Overview

In spite of our many problems as a nation, the quality of life and level of economic opportunity as well as the overall respect for the rule of law, places the United States in a very unique position when compared to the rest of the World. The proof – how many people have come to the U.S. legally and illegally for the last 150 years versus the rest of the world. Central and South Americans are moving to Miami and not Mecca or Ulan Bator!

The reality of the situation is that economic and political stability in Latin America is always short lived and uncertain. Most Latin Americans discovered this truth a long time ago. In most parts of the World, everything is dependent upon your family name and connections or social class. In many large metropolitan areas of the U.S., these distinctions are far less important. Generally speaking, if you work hard, you can still get ahead in this life even if you are not distantly related to El Rey Juan Carlos. How many “rags to riches” stories are there in the U.S. versus Russian or Iran? 

In many cases, foreigners purchase a residence as an investment and a safe haven from their own countries. In many cases, foreigners will send their children to college in the U.S. who may remain in the U.S. after graduation. For many wealthy foreigners, life is much simpler in the U.S. or at least safer and the wealthy foreigner does not walk with a target on his back living while looking over his shoulder for security reasons. As mortgage financing is less available in most countries when compared to the U.S., many foreigners purchase the residence outright. As a result and by definition, these foreigners have substantial assets in the U.S. for tax purposes.

Nevertheless, the tax and financial landscape has become more complicated. For starters, El Tio Samuel (aka Uncle Sam), takes tax collection a lot more seriously than other places. Over the years, many foreigners have purchased a residence and other real estate in the U.S and continue to do so on an ongoing basis. This article is focused on the tax structuring considerations for the purchase of a residence in the U.S. I am not entirely convinced that foreign residents should be resting so comfortably in their homes as a result of the existing poor structuring that is currently in place.  

The 2012 tax court case of G.D. Parker, Inc. v. C.I.R. T.C. Memo 2012-327 (2012) is a perfect example of what can go wrong. Genaro Delgado Parker was a very wealthy Peruvian who owned a “palacio” (palace) in Key Biscayne. He was a taxpayer who could afford the best tax and accounting counsel that Miami has to offer.  The IRS and Tax Court “body slammed” the taxpayer for the structure commonly used by the best advised foreign taxpayers purchasing a residence in the U.S. We will discuss the case below in greater detail.

The last thing that the foreigner taxpayer wants to do is end up on the flip side of the equation of the cliché – “Su casa es Mi Casa” (Your house is my house) as a result of poor tax planning.  The unexpected estate tax or income taxes could result in Uncle Sam ending up with the foreigner’s house as a result of tax liens. In that respect, it might not looks any different than the country that they left.

Tax Planning Considerations in the Purchase of a U.S. Residence.

A. Federal Estate Tax Treatment

The federal estate tax is imposed on the estate of every non-domiciliary decedent  under IRC Sec 2101 based upon the value of gross estate situated in the United States at the time of death.  The exemption threshold is very low - $60,000. Property is not ordinarily included in estate for estate tax purposes unless the decedent owns the requisite property at death. Real property physically located in the U.S. and owned outright has a U.S. situs as does U.S. stock owned by a non-resident at the time of death. Stock in a foreign corporation is defined as foreign situs property

Property that is considered U.S. situs property for estate tax purposes may be purchased directly by a foreign corporation as its parent or ultimate beneficial owner and be treated as having a foreign situs for U.S. federal estate tax purposes. The entity must be classified as a corporation and corporate formalities must be observed and the corporation should be the real owner of the property in substance.

The writing was already on the wall for non-resident aliens purchasing a homestead in the U.S.  Some older case law already existed which examined the business purpose of the corporation owning the U.S. real estate. If the corporation, is disregarded, the shareholder could be treated as the direct owner of the property resulting in an unexpected estate tax. Specifically raw land or a residence used by the shareholder poses some concern.

In Bigio v. C.I.R., a non-resident owned a condominium and other Miami properties on Miami Beach through a Panamanian corporation as a residence. Absent a lease or loan arrangement, the Tax Court determined that the non-resident was the beneficial owner of the condominiums.[1]

Bigio was principally an income tax case focused on the issue of U.S. residency based upon the taxpayer’s substantial presence in Miami during the tax years of question. The Tax Court looked through the ownership by a Panamanian corporation and ruled that Bigio was the beneficial owner, i.e. treated as if he owned the property personally. The structuring in Bigio did not use a separate U.S. entity to own the real estate coupled with the ownership of the U.S. entity by a foreign corporation. The federal estate tax laws for non-residents treat shares in a foreign corporation as non-U.S. situs property.

In G.D. Parker, a wealthy South American taxpayer set up his arrangement the same way that every wealthy South American that owns a home in South Florida arranges the purchase of a residence.[2] The U.S. residence was owned within a U.S. corporation that in turn was wholly owned by a foreign corporation. The family lived in the residence rent-free for an indefinite period of time. The Tax Court ruled that corporation would not be entitled to deduct expenses in running the home or any depreciation deductions.

The Tax Court further ruled that the use of the property without rent constituted a deemed dividend to the foreign parent corporation. The amount of the deemed distribution is fair rental value of the personal use. The dividend distributions to the foreign corporation are subject to the 30 percent withholding tax under IRC Sec 871(a). Note that Venezuela is the only South American country with a tax treaty with the U.S.

Many existing transactions for non-resident aliens owning homes have used a LLC treated as a disregarded entity to own the U.S. real estate. This structuring poses a potential estate tax risk with respect to a LLC that is treated as a pass-through entity, i.e. treated as a sole proprietorship or partnership. The IRS generally will not ordinarily rule in advance whether or not a partnership (LLC) interest is intangible property under when owned by a LLC that is treated as a partnership or sole proprietorship in the case of a single member LLC.  As a result, a LLC that is treated as a disregarded entity, partnership or sole proprietorship, may be considered a U.S. situs asset for federal estate tax purposes.

In that respect, making an election to be treated as a regular corporation is essential for estate tax planning purposes otherwise a single member LLC will be treated as a disregarded entity potentially subjecting the residence owned by the non-resident alien to federal estate taxes. Under the aggregate theory of partnerships (LLC), the owner of a partnership interest may be treated as owning a proportionate interest of the underlying property of the partnership (LLC).

B. How Ugly Can it Get?

The revelation that the ownership of the U.S. homestead is improperly structured is likely to result during an audit and will be a big surprise. The initial estate tax bracket under the progressive rate structure is 26 percent. Absent an arms-length lease between the corporation and the non-resident alien, a deemed dividend will be assessed based upon a fair market rental of the property.

The U.S. corporation is the withholding agent and is personally liable for the withholding on the dividend deemed payable to the foreign corporation that owns the shares of the U.S. corporation. Based upon the personal use of the residence, no deductions (absent business use) the corporation will be unable to deduct any expenses or depreciation. The withholding tax rate on the deemed dividend is 30 percent absent a lower rate under a tax, treaty.

Example

Juan Valdez, a resident and citizen of Colombia, purchased a three bedroom condo on Brickell Key in Miami for $750,000 in January 2010.  Based on rentals within the same condominium, a fair market rental is $4,500 per month or $54,000. The condo is owned within a Florida corporation. The shares of the Florida LLC that is treated as a corporation.  The LLC is wholly owned by a Cayman corporation which is owned by Juan.

Juan’s children have lived in the property on a full time basis since the purchase while they attend the University of Miami. Juan and his wife have lived in the property when they are in the U.S. which is approximately half of the year.

The IRS audits Juan’s returns for the following tax years – 2010-2013. They determine that he should have declared income based upon the value of the deemed dividend of $54,000 each year. The withholding liability amount is $16,200 per year in 2010-2013, four years. An estimate of the taxes, interest and penalties for the four years is $60,080.

C. Federal Tax and Compliance Requirements of Electing to be Taxed as a Corporation

LLCs are entities created by state statute. A single member LLC is treated as a disregarded entity for tax purposes absent an election to be treated as a corporation through the filing of Form 8832. A domestic LLC with two members is treated as a partnership for tax purposes unless it files Form 8832 and elects to be treated as a corporation. A single member LLC is treated as a sole proprietorship absent an election to be treated as a corporation.

An election must be filed within 75 days of the formation of the company. Alternatively, the IRS allows Form 8832 to be filed within the first 75 days of the fiscal year which is the calendar tax year for our foreign buyer. Rev. Proc. 2009-41 permits business entities to file a classification election with an effective date retroactive up to 3 years and 75 days prior to the date that the request is filed.

Normally an entity may not change its corporate status within a 60-month period unless there is a change of ownership of more than fifty percent. The 60-month rule does not apply to a LLC that was a newly formed entity that made its initial election upon formation. Most entities formed by non-resident aliens should be able to fall under this rule in regard to make an election for the LLC to be treated as a corporation for federal tax purposes.

As previously stated in the discussion of federal estate taxes, the corporate election is critical to avoid U.S. federal estate taxation. The LLC will require a tax identification number and file a Form 1120 each year.

Summary

The amount of real estate purchased within the U.S. for either for personal or rental purposes is very significant and shows no signs of slowing down. The amount of home purchases in the Border States – Florida, California, Texas and Arizona – by foreign buyers is significant. This trend is not likely to slow down any time soon. First, foreign buyers like hard assets. The recession in home prices in general presents a buying opportunity. The absence of political and economic uncertainty still presents the U.S. as the favorite safe haven. Many foreigners have purchased a residence in addition to commercial real estate.

The common thinking about how to restructure about the purchase of a home in the U.S. needs to be reviewed and reconsidered. There are some land mines based upon the result in GD Parker. My legal instinct suggests that a large majority of foreign owners are not in compliance based upon the result in GD Parker. As a result, the tax structuring of each and every foreign buyer should be reviewed to avoid any unpleasant surprises.