Investment decisions are difficult nowadays, but I am still getting inquiries from US persons about the US tax effects of owning foreign real property. Tax efficient structuring depends on numerous factors. While an earlier blog post discussed the general concept of what is called a “disregarded entity” and how it is used (and misused) by non-US individuals who purchase US real property, today’s blog post will examine how the disregarded entity can be used by US persons to own foreign real estate. Remember, use of the disregarded entity is simply one possibility; the facts of each case should be carefully examined with a qualified tax advisor to determine if it is an efficient vehicle for the particular investor.
Ownership through a Foreign Corporation
Corporate entities set up for the purpose of owning foreign real estate run the risk of being classified as a “Controlled Foreign Corporation” (CFC) or a “Passive Foreign Investment Company” (PFIC). The tax rules governing these entities are generally known as “anti-deferral” tax regimes and were enacted to prevent US taxpayers from using foreign corporations to defer income taxes. Once a corporation is classified as either a CFC or a PFIC, very onerous tax consequences will follow, including very complex reporting obligations.
The US purchaser (who includes not only US citizens, but green card holders or individuals spending significant time in the US) must undertake proper US income tax planning before setting up the corporate vehicle. Failure to do so can result in harsh tax consequences including current taxation of certain rents even if amounts have not been distributed to the shareholder by the corporation, the loss of beneficial capital gains rates upon sale of the property, and with respect to a principal residence loss of mortgage interest deductions and loss of the exclusion for gain upon sale of the principal residence.
If the owner wishes to change the tax classification from a “corporation” to something else, he can use Form 8832, “Entity Classification Election”. This is discussed in my earlier blog post; the election permits an eligible entity to freely elect how it will be classified for federal income tax purposes. In the case of a foreign (non-US) corporation, it is often helpful to make an election to have the entity treated for tax purposes as disregarded as separate from its owner. In the case of a foreign corporation making an election to be treated as “disregarded”, if it has only a single owner, it will be treated as a “foreign disregarded entity” or “FDE”. In other words, the corporate entity is completely disregarded, but only for US tax purposes. So, for example, assuming local law tax benefits would arise if the property were owned by a local corporation, these would be preserved without the onerous US tax consequences of CFC or PFIC treatment. In the proper circumstances, “checking the box” can truly result in the best of both worlds.
Overview of CFC and PFIC Tax Regimes
A foreign corporation is a CFC when more than 50 percent of its share value or voting power is controlled by so-called “US shareholders” (10% or greater owners). If a US shareholders control less than 50 percent of a foreign corporation’s share value or voting power, it may instead be classified as a PFIC if one of the following applies:
- i) More than 75 percent of the corporation’s gross income is comprised of so-called “passive income”;
- ii) More than 50 percent of the value of its assets are held for the production of “passive income”.
Passive income generally includes capital gains, rent, interest, dividends and royalties.
Punitive Tax Rates
When a corporation is classified as a CFC or a PFIC, certain gains generated by the company will be taxed to the US shareholder as ordinary income. Depending on whether the CFC or PFIC regime applies, amounts can be taxed to the US shareholder at a rate up to 37% percent (plus a possible 3.8% Medicare surcharge also known as the “Net Investment Income Tax,” or NIIT), as opposed to the much more forgiving tax rates on long-term capital gains, which range from 0 to 20 percent depending on the filer’s tax bracket. Often (but not in all cases), the harsh bite of the “anti-deferral rules” will apply, directly or indirectly, to gains on sale of any real property owned by the company, and to any rental income that is not determined to be earned in the “active conduct of a trade or business,” a classification which can be very unpredictable.
In the case of a PFIC, additional taxes and compounded interest charges apply in the event of disposition of the PFIC company stock or receipt by the shareholder of a so-called “excess distribution” from the corporation. While some of these consequences can be avoided by electing to treat a PFIC as a “qualified electing fund” (QEF), this carries additional accounting and reporting requirements and is not always a feasible option.
There are significant record-keeping and reporting burdens imposed on US owners of CFC or PFIC shares. Form 5471 is one reporting form that involves significant disclosure depending on the “Category of Filer” status that the person meets. For example, each US person that controls a foreign corporation and each 10% “U.S. shareholder” of a CFC is required to annually file this form to report its interest in the corporation and to report certain transactions with the entity.
With regard to PFIC, US shareholders of a PFIC must file Form 8621 when the investor receives an “excess distribution” from the PFIC or disposes of his PFIC shares resulting in an “excess distribution” or if he has made a so-called QEF election; even in the absence of such events, the Form is also required annually (there are certain exceptions). Form 8621 requires significant disclosure.
You can learn more about CFCs and PFICs in my earlier blog posting here.
A Possible Answer: Check-the-Box (CTB)
Given the harsh treatment often accorded to foreign “corporations” under the CFC or PFIC regime, “checking the box” can be considered to change the classification of the entity from a corporation to something more desirable. The FDE may possibly be the vehicle of choice. For example, choosing FDE status can prevent disallowance of mortgage interest deductions and disallowance of the exclusion of gain on the sale of a personal residence owned in a foreign country when it is held through a foreign corporation.
A CTB election may also ensure that the US owner of the corporation is properly credited with the foreign taxes paid by the corporation and prevents imposition of the so-called GILTI tax too. With regard to PFICs, making a CTB election can prevent the loss of the beneficial long term capital gains tax rate upon the sale of PFIC shares.
Checking the box is easy… but don’t be fooled. The decision to make a CTB election has to be carefully considered with advice from a knowledgeable tax professional. My earlier blog post on CTB will also be of interest as it is full of details – you know the devil loves details.
Confusion with Foreign LLCs
I have often seen tax return preparers be very confused when faced with a client holding shares in a foreign limited liability company ending in the letters, “LLC”. A non-US LLC is not the same as a US LLC. In the absence of a CTB election, a US LLC is “looked through” and the corporate entity is completely disregarded for US tax purposes. Accordingly, a US LLC is characterized as a “sole proprietorship” if it has a single member, or a “partnership” if it has more than one member. Foreign LLCs are generally treated for US tax purposes as “separate” entities and characterized as “corporations”. The local law must be examined to determine if the implementing legislation gives each member of the LLC “limited liability”. If so, the entity will generally speaking, be treated as a “corporation” for US tax purposes.
Get the right tax advice before you take the plunge and make your foreign realty investment. We can schedule a consultation.
Posted August 18, 2022
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