I. INTRODUCTION
This article provides information regarding commonly overlooked legal and tax pitfalls to non-U.S. investors (“Foreign” or Non-Resident Alien “NRA”) seeking to acquire California real estate.
II. FEDERAL, STATE, AND COUNTY TAXES
A. Federal Capital Gains Tax Upon Disposition
Under the Foreign Investment in Real Property Tax Act (“FIRPTA”), subject to some limited exceptions, upon total or partial disposition of the real property, the buyer is charged with withholding 10% of the proceeds.
B. Federal Income Tax
The United States taxes NRA’s only on rental income when the income is effectively connected with a U.S. trade or business. The default is a 30% withholding tax, unless a timely election is made to be taxed on a net basis at the same rate as a resident corporation.
C. California Capital Gains Tax
California’s withholding tax on capital gains upon disposition of real property is 3.5% of the net proceeds, or in the alternative 12.3% for an individual or pass through entity. This amount is in addition to any federal capital gains tax liability.
D. California Income Tax
The state of California separately subjects the foreign property owner to a withholding tax of 7% from any rental income.
E. Gift and Estate Tax (“Transfer and Death Tax”)
Each NRA has a lifetime unified gift and estate tax exemption of only $60,000 (subject to an annual exclusion of $14,000 per individual receiving a gift). The gift tax is imposed on any life time transfers, and the estate tax is imposed upon any distributions after death. For example, if a foreign property owner transfers all or part of his interest in California real property, including spouse or child, the transferor will be subject to a gift tax based on the net proceeds of any single or cumulative transfer in excess of the $60,000, presently at rate of approximately 40% in 2015.
F. California County Real Property Assessment Tax
Each County in California collects an annual real property ad valorem tax not to exceed 1% based of the value at time of the purchase with annual increases restricted to an inflation factor not to exceed 2% per year. As the rate of return of real property tends to grow faster than the 2% cap, over time the lower tax base becomes a valuable asset. Property owners need to be extra careful when transferring all or part of the real property interest. A non-exempt transfer will result in a total or partial increase in the annual assessment tax.
G. California County Real Property Transfer Tax
Each County in California in which real property is located separately charges a document transfer tax (fee) that is due upon change of ownership of any real property interest. Unless the transfer qualifies for an exemption, the maximum rate is 55 cents per $500 of assessed property value, less any liens and encumbrances.
III. TAX PLANNING OPPORTUNITIES FOR NON-RESIDENT ALIENS
A. Avoiding U.S. Probate Costs
Probate is the court supervised process of validating a decedent’s will and administering the decedent’s estate. Probate takes place in the County in which the real property resides. In California there are statutory probate costs based on a progressive schedule (4% on the first $100,000 gross value; 3% on the second $100,000; 2% on the next $800,000; 1% of the next $9 million). Probate applies if the decedent passed away with no estate plan and even when there is a will. Real property held either directly or indirectly in a trust or through a foreign legal entity avoids probate.
B. Limiting Tax Liability
i. Gift and Estate Tax
The primary means for a foreign property owner to avoid the U.S. gift and estate tax is by holding the real property either directly or indirectly through a foreign corporation. In the alternative, the property owner can encumber the equity of the real property with debt.
ii. Repatriation of Earnings as Business Income
Direct investment in real property through a foreign corporation is recommended where the purpose of real property is not intended to produce rental income. Investment through a U.S. subsidiary (e.g. LLC) will be generally preferable where the foreign investment is an active and ongoing real estate operation where distributions are made or considered to be made to the foreign owner. When classified as a foreign corporation, a branch profits tax, in the form of a 30% withholding tax, is imposed when repatriated outside the U.S. This “add-on” tax applies upon distribution to the foreign shareholder and is intended to prevent avoidance of the U.S. corporate double taxation. Tax treaties may reduce or eliminate this tax. Another possible solution includes the use of a “pass-through” legal entity.
iii. Indirect Ownership-Repatriation of Earnings as Debt Interest Payments
Generally, a payment of interest from a U.S. debt obligation to a foreign investor will be subject to a 30% withholding tax. Under IRC 871(h) a U.S. person (individual or legal entity) can qualify for tax exempt “portfolio interest” if the debt instrument is in registered form and the interest payments are made only to a foreign person. There are limitations. If a corporation is involved, the foreign recipient cannot be a more than 10% shareholder of the distributing U.S. legal entity. However, the 10% shareholder rule does not apply transactions between individuals. For example, if an NRA parent who has a U.S. tax paying daughter wants to invest in U.S. real property, rather than acquiring it outright, the father could loan money to the daughter who then purchases real property, secured by a non-recourse loan for the benefit of the father. The rental income of the property owned and managed by the daughter will then be repatriated in the form of tax free interest payments to the NRA father. The portfolio interest tax exemption can also be utilized to reduce or avoid capital gains upon sale by the NRA through a properly structured seller’s note equal to the amount of the otherwise applicable capital gain.
iv. IRC 1031 Exchange
Taxpayers exchanging property may not be required to recognize gain on certain transactions. Among these are like kind exchanges of real property. FIRPTA does not apply and no gain is recognized if the foreign real property owner can avail himself or herself under applicable treaty provisions to be treated as a U.S. corporation for purposes of like kind exchanges, deferring the FIRTPA withholding while still avoiding the estate tax.
v. California Assessment Tax
There are very few exceptions to avoiding a reassessment of the County assessment tax at present market rate upon total or partial disposition of real property interest. One example includes the parent-child exclusion. In addition, legal entities are subject to different reassessment rules, allowing for more flexibility of transfers to persons who are not lineal family members.
IV. DISCLOSURE REQUIREMENTS
The main reporting requirements are set forth in the following regulations: the International Investment and Trade in Services Survey Act of 1976 (IISA), the Agricultural Foreign Investment Disclosure Act of 1978 (AFIDA), the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA), and the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). The scope of disclosure will depend on the level of control and ownership interest in the real property acquisition as well as the character and type of real property.
V. OTHER CONSIDERATIONS
A. Risks of Lawsuits and Zoning Regulations
Foreign Investors must also be cognizant of California’s more litigious environment compared to many other countries. Among the most common types of lawsuits against property owners are tenant habitability claims, personal injury claims, civil rights claims, and environmental hazard claims. Given these risks, Title Insurance, Property Insurance, General Liability Insurance, and Property Management Services are indispensable.
Due diligence is also required to ensure that local zoning regulations will permit the investment real property to be used as intended.
B. Home Country Tax on Foreign Property Ownership
Before acquiring any interest in California real property, the foreign investor has to consider the tax obligation in the home country and any beneficial impact of a tax treaty. Real property is a unique class of investments, often viewed as passive in nature, and may not be considered part of tax advantaged international trade. If there is no U.S. Tax Treaty, extra consideration must be given to any potential double taxation and availability of foreign tax credits.
VI. CONCLUSION
If you are a Foreign Investor interested in acquiring California Real Property, there are significant and complex tax, legal, and business cost considerations. You do not want to be caught unaware and wind up paying more money than is necessary, with less remaining for your family members. For additional information on structuring a California Real Property Investment, please contact the Law Offices of Hanlen J. Chang.
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