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Article - With Planning, Foreign Purchasers of Real Estate in the United States Can Reduce or Eliminate Estate Taxes

With Planning, Foreign Purchasers of Real Estate in the United States
Can Reduce or Eliminate Taxes

With the confluence of continued low interest rates, a weak dollar and the stability of the U.S. marketplace, foreign investors are buying significant amounts of investment and residential real estate in the U.S.  Unfortunately, foreign investors are often not adequately advised of the potential tax ramifications of their acquisition of U.S. real estate.  This article identifies an estate tax issue faced by foreign purchasers of U.S. real estate and discusses three techniques to minimize or eliminate exposure to this tax.

The U.S. federal estate tax is a tax imposed on the transfer of property upon the death of an individual.  While U.S. citizens and non-citizens who live in the U.S. with the intention of making their permanent home in the U.S. are generally subject to estate taxes on all property they own at the time of their death, persons who are not U.S. citizens and who do not make the U.S. their permanent home are only subject to U.S. federal estate taxes on so-called "U.S. Situs Property" when they die.  U.S. Situs Property generally includes U.S. real estate, shares of stock issued by corporations formed in the U.S., tangible property located in the United States (e.g., artwork, jewelry, etc.), and certain debt obligations of U.S. issuers.  Consequently, if a foreign individual dies owning U.S. Situs Property that has a value of more than $60,000, estate taxes of up to 47% of the value of the property at the time of death will be due to the federal government. 

Fortunately, with proper planning, foreign individuals can minimize or eliminate U.S. federal estate tax liability.  One way for a foreign individual owning U.S. Situs Property to address the issue of federal estate taxes is through life insurance.  A foreign individual who owns U.S. Situs Property for a limited time can purchase term life insurance in an amount equal to the estimated U.S. estate tax liability to cover any estate tax liability that might be incurred if he or she dies while owning this property.  As life expectancies increase, life insurance costs continue to fall and healthy individuals can obtain significant insurance coverage at relatively modest costs.  Additionally, the tax law expressly provides that life insurance proceeds payable on the death of an individual who is not a resident and not a citizen of the United States is not U.S. Situs Property, even if the insurance is acquired from an insurance company located in the United States.  In other words, the insurance proceeds will not be subject to estate tax.

Another way for a foreign individual owning U.S. Situs Property to reduce federal estate taxes is to reduce the value of the property.  Since estate taxes are calculated on the "fair market value" of an individual's property at the time of death, individuals owning U.S. Situs Property can reduce the fair market value of such property by leveraging it with a non-recourse mortgage.  Under the tax laws the fair market value of property is calculated net of all non-recourse mortgages.  Consequently, the amount of federal estate taxes imposed on a non-U.S. individual will be based on the value of the U.S. Situs Property less the amount of the non-recourse mortgage.

The use of life insurance and leveraging property can minimize or eliminate estate taxes whether or not the U.S. Situs Property has already been purchased by the foreign individual.  An additional planning technique to eliminate U.S. estate tax liability for foreigners who have not yet acquired U.S. Situs Property is the use of a non-U.S. corporation to acquire the property.  As discussed above, U.S. Situs Property includes shares of stock issued by corporations incorporated in the U.S.  However, U.S. Situs Property does not include shares of stock issued by corporations incorporated outside the U.S.  As a result, if a foreign individual establishes a non-U.S. corporation and that corporation then acquires U.S. real property or other U.S. Situs Property, under current Internal Revenue Service guidance the value of such property should not be included in the foreign individual's transfer tax base (and therefore not be subject to estate tax) as long as the structure and procedures relating to the non-U.S. corporation are respected.  In other words, the tax law exempts U.S. Situs Property that is acquired and owned by a non-U.S. corporation from estate tax. 

Non-U.S. corporations are often established in "tax haven" jurisdictions like the British Virgin Islands, the Cayman Islands and the Bahamas because these jurisdictions do not impose taxes on transactions related to the corporations.  Frequently owners of non-U.S. corporations formed in these jurisdictions place the shares of these corporations into revocable trusts to manage the property and to ensure that their estate planning objectives are achieved.

While using a non-U.S. corporation does not make sense in every situation, it is often an effective way to eliminate U.S. estate tax liability for a foreign individual who wants to own U.S. real estate or other U.S. Situs Property. 

Whenever a non-U.S. individual undertakes U.S. tax planning in connection with the acquisition of U.S. Situs Property several issues must be considered.  Plans that save U.S. estate taxes must be considered in light of the individual's non-tax objectives, the tax consequences to the individual in his or her home country, and the U.S. income and other tax consequences of a particular structure.  The income tax consequences must be carefully considered when contemplating the acquisition of U.S. real property through a non-U.S. corporation since the use of a corporate structure may have a material effect on the incidence and rate of U.S. income taxes on the sale or rental of the property.

As seen in the Mann Report, April 2005.