Coming to America? Time to seek international tax advice!

• Author: Hadjilogiou, Steven

People do not like spending more money than necessary. Yet, a few times a month a new client calls with a complicated and costly tax issue, which almost certainly will result in unnecessary amounts of legal fees and tax liability. In every one of these cases, the tax bill and legal fees could have been entirely prevented and should have never existed in the first place had the client undertaken proper tax planning.

The reality is that many transactional professionals do not involve tax counsel up front. Too often we hear that our clients have received tax advice from a friend, a realtor, or simply disregarded advice to seek tax counsel because the expense of upfront tax advice was deemed to be unnecessarily expensive. Moreover, some professionals may believe that tax counsel could ruin or overly complicate their deal, resulting in lost commissions or fees to the professional. Sometimes tax is complicated, but what should be more concerning is steering a client into a tax disaster. Traps for the unwary are especially prevalent when dealing with international clients and cross-border transactions.

United States federal income tax and estate and gift tax laws are challenging and are especially difficult when working with international clients. To further complicate matters, President-elect Trump has proposed during the course of his campaign an outright elimination of the estate tax and a significant reduction of corporate tax rates. At the time of publication, these proposed changes are merely speculative. Furthermore, the world has increasingly become more transparent with 87 countries currently signed on to participate in the OECD's Common Reporting Standard and the United States' Foreign Account Tax Compliance Act (Pub. L. 111-147), both of which require automatic exchange of certain taxpayer information between countries. Although there are numerous types of relevant transactions, this article outlines three common scenarios in which an international tax attorney should be consulted in advance.

Foreign Investment in U.S. Real Estate

For many foreign individuals, or as technically known in tax parlance as non-resident aliens (NRA), (1) the most important U.S. tax consideration when considering an investment in U.S. real estate is how to prevent U.S. federal estate and gift taxes from applying. This is driven primarily by the fact that non-U.S. domiciliaries (2) are allowed to exclude only the first $60,000 in value of U.S. situs assets from their U.S. estates and the remainder subject to U.S. estate tax at federal rates up to 40 percent plus applicable state estate taxes. Thus, some non-U.S. domiciliaries own U.S. real estate through a foreign corporation, (3) because shares in a foreign corporation are explicitly excluded from the definition of U.S. situs assets. However, foreign corporations are subject to higher income tax rates and are also potentially subject to the so-called branch profits tax on sales of appreciated real estate. The optimal structure to hold real estate should minimize U.S. estate and gift tax exposure and provide the opportunity for the reduced 20 percent capital gains rate on future sales of real estate.

Before we discuss the least to most optimal U.S. real estate structures for NRAs, we must touch on a very important U.S. statutory regime that applies to NRAs and foreign corporations that directly or indirectly own real estate in the United States. This regime is known as the Foreign Investment in Real Property Tax Act of 19804 (FIRPTA). FIRPTA, as codified principally in Internal Revenue Code (IRC) [section] [section] 897 and 1445, governs the taxation of dispositions of U.S. real property interests (USRPI) by foreign persons. I.R.C. [section] 897(a) generally requires gain or loss from the disposition of a USRPI by a foreign person to be taken into account as if the foreign person were engaged in a trade or business within the U.S. during the taxable year and as if such gain or loss were effectively connected with such trade or business. (5) As a result, recognized net gains generally are subject to U.S. federal income tax at graduated rates. (6) The term "USRPI" generally means an interest (other than an interest solely as a creditor) 1) in real property located in the United States or the Virgin Islands; or 2) in a U.S. corporation that is (or, during the five-year period preceding the disposition of the interest, was) a U.S. real property holding corporation (USRPHC). (7) In general, a U.S. corporation is a USRPHC if the fair market value of the corporation's U.S. real property interests equals or exceeds 50 percent of the aggregate FMV of 1) its USRPIs; 2) its interests in real property located outside the United States; and 3) its other assets that are used or held for use in a trade or business. (8)

To enforce the substantive tax rules in I.R.C. [section] 897, I.R.C. [section] 1445 imposes on a transferee (i.e., the buyer) the obligation to withhold when 1) the transferor of the property is a foreign person; and 2) the property transferred is a USRPI. (9) When withholding is required, the buyer of the USRPI generally must deduct and withhold 15 percent of the purchase price. (10) In addition, an exception to the withholding requirement may apply when a taxpayer disposes of a USRPI in an exchange that qualifies for nonrecognition treatment, such as a 1031 exchange or tax-free corporate reorganization. (11)

* NRA Directly Owns U.S. Real Estate--NRAs commonly directly own U.S. real estate. If the NRA ever decides to sell the U.S. real estate, he or she should generally be eligible to receive the reduced capital gain rates on the sale of the real property held for longer than a year. (12) However, the NRA will be subject to FIRPTA tax withholding on the sale, which will require that the buyer withhold 15 percent of the amount of the sales price. Absent an exception, FIRPTA will apply even if the real estate is sold at a loss or small amount of gain.

If the NRA were to die owning the U.S. real estate, the U.S. real estate would be subject to U.S. federal estate tax at rates up to 40 percent of the value of the property to the extent its fair market value exceeded $60,000. The decedent's beneficiary would be entitled to a step-up in the adjusted basis of the real estate, which would cause the adjusted basis to equal the fair market value of the real estate in the hands of the beneficiary. (13) The step-up generally is a favorable result if the real estate has appreciated in value. By receiving the step-up in basis, if the NRA were to turn around and immediately sell the U.S. real estate, he or she would likely have...