Three Tax Pitfalls for Foreign Owners of U.S. Real Property
Many nonresident aliens invest in U.S. real estate which can be complicated from a tax perspective. These complications include potential U.S. estate tax exposure as well as income and information reporting obligations, which are more fully described below.
The Estate Tax
A quick search may lead you to believe that the U.S. estate tax does not apply to real estate held by a nonresident alien as long as real estate does not exceed $12,060,000 in value, which is the 2022 U.S. estate tax exemption amount. However, that generous exemption is only available to resident aliens or U.S. citizens. A nonresident alien decedent is only entitled to a $60,000 exemption, with any amount in excess of that exemption subject to estate tax at rates ranging from 26% to 40% for estates exceeding $1 million in value. In South Florida, a hub for foreign investment, the average fair market value of a single-family home can easily exceed $1 million leading to a large tax bill that must be paid nine months after death. If the estate does not have the liquidity to pay the tax, this can present a difficult situation. During this time there can be an accrual of failure to pay penalties if the estate is not yet settled and is unable to free up any cash or sell the home to timely pay the tax to the IRS.
With proper planning, the estate tax and liquidity issue can be remedied.
Filing Requirements and Payment of Tax
Even if a U.S. property produces no income or has no activity, if it is held by a business entity, the business entity or trust may be required to file annual federal and sometime state tax returns. If a foreign individual is the lessor of a U.S. property or the recipient of rental income therefrom, and is not exempted by treaty, the foreign person must file a Form 1040-NR, U.S. Nonresident Income Tax Return for this income. Failure to file penalties, failure to pay penalties, estimated tax penalties, accuracy-related penalties, and interest thereupon, are all possible if there are any filing errors.
Federal income tax is not the only possible type of tax. States may impose their own income tax or franchise taxes for the privilege of doing business (owning a property) in the state, tangible tax return filing requirements, and some cities have their own income tax and filing requirements. Many states and cities levy a sales tax on rent from commercial properties or short-term rental properties and impose additional taxes on short-term rental properties such as tourist, occupancy, transient or other lodging tax; excise tax; or gross receipts tax. These taxes sometimes require monthly or quarterly tax filings even if the tax or current period income is zero. States and cities assess their own penalties, similar to the federal penalties mentioned above.
Depending on the structure chosen and residency status of the various entities and individual partners, shareholders, or beneficiaries, there are several international information reporting forms that may need to be filed with the IRS or the Financial Crimes Enforcement Network (FinCEN). Penalties for not filing, filing late, or improperly filing these forms are significant, ranging from $10,000-$25,000 initial penalties per form per year, $50,000 continuation penalties, or sometimes a percentage of the balance of an account or transfer amount. Common international information reporting forms required are FinCEN 114 (FBAR); Form 8938 reporting foreign bank accounts or assets of U.S. persons (a U.S. entity is a U.S. person); and Form 5472 reporting foreign ownership of a U.S. corporation or reporting a foreign corporation doing business in the U.S.
Rental income paid to a foreign person is subject to source withholding and the filing of an information return by the withholding agent. Often the entity intermediary is responsible for this task and failure to do so can make the withholding agent liable for not only the tax of the foreign person but also subject the withholding agent to penalties for failure to file, pay and deposit.
Once penalties are assessed and begin accruing, the IRS and State Department of Revenue can put a lien on the property, levy rental income, or even seize and sell the property at auction. Nonresident aliens with a federal tax lien may have their information shared with the Department of Homeland Security.
Tax on Worldwide Income
Owners of U.S. property may be tempted to visit the U.S. often. However, staying in the U.S. more than 183 days in a three-year period may make you a U.S. resident for tax purposes, subjecting you to tax on your worldwide income and often requiring additional information filings for foreign businesses, assets, bank accounts, etc., even if they are unrelated to the U.S. real property. Due to the way the days are calculated under the substantial presence test,1 if you are careful to stay below 120 days of presence each calendar year, you may not subject yourself to U.S. tax through this test. This is because when calculating whether 183 days of presence has elapsed in a three-year period for purposes of the substantial presence test only 1/3 of the days of the tax year immediately preceding the current tax return year are counted, and only 1/6 of the days of the year prior to the immediately preceding year are counted when added to the days in the current tax return year.
However, there are ways to not be considered a U.S. resident for tax purposes even if you exceed 183 days of physical presence in a three-year period. The substantial presence test has a specific formula of counting days of presence in the U.S., with certain days excluded for medical, transit, certain commutes, or other purposes. There are also other options for some foreign persons whose countries of citizenship have a treaty with the U.S. with a treaty tie-breaker provision. Alternatively, if one has a closer connection to a foreign country than the U.S. and has not taken steps to become a U.S. person (“closer-connection” test), in certain cases that person may be able to claim there is no U.S. residency for tax purposes.