Asian investors can minimize the tax hit on property purchases but good advice and a lot of paperwork is needed. If you live in Hong Kong and want to buy a home in Palo Alto for your daughter while she goes to Stanford University, you have a lot more to think about than finding a nice neighborhood.
That’s because buying U.S. property places you squarely in the U.S. tax system, adding big costs to your purchase. That’s hardly surprising news if you’re from the U.S., but it’s a shock to lots of non-U.S. residents.
“If you are coming from a low-tax or no-tax jurisdiction, that is not the opening question ...it comes up as an after-thought,” says Maury Golbert, chair of the real estate services group at Berdon, a New York accounting firm. “That’s a dangerous proposition for a number of reasons.”
Mainly, those reasons have to do with taxes. The most onerous for non-U.S. residents is the inheritance or estate tax, a levy that doesn’t exist now in China, for instance. The U.S. charges a 40% inheritance tax on the value of any asset owned by a non-U.S. resident over $60,000 at the time of the owner’s death. The exemption is $5.43 million for citizens and residents.
So, if you buy a $2 million home, the U.S. government will charge your heirs 40% of $1,940,000 (plus appreciation, if any) or $776,600. That’s hardly small change. There’s a good reason that Wealth-X, a firm that tracks the ultra-affluent across the globe, cautions that “efficiently managing any estate taxes is imperative to ensure the preservation of wealth for future generations.”
There are other potential taxes as well. Say you buy an apartment in Manhattan as an investment, and you rent it, you will have to pay tax on the rental income at U.S. ordinary income tax rates of up to a maximum of 39.6%. And if you sell this investment property after one year, the tax on your capital gains may be as high as 20%.
Some non-U.S. investors buy U.S. luxury property without even seeing what it looks like. These buyers don’t view it as an investment, but as a hedge against geo-political risk in their home country, says David Friedman, Wealth-X’s president. For them, the U.S. and its rule of law offer protection for their capital. But it is protection that many buyers don’t realize comes at a cost.
As you might expect, there are several strategies for minimizing potential tax hits. The problem is Asian investors – particularly those in the first generation to accumulate wealth – often wrongly think they can solve the problem on their own. A common strategy is to appoint a “nominee,” such as one of their children, to act in their place as the buyer, says Todd Beutler, foreign legal consultant at DLA Piper in Hong Kong. The strategy may be common throughout Asia for avoiding the intrusion of probate courts, or avoiding liability, but it doesn’t work in the U.S. (and often not in Asia either).
Instead, accountants and lawyers often recommend non-U.S. buyers buy property through some type of legal structure, like a foreign-owned limited liability corporation (LLC) or a trust. Both can buffer the tax hit.
Which structure you choose (we’ll detail these options further down) will depend on where you buy the property – there are U.S. state and local taxes to consider as well as federal taxes –, how long you hold it, and its value, among other things specific to your own situation.
One solution that doesn’t involve setting up a separate structure is to buy a U.S. term life insurance policy for the value of the taxes your heirs would be obligated to pay, taking into account the likely appreciation of the property. The policy payout should be designed to pay off the estate taxes, as well as any income taxes or other expenses of the estate, says Kristin Bulat, a vice president at NFP, a U.S. benefits, insurance and wealth management firm.
Bulat says at least half of foreign investors who come to the U.S. to buy property aren’t aware of the potential tax issues. “We’ve been talking about it a lot,” she says. “As we see the market growing, there’s a lot more discussion about it and people are moving in that direction.”
One caution: you have to have some kind of tie to the U.S. to buy life insurance, Bulat says, so a policy can only be secured after the real estate is bought or if you have some other U.S. connection.
Beutler at DLA Piper agrees life insurance is a good option, but he recommends it only for smaller purchases, or moreover, if you only plan to own property for a short time. “We don’t want to drive people to complicated structures if they don’t need them,” he says.
For a long-term property investment, one option is to create a foreign company – i.e. via the British Virgin Islands – that in turn forms a U.S. LLC to buy the real estate. Since a foreign company ultimately owns the property, the U.S. government can’t assess an inheritance tax.
While there are have been media reports of corrupt officials hiding money and their identity by using foreign shell corporations to buy U.S. property, the structure is a legal means for non-U.S. buyers who want to cut their tax bills, experts say. Two requests to the U.S. IRS to confirm this were answered, however, only with links to IRS forms on the estate tax rules and income tax rules for non-residents.
Buying property through a foreign corporation doesn’t absolve you from paying U.S. taxes. Corporations have to pay a capital gains tax of 35% on the increase in their property’s value when it is sold, while an individual would only pay a capital gains tax of 20%, according to Beutler. The upside for a corporation is the after-tax gains on the property sale can be distributed tax-free to the foreign parent company as the U.S. LLC is liquidated.
A more flexible option may be to create a family trust structure and to use the trust to form a U.S. LLC to buy the property. The U.S. government doesn’t levy estate taxes on trusts, and, if your heirs sell the property, they will be treated as individuals and taxed on only 20% on the property’s capital gains.
Another plus of a trust owning your property is that it allows your beneficiaries to live in the property rent-free. That’s a benefit that’s not available to corporate owners of real estate. A trust also can be used to make other investments, giving a family more flexibility in managing their assets, Beutler says.
The upfront cost of setting up a trust can be higher than the dual-company approach – from $4,000 to $15,000 or more for a trust, and about $7,500 or more to set up a U.S. corporation (considering related tax matters and legal advice too), but the annual fees for doing each is about the same and often can be very little.
Private banks can integrate some of this offshore planning with their U.S. investment planning for their clients, Beutler notes.
The long arm of U.S. tax law is more like an eight-arm octopus as surprising fees appear to dart out of nowhere. Among these are the gift tax, levied, say, if your dad buys you an apartment and puts it in your name, and FIRPTA, the Foreign Investment in Real Property Tax Act, which requires someone who buys property from a non-U.S. resident to withhold 10% of the sale price for taxes.
And there’s more. The point is to seek assistance and find out what the potential taxes and other costs may be. But as Berdon’s Golbert says, there’s no magic formula, no right way or no wrong way. You just have to analyze the various options and figure out what works best for you. One strategy that is guaranteed to fail is doing nothing, figuring the U.S. government won’t notice.
As Golbert puts it, “The cost of compliance is much cheaper than the cost of non-compliance.”