecture and write on issues involving International Tax.
Less than 1% of Tax Attorneys Nationwide
Out of more than 200,000 practicing attorneys in California, less than 400 attorneys have achieved this Certified Tax Law Specialist designation.
The exam is widely regarded as one of (if not) the hardest tax exam given in the United States for practicing Attorneys. It is a designation earned by less than 1% of attorneys.
Our International Tax Lawyers represent hundreds of taxpayers annually in over 60 countries.