United States: Home Sweet Home Or A House Of Cards?

Last Updated: August 8 2014
Article by Gerald Nowotny

Tax Planning Considerations for the Purchase of a Residence in the U.S. by Foreign Buyers

Overview

In spite of its many problems as a nation, the quality of life and level of economic opportunity as well as the overall respect for the rule of law, places the United States in a very unique position when compared to the rest of the World. The proof of my thesis – how many people have come to the U.S. legally and illegally for the last 150 years versus the rest of the world? Central and South Americans and others are moving to the United States and not Beijing, Moscow or Outer Mongolia.

The combination of economic and political stability along with a stable currency and low inflation continue to make the United States a desirable final destination. These considerations – political and economic instability- are frequently short lived and uncertain in many parts of the world. Many non-Americans discovered this truth a long time ago. In many large metropolitan areas of the U.S., wealthy individuals and their families can live without personal scrutiny and threat to their personal freedom and security.

Many foreigners purchase a personal residence as an investment and a safe haven from their own countries in the pursuit of their own version of life, liberty and the pursuit of happiness on American soil. In many cases, foreigners send their children to college in the U.S. with the children frequently remaining in the U.S. after graduation for a number of years. As home financing is less available in many countries when compared to the U.S., many foreigners purchase the residence outright. As a result and by definition, these foreigners have substantial assets in the U.S. for tax purposes.

Traditionally, the tax structuring for wealthy foreigners in regard to the purchase of a U.S. personal residence has focused on federal estate tax planning considerations and not federal income taxation. As a practical matter, why would the homeowner worry about income taxation if there is no rental income associated with principal residence?

The 2012 Tax Court case of G.D. Parker, Inc. v. C.I.R. T.C. Memo 2012-327 (2012) is the proverbial "game changer" for this planning scenario and shifts the focus to income tax considerations. The case is a perfect example of what can go wrong.1

Genaro Delgado Parker is a very wealthy Peruvian who owned a large ocean front home in Key Biscayne. The taxpayer owned a Florida corporation which had a number of subsidiary companies including another Florida corporation which owned the Key Biscayne home. The shares of the holding company were owned by a Panamanian corporation. In this respect, the taxpayer did what a large number of foreign buyers have done when it comes to purchasing a personal residence.

The client and his family lived in the home rent-free for several years (2003-2005). The IRS disallowed deductions under IRC Sec 262 for repairs and maintenance and depreciation on the basis that these deductions were personal and family expenses and not business expenses. These expenses over a three year period averaged $125,000-$150,000 per year approximately. Further, the IRS treated the rent-free use of the house as a constructive dividend paid to the taxpayer through the corporate chain up to the taxpayer personally.

When a shareholder or his family is permitted to use corporate property for personal purposes, the fair rental value of the property is includable in his or her income as a constructive dividend to the extent of the corporation's earnings and profits.2 For a corporate benefit to be treated as a constructive dividend, the item must primarily benefit the taxpayer's personal interests as opposed to the business interests of the corporation.3

The IRS hired a local real estate expert to determine the fair market value rent that should be imputed as a constructive dividend and determined that the fair rental was $23,000 per month or $360,000 per year for each year over a three-year period.

IRC Sec 881(a) imposes a tax of 30% dividends received from U.S. sources by a foreign corporation except as provided under IRC Sec 881(c), to the extent the dividend received is not effectively connected with the conduct of a trade or business within the United States. A lower rate may apply where the taxpayer has the benefit of a lower rate under a tax treaty. IRC 1442(a) generally requires the payor of interest subject to the tax imposed by section 881(a) to deduct and withhold that tax at the source. If the payor does not do so, it becomes liable for such taxes under IRC Sec 1461. The IRS assessed substantial accuracy-related penalties and interest in the Parker case.

The amazing aspect of this case is the fact that the original tax audit was primarily focused on the taxpayer's other corporate transactions. Once you let the IRS into the tent, they have the ability to look under every stone! The last thing that the foreign taxpayer wants to do is end up on the flip side of the equation of the cliché – "Su casa es Mi Casa" (Your house is my house) as a result of poor tax planning. 

The planning paradigm has shifted to a balance of planning for unexpected estate taxes and income tax considerations for use of the personal residence. A failure to acknowledge these considerations could result in Uncle Sam ending up with the foreigner's house as a result of tax liens.

Tax Planning Considerations in the Purchase of a U.S. Residence.

A. Federal Estate Taxes

The federal estate tax is imposed on the estate of every non-domiciliary decedent  under IRC Sec 2101 based upon the value of gross estate situated in the United States at the time of death.  The estate tax exemption threshold is very low - $60,000. Property is not ordinarily included in the taxpayer's estate for estate tax purposes unless the decedent owns the property at death. Real property physically located in the U.S. and owned outright has a U.S. situs as does U.S. stock owned by a non-resident at the time of death. Stock in a foreign corporation is defined as foreign situs property

Property that is considered U.S. situs property for estate tax purposes may be purchased directly by a foreign corporation as its parent or ultimate beneficial owner and treated as having a foreign situs for U.S. federal estate tax purposes. The entity must be classified as a corporation and corporate formalities must be observed and the corporation should be the real owner of the property in substance.

The writing was already on the wall for non-resident aliens purchasing a homestead in the U.S prior to the GD Parker case.  Some older case law already existed which examined the business purpose of the corporation owning the U.S. real estate. If the corporation is disregarded, the shareholder can be treated as the direct owner of the property resulting in an unexpected estate tax. Specifically, raw land or a residence used by the shareholder poses some concern.

In Bigio v. C.I.R., a non-resident owned a condominium and other Miami properties on Miami Beach through a Panamanian corporation as a residence. Absent a lease or loan arrangement, the Tax Court determined that the non-resident was the beneficial owner of the condominiums.4

Bigio was principally an income tax case focused on the issue of U.S. residency based upon the taxpayer's substantial presence in Miami during the tax years of question. The Tax Court looked through the ownership by a Panamanian corporation and ruled that Bigio was the beneficial owner, i.e. treated as if he owned the property personally. The structuring in Bigio did not use a separate U.S. entity to own the real estate coupled with the ownership of the U.S. entity by a foreign corporation. The federal estate tax laws for non-residents treat shares in a foreign corporation as non-U.S. situs property.

Many existing transactions for non-resident aliens owning homes have used a LLC treated as a disregarded entity to own the U.S. real estate. This structuring poses a potential estate tax risk with respect to a LLC that is treated as a pass-through entity, i.e. treated as a sole proprietorship or partnership. The IRS will not generally issue an advance ruling on whether or not a partnership (LLC) interest is treated as intangible property when owned by a LLC that is taxed as a partnership or sole proprietorship in the case of a single member LLC.  As a result, a LLC that is treated as a disregarded entity, partnership or sole proprietorship, may be considered a U.S. situs asset for federal estate tax purposes.

In that respect, making an election to be treated as a regular corporation is essential for estate tax planning purposes otherwise a single member LLC will be treated as a disregarded entity potentially subjecting the residence owned by the non-resident alien to federal estate taxes. Under the aggregate theory of partnerships (LLC), the owner of a partnership interest may be treated as owning a proportionate interest of the underlying property of the partnership (LLC).

B. How Ugly Can it Get?

The revelation that the ownership of the U.S. homestead is improperly structured is likely to result during an audit and will be a big surprise to the taxpayer. The initial estate tax bracket under the progressive rate structure is 26 percent. The threshold for the non-resident alien is $60,000 of assets in the U.S. estate. Absent an arms-length lease between the corporation and the non-resident alien, a deemed dividend will be assessed based upon a fair market rental of the property to the taxpayer. Corporate level deductions for repairs and maintenance along with depreciation will be disallowed. The U.S. corporation is the withholding agent and is personally liable for the withholding on the dividend deemed payable to the foreign corporation that owns the shares of the U.S. corporation. Based upon the personal use of the residence, the withholding tax rate on the deemed dividend is 30 percent absent a lower rate under a tax, treaty.

Example

Frukko, a resident and citizen of Colombia, purchased a three bedroom condo on Brickell Key in Miami for $750,000 in January 2010.  Based on rentals within the same condominium, a fair market rental is $4,500 per month or $54,000 per year. The condo is owned within a Florida corporation. The Florida LLC is treated as a corporation for federal tax purposes.  The LLC is wholly owned by a Cayman corporation which is owned by Frukko.

Frukko's children have lived in the property on a full time basis since the purchase while they attend the University of Miami. Frukko and his wife have lived in the property when they are in the U.S. which is approximately half of the year.

The IRS audits Frukko's returns for the following tax years – 2010-2013. They determine that he should have declared income based upon the value of the deemed dividend of $54,000 each year. The withholding liability amount is $16,200 per year in 2010-2013, four years. An estimate of the taxes, interest and penalties for the four years is $60,080.

C. Federal Tax and Compliance Requirements of Electing to be Taxed as a Corporation

LLCs are entities created by state statute. A single member LLC is treated as a disregarded entity for tax purposes absent an election to be treated as a corporation through the filing of Form 8832. A domestic LLC with two members is treated as a partnership for tax purposes unless it files Form 8832 and elects to be treated as a corporation. A single member LLC is treated as a sole proprietorship absent an election to be treated as a corporation.

An election must be filed within 75 days of the formation of the company. Alternatively, the IRS allows Form 8832 to be filed within the first 75 days of the fiscal year which is the calendar tax year for our foreign buyer. Rev. Proc. 2009-41 permits business entities to file a classification election with an effective date retroactive up to 3 years and 75 days prior to the date that the request is filed.

Normally an entity may not change its corporate status within a 60-month period unless there is a change of ownership of more than fifty percent. The 60-month rule does not apply to a LLC that was a newly formed entity that made its initial election upon formation. Most entities formed by non-resident aliens should be able to fall under this rule in regard to making an election for the LLC to be treated as a corporation for federal tax purposes.

As previously stated in the discussion of federal estate taxes, the corporate election is critical to avoid U.S. federal estate taxation. The LLC will require a tax identification number and file a Form 1120 each year.

D. LLC Taxed as a Partnership

Historically, foreign buyers have structured their real purchases using LLCs taxed as a partnership for federal tax purposes. As previously discussed, this structure has some estate tax uncertainties due the Internal Revenue Service's lack of clarity on whether it subscribes to the entity theory or the aggregate theory of partnerships.

In the entity theory, the LLC is treated as a distinct entity separate from its owners. In the aggregate theory, the LLC is treated as a collection of assets owned by the members on a pro rata basis. If the aggregate theory applies, the member under the U.S-situs rules would be subject to transfer taxes on his pro rata ownership. Under the entity theory, the LLC interest would be treated as intangible property.

E. Where Do We Go From Here?

The scale of the potential tax adversity as demonstrated in GD Parker for foreigners purchasing a personal residence is significant. It is always alarming when you find out that you may be sleeping in a minefield.

Moving forward, taxpayers and their advisors would be well advised to revisit their existing structures and make revisions. The decision in GD Parker suggests that corporate ownership of personal real estate with the shares being owned by a foreign corporation in order to eliminate U.S. transfer taxes is still a functional solution. However, taxpayers would be well advised to structure an arms-length lease based upon a fair market rent based on comparable rentals in the jurisdiction where the property is located. Oddly enough, in many instances, the tax rate at the corporate level may end up being lower than the marginal tax rate of the individual if the LLC were taxed as a partnership.

Summary

The amount of real estate purchased within the U.S. either for personal or rental purposes is very significant and shows no signs of slowing down. The amount of home purchases in the Border States – Florida, California, Texas and Arizona – by foreign buyers is significant. First, foreign buyers like hard assets. The recession in home prices in general presents a buying opportunity. Second, the absence of political and economic uncertainty still presents the U.S. as the favorite safe haven. Many foreigners have purchased a residence in addition to commercial real estate.

The common thinking about how to restructure the purchase of a home in the U.S. needs to be reviewed and reconsidered. The tax minefield has new land mines based upon the result in GD Parker. My legal instinct suggests that a large majority of foreign owners are not properly structured based upon the result in GD Parker. As a result, the tax structuring of each and every foreign buyer should be reviewed to avoid any unpleasant surprises.   


1 G.D. Parker V. Commissioner, TC Memo 2012-312 (2012).

2 Commissioner v. Riss, 374 F.2d 161, 166-167, 170 (8th Cir. 1967), aff'g in part, rev'g in part T.C. Memo. 1964-190; Melvin v. Commissioner, 88 T.C. 63, 80-81 (1987), aff'd, 894 F.2d 1072 (9th Cir. 1990); Falsetti v. Commissioner, 85 T.C.332, 356 (1985).

3 Ireland v. United States, 621 F.2d 731 (5th Cir.1980); Palo Alto Town & Country Village, Inc. v. Commissioner, 565 F.2d 1388 (9th Cir.1977), remanding T.C. Memo. 1973-223; Commissioner v. Riss, 374 F.2d 161.

4 Bigio v. C.I.R., T.C. Memo, 1991-319.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Similar Articles
Relevancy Powered by MondaqAI
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions