By now the word has gotten out to most U.S. REALTORS® that there is a special trap for unwary foreign investors in U.S. real estate: the U.S. federal estate tax. If a foreign person is holding U.S. real estate – including a house or condominium – on the date of his death, the value of that property above $60,000 is subject to the U.S. estate tax at rates of up to 40%. This can come as a rather rude shock, on top of the death of a beloved parent, when the surviving spouse or children try to sell the house but the title company insists on a copy of the estate tax return and proof of payment of the estate tax.
Generally, the foreign investor has three choices for dealing with the estate tax:
- roll the dice – the investor can take the chance that he will not get hit by a bus before he sells the property;
- invest through a foreign corporation – the estate tax does not apply to stock (shares) of a foreign corporation owned by a foreign person, even if the only assets owned by the foreign corporation are U.S. assets; or
- invest through a specially-drafted trust – assets owned by a trust that is specially drafted to avoid the estate tax are not included in the “taxable estate” of a foreign decedent.
For foreign investors unwilling to “roll the dice,” using a foreign corporation is usually the more popular option, since it is relatively easy and inexpensive, very flexible – the ownership of the corporation can easily be changed – and perhaps most important, the investor can retain direct control and beneficial ownership of the U.S. property. However, it has one big drawback: any gain earned on the sale of the U.S. real property will be subject to ordinary corporate income tax rates of generally up to 34%, rather than the 15% or 20% long-term capital gain rate generally applicable to individuals who have held the property for at least a year (the 3.8% tack-on of the Affordable Care Act generally does not apply to foreign persons).
In contrast, a trust can also take advantage of the long-term capital gain rates, since trusts are generally taxed like individuals for income tax purposes. Thus, a trust can provide the benefit of avoiding the estate tax while not sacrificing the long-term capital gain rates for income tax purposes. Thus, a trust is an attractive alternative to a foreign corporation as a means for a foreign investor to hold U.S. real property without being subject to the estate tax on the property.
The disadvantages of a trust are mainly its greater complexity, less flexibility, and the loss of direct control and beneficial enjoyment of the property. That is, in order to avoid the estate tax, the trust must be irrevocable, and the rights of the foreign investor who is contributing property or money to the trust – called the “grantor” – must be substantially restricted. It is something of a Rubik’s Cube (copyrighted name, whatever), with different sides of the cube consisting of who is the grantor, who is the trustee (who controls the trust), and who are the beneficiaries.
Very generally, the grantor cannot have the right to withdraw funds from the trust at will or to direct who will receive distributions from the trust. The best scenario is if the grantor is not a beneficiary or the trustee, rather the beneficiaries are his spouse and children, and the trustee is an independent third person, such as a trust company. However, it is possible to back off from this “best scenario,” such that, for example, the grantor (the main client) is a beneficiary but is not the trustee, and the trustee has the power but not an obligation to make distributions to the grantor. Alternatively, the grantor can be the trustee but not a beneficiary. In any event, careful attention must be paid to the drafting of the trust so that it is not drawn back into the taxable estate of the grantor or any of the beneficiaries.
There are also income tax aspects of the trust which are too complex to discuss here, but generally any income from real estate, whether rent or gain from the sale of the property, is going to be subject to U.S. income tax, and generally the choice is whether the trust or the grantor is going to have to pay the tax. Of course, in many cases the real property will not be producing income unless and until it is sold.
In sum, a trust is an often overlooked alternative for avoiding the U.S. estate tax for foreign persons purchasing U.S. real estate. Although it has its disadvantages in terms of greater complexity and less flexibility, it offers the significant benefit of an income tax rate on gain that is approximately half of the rate that applies to foreign corporations.
Allan Tiller is an attorney in Houston, Texas specializing in international tax matters. This article is for general informational purposes only and is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed in this article. Mr. Tiller currently serves as an honorary HAR International Advisory Group member.