Foreign investment in the United States (“U.S.”) is generally considered advantageous due to the stability of its economic system and a tax structure that, although complex, facilitates foreign investment. The U.S. has a legal system where every state within its territory coexists with the federal system of government. Accordingly, when investing in the U.S., there are key factors (e.g., geographic location; type of investment; local, state, and federal tax issues; corporate and estate taxes) that must be taken into consideration, which will be discussed in this and forthcoming articles.
This is the first of four articles that will provide a general overview of different investment structures, specifically on real estate (“R.E.”) investments in the U.S. and their tax implications. It will analyze such investment structures in the following four scenarios:
1. Personal Investment (Federal taxation);
2. Personal Investment (State and Estate taxation);
3. Investment through a domestic company;
4. Investment through a foreign entity and “Tandem Structures.”
Generally, and not considering R.E. Property Taxes and local taxation where applicable, there are four basic types of taxes imposed on the holding and disposition of a R.E. investment in the U.S.:
- Income Tax;
- Withholding T ax on Fixed, Determinable, Annual, or Periodic income;
- Capital Gain Tax;
- Estate Tax.
Application of Income Tax depends on whether a non-U.S. citizen will be considered a tax resident alien or non-resident alien. A non-citizen is considered a U.S. resident alien, for tax purposes, if lawfully admitted as a legal permanent resident (green card holder), or if the non-citizen meets the substantial presence test as required by the Internal Revenue Code of 1986 (“I.R.C.”), and its amendments.
The substantial presence test requires an individual to be present in the U.S. for at least 31 days during a calendar year, and 183 cumulative days during a 3-year period (including the current year and the two preceding years). The 183-day requirement is determined according to the following formula: an individual is treated as present in the U.S. if physically present in the country all days in the current year; 1/3 of the days present in the preceding year; and 1/6 of the days present in the second preceding year. The following example illustrates the application of the Substantial Presence Test:
In the example described in Chart 1, the non-U.S. citizen will be considered a tax resident alien because the individual cumulated more than 183 days all together in the 3-year period.
Resident aliens are generally subject to income taxation on their worldwide income in the same way as U.S. citizens. Nonetheless, resident aliens may claim a foreign tax credit in order to avoid double taxation.
In turn, non-resident aliens’ income, subject to U.S. income tax, is divided into two categories depending on whether or not the income is effectively connected with a trade or business in the U.S. In the first category, if engaged or considered to be engaged in a trade or business in the U.S. during a fiscal year, the non-resident alien (“NRA”) will be treated as a taxpayer subject to the same rates that apply to U.S. citizens and residents.
The chart below illustrates the tax rates applicable to joint tax returns for married couples.
$17,850 or less
$17,851 – $72,500
$72,501 – $146,400
$146,401 – $223,050
$223,051 – $398,350
$398,351 – $450,000
$450,001 and above
In this case, the net income (gross income minus allowable deductions) is determined and a Form 1040NR, U.S. Nonresident Alien Income Tax Return, is required to be filed. NRAs must apply and obtain an Individual Taxpayer Identification Number (“ITIN”) with the Internal Revenue Service (“IRS”). The application must include a copy of the NRA’s passport certified by the issuing agency.
In the second category, NRAs’ income that is not effectively connected with a trade or business in the U.S., will be subject to a flat tax of 30% or a lower treaty rate (if applicable) of the gross amount of U.S. source fixed or determinable, annual or periodical income (“FDAPI”). Deductions are not allowed and the NRA does not have to file a tax return.
It may be worth nothing that this 30% tax rule may apply to real property rental income when a NRA taxpayer chooses not to treat that income as effectively connected with a trade or business. In such case, the tenant is responsible to withhold the tax from the rental income and remit it to the IRS. If the NRA chooses to treat the real property rental income as effectively connected to a trade or business in the U.S. during the fiscal year then, the IRC allows deductions to be claimed against the gross income (e.g., condominium expenses, property tax, utilities, repair costs, furniture depreciation, amortization of property) and the NRA would be taxed at the graduated rates that apply to U.S. citizens and resident aliens.
A NRA is subject to long-term capital gains tax rates in the same way as a U.S. citizen, as the chart below illustrates (this rate is lower than that of Chart 2).
CAPITAL GAIN INCOME
$72,500 or less
$72,501 – $450,000
$450,001 and above
Capital gain profit generated from the sale of real estate (or any other assets held for investment purposes) is calculated on the difference between the purchase price, purchase expenses, selling price, selling expenses, and improvement and remodeling costs.
Be aware that any capital gain or rent may also be subject to state tax. This issue will be discussed in Part II of these series of articles.
Cav. Piero Salussolia,Esq.;
Lizet Cardozo, Abg. (admitted in Colombia only);
Monica Tirado, Abg. (admitted in Colombia only).
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