Tax Effective Strategies for Purchasing and Owning U.S. Real Estate

Transcription

1 Tax Effective Strategies for Purchasing and Owning U.S. Real Estate Smythe Ratcliffe LLP US and Cross-Border Tax Seminar Presentation By Robert E. Ward, J.D., LL.M. Robert E. Ward and Associates, P.C East-West Highway, Suite 650 Bethesda, Maryland One Bentall Centre, 505 Burrard Street Vancouver, British Columbia V7X 1M

2 A Primer on U.S. Taxation 1

3 The U.S. Tax System Why Do We Care? Are you a U.S. Citizen? Are you a U.S. Resident? Do you own U.S. Situs Assets? Do you have U.S. Source Income? 2

4 The U.S. Tax System One System, Many Taxes Income Taxes Gift Taxes Estate Taxes Generation-Skipping Transfer Taxes 3

5 Understanding the U.S. Income Tax Rates for Individuals % on Ordinary Income Tax Issues 15-20% on Capital Gains and Qualifying Dividends 3.8% on Net Investment Income Maximum Income Tax Rate for Corporate Taxpayers: 35% The Income Tax Brackets are Different: 2013 Maximum Tax Bracket for Individuals $400,000 for Single Filers $425,000 for Head of Household $450,000 for Married Filing Jointly 2012 Maximum Tax Rate for Corporations: Over $10 Million 34% Bracket: $75,000 - $100,000 39% Bracket : $100,000 - $335,000 34% Bracket: $335,000 - $10 Million State Income Tax Rates Individuals: 0-11% Corporations: % 4

6 U.S. Income Tax Brackets 2013 Single Taxpayer Income Tax Rate 3.8% Net Investment Income Tax Total Tax Rate 0 8, ,925 36,250 15% 0 15% 36,250 87,850 25% 0 25% 87, ,250 28% 0 28% 183, ,000 33% 0 33% 200, ,350 33% 3.8% 36.8% 398, ,000 35% 3.8% 38.8% 400, % 3.8% 43.4% British Columbia Combined Federal & Provincial 20.06% % ($135,054) 5

7 U.S. Transfer Tax System Gift, Estate, Generation-Skipping Transfers without consideration are subject to tax Transfers while alive are subject to gift tax Transfers at death are subject to estate tax Transfers across generations are subject to generation-skipping transfer tax 6

8 U.S. Gift Tax Gift Tax Rates Federal Gift Tax Rate: State Gift Tax Rate: Connecticut % % 7

9 U.S. Estate Tax Estate Tax Rates Federal Estate Tax Rate: % State Estate Tax Rate: (Connecticut, Delaware, District of Columbia, Hawaii, Illinois, Kansas, Maine, Maryland, Massachusetts, Minnesota, New Jersey, New York, North Carolina, Ohio, Oklahoma, Oregon, Rhode Island, Tennessee, Vermont, Washington) % 8

10 U.S. Generation Skipping Transfer Tax (GSTT) GSTT Rate: Flat Maximum Federal Estate Tax Rate % GSTT Transfers: Direct Skips Taxable Distributions Parent Child Trust Taxable Terminations Grandchild 9

11 U.S. Persons Taxable on Worldwide Assets at Death Wealth Transfer Tax-Not a Tax on Gains U.S. Gift & Estate Tax Filing Requirements Gift Tax Return: April 15 of Year after Year in which Gift Made (6 month extension available) Estate Tax Return: Within 9 months from Date of Decedent s Death (6 month extension available) GSTT Return: Filed with the Gift or Estate Tax Return No Extension Available for Payment of Tax 10

12 Scope of U.S. Estate Tax Assets Subject to Tax US Citizen or Resident US Person Worldwide Assets Including: Tangible and Intangible Property Decedent-owned Life Insurance Retirement Plan Assets Survivor Annuities Transferred Assets with Retained Interests Non-US Citizen or Non Resident Non-Resident Alien (NRA) US Situs Assets Including: Tangible Personal and Real Property Present in the United States Shares of US Corporations Debt Obligations of US Persons Other Than: Bank Deposits Portfolio Interest: Generally, Publicly traded Debt Instruments Including U.S. Treasury Obligations and Municipal Bonds Wealth Transfer Tax Not a Tax on Gains 11

13 Scope of U.S. Gift Tax Assets Subject to Tax US Citizen or Resident US Person Worldwide Assets Including: Tangible and Intangible Property Non-US Citizen; Non Resident Non-Resident Alien (NRA) US Situs Assets Including: Tangible Personal and Real Property Present in the United States including mineral interests Interests in Partnerships which own Tangible Personal and Real Property Present in the United States Wealth Transfer Tax Not a Tax on Gains 12

14 The U.S. Tax System One System, Many Taxes Maximum Rates B.C. $1.00 $1.00 Income Tax: 43.4% Generation-Skipping Transfer Tax 40% Gift Tax: 40% Gift Tax on GSTT: 40%.02 Ouch! 13

15 Acquisition and Ownership of US Assets Effective Strategies to Avoid U.S. Estate Taxation 14

16 Acquisition and Ownership of US Assets Strategy #1 Do Not Own US Assets (At Death) 15

17 Individual Ownership of U.S. Vacation Real Estate Individual Real Estate Privacy Concerns Estate Tax But- only one level of tax on sale! Qualifies for preferential capital gain treatment on sale U.S. Tax filing obligation on sale Probate No liability protection for owner or heirs 16

18 Joint Ownership of U.S. Real Estate with a Spouse Husband & Wife Real Estate Privacy Concerns Estate Tax -- TWICE But- only one level of tax on sale! Qualifies for preferential capital gain treatment on sale U.S. Tax filing obligation on sale Probate No liability protection for owner or heirs 17

19 Will There Be an Estate Tax to Pay? US Citizen or Resident US Person US Estate Tax Exemption Non-US Citizen or Non Resident Non-Resident Alien (NRA) US Estate Tax Exemption 2011: $5,000,000 (indexed for inflation) 2012: $5,120, : $5,250,000 Greater of $60,000 OR Treaty Credit US Estate Tax Exemption x US Assets Worldwide Assets 18

20 Treaty Credit If Worldwide Assets Do Not Exceed the US Estate Exemption There Will Be No US Estate Tax Liability CAUTION: Worldwide Assets Are Determined by US Estate Tax Principles 19

21 Hypothetical #1 Sid & Nancy* Canadian Residents Financial Statement Sid Nancy UK Property $5,000,000 Canadian Residence $2,000,000 Canadian Investment Portfolio $3,000,000 US Property $2,000,000 Life Insurance $3,000,000 $15,000,000 $0 Sid Dies December 1, 2013 Treaty Estate Tax Credit Formula: $5,250,000 X $2,000,000 $15,000,000 $700,000 (US Estate Tax Exempt Amount) US Estate Tax Liability = $ 473,027 *R.I.P. 20

22 Strategy #2: Ownership of US Real Estate Through a Trust Advantages Can Avoid US Estate Taxation Qualifies for Preferential US Capital Gains Treatment Avoids Probate Limits Liability Preserves Control Addresses Incapacity Protects Heirs Disadvantages Possible Withholding Possible Return Requirement 21

23 Use of a Trust Step One: Funding the Trust Trustee Trust Protector Canadian Irrevocable Trust Settlor (Grantor) $ Beneficiary How should the Trust be Funded? 22

24 Use of a Trust Step Two: Purchase of the Property Trustee Trust Protector Settlor $ Canadian Irrevocable Trust Beneficiary Mortgage $ Property $ Lender Seller 23

25 Use of a Trust Step Three: Ownership of the Property Trustee Trust Protector Settlor $ Irrevocable Trust Use (Income) Beneficiary Property 24

26 Use of a Trust Step Four: Sale of the Property Trustee Trust Protector Settlor $ Canadian Irrevocable Trust Use (Income) Beneficiary Buyer $$$ Property New Property Seller Who is the Beneficiary? The Settlor s Spouse and Children Who is the Trustee? 25

27 Design What Kind of Trust? - Generation-Skipping Trust Settlor Trustee Canadian Irrevocable Trust (US Property) Settlor's Spouse and Children Generation-Skipping Trust Settlor's Children and Decendants Subject to 21-Year Rule (Deemed Diposition) ITA Section 104(4) Generation-Skipping Trust Successive Generations in Perpetuity 26

28 What If Your Client Already Settlor Owns U.S. Property? Design Transfer to a Trust Trustee Trust Protector US Property Irrevocable Trust Beneficiary (Settlor's Spouse and Children) Generation- Skipping Trust Beneficiaries (Settlor's Children and Descendants) Successive Generations in Perpetuity Disposition Triggering Canadian Capital Gains Tax Disposition Triggering US Gift Tax 27

29 Avoiding US Gift Tax Sale in Exchange for Promissory Note Settlor Trustee Trust Protector US Property Promissory Note Irrevocable Trust Generation- Skipping Trust Beneficiary (Settlor's Spouse and Children) Beneficiaries (Settlor's Children and Descendants) Successive Generations in Perpetuity 28

30 Avoiding US Gift Tax Leveraging the Property to Reduce Equity Bank Mortgage Refinance Proceeds Settlor Trustee Trust Protector US Property (Subject to Mortgage) Irrevocable Trust Generation- Skipping Trust Beneficiary (Settlor's Spouse and Children) Beneficiaries (Settlor's Children and Descendants) Successive Generations in Perpetuity 29

31 Individual Ownership of U.S. Investment Real Estate Individual Investor Real Estate Advantages Preferential capital gain treatment Single level of tax Profits and losses offset (in the case of multiple properties) No FACTA compliance Disadvantages 30% gross withholding on rental income 10% gross withholding on proceeds of sale Must file U.S. income tax return on sale or annual U.S. income tax returns if engaged in U.S. trade or business (either by election or default) Estate tax exposure Privacy concerns Probate No liability protection for owner or heirs 30

32 Taxation of Income from US Investment Property Fully Subject to US Income Taxation Nonresident aliens are taxed on gross rental income at a rate of 30% (IRC Section 871(a)) Nonresident aliens are taxed on gain realized on sale of US property at long term capital gain (15% to 23.8%) or graduated rates of 15% to 43.4% (IRC Section 897(a)(1)) Withholding on Nonresident Aliens: Imposed on a Gross Basis Rental income: 30% (IRC Section 1441(a)) Income from Sale of Property: 10% (IRC Section 1445(a)) Election to Treat Income as Effectively Connected with a US Trade or Business (IRC Section 871(d)) Nonresident aliens are taxed on rental income net of expenses at graduated rates of 15% to 43.4% (IRC Section 871(b)) Cannot be made by partnership. Made by the partners (Treas. Reg. Section (d)(3) 31

33 Non-Residents/Non-Citizens with U.S. Source Income Gross Withholding Rates IRC Tax Treaty Interest (Bank Accounts) Not U.S. Source No Withholding Interest (Debt Obligations) 30% (subject to exceptions) 0 Dividends 30% 5/15% Royalties 30% 10/0** Rents 30% No Relief Salaries and Wages 30% Exempt* Alimony 30% 0% Pensions and Annuities 30% 15% Property Sales Real Property 10% No Relief Timber, Coals, Iron Ore 30% No Relief Most Other Property 0* No Withholding *Subject to 183 day rule. **Copyright (other than motion picture and television), computer software, and most patent royalties 32

34 What Gross Withholding Means to Cash Flow Rental Income Rental income: Subject to 30% withholding tax Example: Lessee pays $200 rent to owner Owner pays expenses to 3rd parties related to the property of $100 (e.g., maintenance, real property taxes, insurance) Gross rental income = $200 Withholding tax = $60 Net cash owner gets = $40 ($100 - $60) Effective tax rate of 60% 33

35 Alternative: Election Under IRC 871(d), 882(d) to be Treated as Engaged in a U.S. Trade or Business Rental Income Tax limited to net income from property Example: Lessee pays $200 rent to owner Owner pays expenses related to the property of $100 (e.g., maintenance, real property taxes, insurance) Gross rental income = $200 Net rental income (before depreciation & interest deductions) = $100 Maximum Tax (assuming no depreciation or interest) = $43.4% Effective tax rate = $43.4% and lower with depreciation, interest, & other deductions Must give Form W-88ECI to Lessee to eliminate withholding tax obligation Owner must file U.S. income tax return 34

36 Alternative: Engaged in a U.S. Trade or Business without Election When does leasing make foreign owner ETB? General Rules: Rental of one property to one tenant under a net lease is not ETB See Rev. Rul ; Neill, 46 B TA 197(1942) Rental to many tenants is ETB See Pinchot, 113 F.2d 718 (2d Cir. 1940) (11 real estate properties) Election to be ETB: 871(d), 882(d) Often recommended since lower tax burden (due to deductions) Must give Form W-8ECI to lessee to eliminate withholding tax obligation Owner must file U.S. income tax return 35

37 Sale of U.S. Real Estate Withholding Requirement: 1445 Buyer must withhold 10% of Amount Realized on Sale Problem: Overwithholding Example: Sell real estate with a tax basis of $900 for $1,000 Buyer must withhold $100 tax (10% of $1,000) even though gain is only $100 & tax will be less than that Solution: Get Withholding Certificate by filing Form 8288-B before the sale Seller will need to get an Individual Taxpayer Identification Number ( ITIN ) 36

38 Ownership of U.S. Investment Real Estate Through a Trust Advantages Can Avoid US Estate Taxation Qualifies for Preferential US Capital Gains Treatment Avoids Probate Limits Liability Preserves Control Addresses Incapacity Protects Heirs Disadvantages Withholding Return Requirements 37

39 Ownership of US Investment Real Estate through a Corporation Advantages Avoids Estate Taxation Avoids Probate Limits Liability Preserves Control Disadvantages Loss of Preferential Capital Gain Treatment Potential Double Taxation Loss of Flexibility: Imputed Income for Personal Use Risk of Incapacity Filing Obligations FACTA Compliance 38

40 Ownership of US Investment Real Estate through a Corporation Foreign Corporation Option Individual Investor Canada Corp. Real Estate No Estate Tax Branch Profits Tax (Gain will be effectively connected income subject to US Tax or because of FIRPTA) Sale of Stock Tax Free BUT! Tax-Free Refinancing Distributions When Canadian Corporation refinances and distributes refinance proceeds to FP there is no withholding No Preferential Capital Gains Treatment 39

41 Ownership of US Investment Real Estate through a Corporation U.S. Corporation Option Individual Investor US Corp. No Branch Profits Tax Dividend Withholding Tax (5% Treaty Rate) Estate Tax Sale of Stock Taxable USRPHC Taxable Refinancing Distributions No Preferential Capital Gains Treatment Real Estate 40

42 Ownership of US Investment Real Individual Investor Canada Corp. US Corp. Real Estate Estate through a Corporation Best Option?! Advantages No Branch Profits Tax No Estate Tax No Disclosure Sale of Stock of Foreign Corporation avoids FIRPTA (NB once real estate is sold, US company is no longer a RPHC) Disadvantages Corporate chain required for each property Taxable Refinancing Distributions No Preferential Capital Gains Treatment 41

43 Shared Appreciation Loan Treas. Reg. Section (h), Example 2 Step 1: Purchase Individual Investor Seller $ U.S. RealEstate U.S. Individual (Buyer) $Loan$ Canada Corporation 42

44 Shared Appreciation Loan Treas. Reg. Section (h), Example 2 Step 2: Ownership Individual Investor U.S. Individual Shared Appreciation Mortgage Canada Corporation Real Estate Secures Loan 43

45 Shared Appreciation Loan Treas. Reg. Section (h), Example 2 Step 3: Sale and Repayment Individual Investor Buyer $ U.S. U.S. Real Estate Individual (Seller) $Payment of Mortgage$ Canada Corporation 44

46 Using Shared Appreciation Loan to Avoid FIRPTA (cont d) Regulation Section (h), Example 2 Foreign corporation makes $1 million loan to domestic individual which is secured by mortgage on real property purchased with loan proceeds. Loan agreement entitles lender to fixed monthly payments constituting repayment of principal plus fixed interest rate. Lender also entitled to receive certain percentage of the appreciation in value of real property at the time that the loan is retired. Shared appreciation loan treated as US real property interest (USRPI), but receipt of final payments do not constitute disposition of USRPI for purposes of IRC Section

47 Using Shared Appreciation Loan to Avoid FIRPTA (cont d) Example 2 concludes that IRC Section 897 is not triggered on receipt of final loan payment because payment constitutes principal and interest, not gain for tax purposes. Thus, appreciation payment is treated as interest for tax purposes. Cannot qualify for exemption from withholding under portfolio interest rules because payment is contingent interest. IRC Section 871(h)(4) However, can rely on Article XI(4) of Tax Treaty with zero percent withholding on interest. 46

48 Ownership of US Investment Real Estate through a Corporation Multiple Properties Individual Foreign Corp. Advantages Dealer status nullifies loss of capital gain treatment Consolidated US return allows losses of some properties to offset income of others No Estate Tax No Branch Profits Tax US Corp. Loan US 1 US 2 US 3 Disadvantages Same as prior slides Problems with distribution of sales proceeds from sale of property without liquidation of US corporation 47

49 FIRPTA Avoidance Using a Real Estate Investment Trust (REIT) Individual Investor REIT U.S. Real Estate Advantages No U.S. Income Tax on sale REIT shares if REIT is Domestically Controlled Reduced withholding on REIT distributions (15%) under tax treaty No requirement to file U.S. return Avoids Probate Limits Liability Disadvantages Estate Tax 48

50 FIRPTA and Estate Tax Avoidance Using a REIT with an Irrevocable Trust Trustee Trust Protector Individual Investor Irrevocable Trust Income and sale proceeds Beneficiaries (spouse and children) REIT U.S. Real Estate Advantages No U.S. Income Tax on sale REIT shares if REIT is Domestically Controlled Reduced withholding on REIT distributions (15%) under tax treaty No requirement to file U.S. return Avoids Probate Limits Liability No Estate Tax 49

51 General Rule REITs Sale of REIT Stock Gain is taxable under FIRPTA Exceptions: Publicly Traded REIT: No tax on shareholder owning 5% or less since not USRPHC IRC 897(c)(3) Domestically controlled REIT Domestically controlled if 50% or more of the REIT is owned by U.S. persons during last 5 years or if less, time REIT has been in existence No tax since not USRPI IRC 897(h)(2) 50

52 PLR Domestically-Controlled REIT 51

53 Domestically-Controlled REIT Structure PLR IRC 897 (h)(4)(b) defines a domestically controlled REIT as a REIT in which at all times during the testing period less than 50 percent in value of the stock was held directly or indirectly by foreign persons. (Emphasis supplied.) Issue: Can the domestic ownership requirement of IRC 897(h)(4)(B) be satisfied when a majority of the REIT shares are held by foreign persons through two U.S. C corporations? Ruling: Yes, because the two U.S. C corporations are each fully taxable domestic Subchapter C corporations for U.S. federal income tax purposes and are not otherwise a REIT, RIC, hybrid entity, conduit, disregarded entity, or other flow-through or look-through entity. 52

54 Tax Effective Strategies for Purchasing and Owning U.S. Real Estate Smythe Ratcliffe LLP US and Cross-Border Tax Seminar Presentation By Robert E. Ward, J.D., LL.M. Robert E. Ward and Associates, P.C East-West Highway, Suite 650 Bethesda, Maryland One Bentall Centre, 505 Burrard Street Vancouver, British Columbia V7X 1M