Tag: Hanlen Chang

Naming a Foreign Relative as Trustee for a U.S. Trust

Introduction

In Metropolitan areas, such as the San Francisco Bay Area, it is common to have an estate planning client inquire about naming a foreign relative as Trustee or Co-Trustee.

Naming a Non-Resident Alien (“NRA”) relative as Trustee can cause the U.S. Trust to be re-characterized, for U.S. tax purposes, as a foreign trust due to the NRA’s exercise of substantial control of the Trustee powers.

If the goal is to maintain the Trust as a U.S. domiciled trust the requirements of Treas. Reg. Section 301.7701-7 of “court test” and “control test” must be satisfied.

Court Test

For this test to be satisfied a court within the United States must be able to exercise primary supervision over the administration of the Trust. There is a safe harbor if the following three requirements are met:

  • The trust instrument does not direct that the trust be administered outside the United States;
  • The trust in fact is administered exclusively in the United States;
  • The trust is not subject to an automatic migration provision described in Treas. Reg. Section 301.7701-7(c)(4)(ii).

Control Test

This test requires that one or more U.S. persons have the authority to control all substantial decisions of the trust. Treas. Reg. Section 301.7701-7(d)(1)(ii).

“Control” means “the power, by vote or otherwise, to make all of the substantial decisions of the trust, with no other person having the power to veto any of the substantial decisions.”

Tax Impact of Foreign Trust Status

Depending on the circumstances, capital gain realization may be imposed on the transfer of property to the “now foreign trust”, i.e. forced sale treatment.

One Year Period to Cure Unintended Loss of U.S. Trust Status

If a U.S. Trust becomes a Foreign Trust due to the nomination of a NRA Trustee, the Trust has 12 months from the date of cessation of U.S. Trust status to reassert U.S. status by satisfying the aforementioned requirements of the “court test” and “control test”.

Conclusion

While it is not impossible to have a NRA relative act as Co-Trustee, the NRA relative should never be nominated as sole acting Trustee.

Even if a NRA relative is nominated as Co-Trustee, the Trust terms must make clear that any tie breaking decision is made by the U.S. Co-Trustee.

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Currency Manipulation and the Minimum Wage

Recently there has been a lot of political discourse about currency manipulation and its effects on international trade.

We often hear or read that a devalued currency is an advantage while being a disadvantage to countries.

Virtually never are we provided information on the “how or why” an advantage is conferred by devaluing a currency.

The biggest impact of currency manipulation is to confer a competitive advantage in terms of labor input. It does not provide an advantage for raw material input costs (e.g. commodities) as those prices as set on a global basis. By lowering one’s currency one pays a higher price for these input costs, offsetting any advantage. However, labor costs are still a significant factor that goes into processing and making a product.

Often times a currency manipulator will also want to “peg” its currency to the U.S. dollar, meaning the exchange rate is fixed. If the peg is artificially low and below fair market fundamentals, it will incentivize U.S. multi-national corporations to outsource to the pegging country because companies like predictability and do not want fluctuations in the exchange rate affecting day-to-day profitability.

This is why any discussion about raising the minimum wage must be contemplated within the context of international trade and currency exchange rates. While it is a morally just to demand a higher minimum wage, it matters little when one does not have a job in the first place. Ask any small business owner if he or she would appreciate “free help”. This is a no brainer. Anyone who says labor cost is not a factor is divorced from reality and clueless about basic economic principles.

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Pre-Immigration Tax Planning to the United States

Purpose of Pre-Immigration Planning

Because a U.S. citizen or resident alien is taxed on his or her worldwide assets and income, a prospective immigrant from a lower territorial tax country needs to seriously consider pre-immigration tax planning.

U.S.  Residence for Income Tax Purposes

An individual is considered a Non-Resident Alien, and is thus not considered a resident for U.S. tax purposes, if the weighted number of days spent in the U.S. within the last 3 years combined is less than 183 days, or the individual spent less than 31 days in the U.S. in the most current year.

U.S. Domicile for Transfer Tax Purposes

For transfer tax purposes, an individual is a U.S. resident if he or she intends to remain in the U.S. indefinitely as determined by the totality of circumstances.

Taxation of Non-Resident Alien

If one is neither a resident for U.S. income tax or transfer tax purposes, one is considered a Non Resident Alien (“NRA”) and is subject to taxation on income effectively connected with a U.S. trade or business or from passive U.S.  sourced investments such stocks, bonds, and rental income.

Mitigating the Impact of U.S. Taxation

For those seeking to mitigate or avoid higher U.S. taxes or in some circumstances double taxation from two jurisdictions, there are various strategies. The most commonly utilized strategy is pre-immigration gifting of assets, including partial disposition with retention of income stream through an Non-U.S. irrevocable trust or legal entity. Other options include capitalizing on the home country’s lower capital gains tax rate by selling assets with substantial appreciation.

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California Real Property County Taxes – Proposition 13 and 19

Under California Proposition 13, 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.

Proposition 13 disincentivizes sales in instances where the assessment value is lower than the market value. This is because selling and purchasing a comparable real property at the same price point would result in a significantly higher annual assessment.

For residential real property owners, there is a parent to child reassessment exemption credit of 1 million dollars (at the time of transfer – difference of Fair Market Value minus present annual property tax assessment.) This credit is for one residential property only. No second property or rental property qualifies.

In order to keep this Proposition 19 parent to child credit, one must live at the subject residential property for at least one year post transfer.  The county may physically verify that you are actually living there.

Also under Proposition 19, those age 55 or older can transport the preexisting proposition 13 rate to a new property in another county.

For real property held and owned by a legal entity (e.g. LLC), a change of majority control or ownership results in a reassessment. This has encouraged fractionalized ownership where no one person owes more than 50%.

Assuming real property values exceed 2% growth over time, Proposition 13 has an elevated impact for long-term investors who need to be extra cautious when structuring ownership and title upon acquisition, and prior to lifetime dispositions and death. Failure to do so can result in otherwise avoidable partial or total reassessment.

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A Guide for Foreign Investors Looking to Acquire California Real Estate

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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