Many foreign individuals and US people (citizens, green card holders and US tax residents) invest in the US real estate market as a way to diversify their assets holdings and as a potential long-term investment. For example, an individual who has ceased living in the US may find themselves to be a landlord, having leased their former US home. Alternatively, a non-US person may invest in US real estate, with an intent to either rent out the property or use it as a holiday home. However, without relevant planning, the tax implications of owning US real estate for both US and foreign investors can become a costly and time-consuming exercise. Furthermore, for individuals that are required to pay taxes in more than one jurisdiction, careful consideration is needed to ensure double tax treaties and foreign tax credits and aligned in a timely manner. Below, we discuss the main items to consider when investing in US real estate.
US rental income
If an individual is renting out US property, they will have an annual Federal filing obligation. State taxes may be relevant depending on the location of the property. The calculation of net profits can be different according to different local tax rules. This can often complicate the tax reporting requirements of a ‘simple’ investment.
Furthermore, individuals required to pay taxes in two jurisdictions (e.g., the US and UK) are often surprised to learn of the different methods used to calculate taxable rental income. For example, allowable expenses such as depreciation and mortgage interest are factored in when calculating net profits for US tax purposes, which can often come as a surprise to non-US individuals.
Additionally, effectively utilising prior year rental losses (commonly as passive activity losses) and considering the different tax year ends is required to ensure your effective worldwide tax rate relating to rental profits is not overstated.
Foreign Investment in Real Property Tax Act (FIRPTA)
For individuals who have no US connection, a key piece of legislation from a US Federal tax perspective is the Foreign Investment in Real Property Tax Act (FIRPTA). This says that the individual or entity who pays rent to a non-US person must withhold 30% Federal tax and pay this over to the IRS (Internal Revenue Service). The landlord would report this tax withholding on their federal non-resident tax return.
There are two ways in which non-US taxpayers can report their rental income to the IRS. The default position is that gross rental income is reported and a flat tax rate of 30% is owed to the IRS. It is possible however, for a taxpayer to make an election on their non-resident US tax return for the rental activity to be considered ‘effectively connected’ to a US trade or business. By doing so, they can benefit from deductions for rental expenses, such as property taxes and depreciation. The net income is also taxed at the graduated Federal tax bands, whereby they are likely to achieve a lower average US tax rate. In most circumstances it will be beneficial for this election – known as an 871(d) election - to be made, however the taxpayer should consult a tax advisor to check their eligibility for the election and whether this is likely to be beneficial for them overall.
Capital Gains Tax
Upon sale of US property, individuals may be subject to US Capital Gains Tax if a net gain is realised. Various expenses such as realtor fees, legal fees and the cost of capital improvements can be claimed to reduce the taxable gain. If the property has been held over one year, then a Federal tax rate of 20% will apply. Depreciation expenses previously claimed, are recaptured at a 25% tax rate.
As the US has the primary taxing rights to any capital gain generated from the sale of US real estate, UK resident individual's selling US property can often use the US/UK double tax treaty to claim a credit for any US taxes paid on the capital gain.
Sale of main home (principal residence)
Although the US and UK tax authorities provide relief to individuals who sell their main home, the qualifying factors for Capital Gains Tax exclusion in the US and UK are different. For example, UK individuals used to the idea of not paying any Capital Gains Tax when they sell their qualifying main home, may be surprised to learn they can only exclude up to $250,000 ($500,000 if filing jointly) of capital gains for US tax purposes. Therefore, advice needs to be taken to ensure there are no unexpected tax charges.
Sale of US real estate by non-resident individuals
There are added complications for non-US individuals who sell US real estate. FIRPTA (mentioned above) also applies on a sale of US real estate. A withholding agent (which is usually the new buyer) must withhold 15% of purchase price from any non-US individual who sells their US property Often this will mean that Federal tax is overpaid and if the requisite forms are not filed – as discussed below – there may be a substantial delay to receive a refund of this tax from the IRS via the non-resident tax return.
To potentially reduce FIRPTA tax withholding on sale, Forms 8288-A and 8288-B (Application for Withholding Certificate for Disposition by Foreign Persons of US Real Property Interests) should be completed by the withholding agent and taxpayer respectively. These must be filed with the IRS within 20 days of transfer of the property. A Federal tax return will still need to be filed for the year of the sale.
US Gift and Estate Taxes
It is worth noting that while US persons have a remarkably high lifetime gift and estate tax exemption, the same cannot be said for non-US persons; and if a non-US person dies holding US real property, or any other assets caught by the gift and estate tax rules, only $60,000 of the value will be exempt from 40% US estate tax. Therefore, depending on any other relevant tax jurisdictions, a protective trust or corporate structure may be of interest.
US Limited Liability Companies
Finally, it is common for individuals to hold US real estate via a US Limited Liability Company (LLC) rather than holding directly. Although this ownership structure can provide limited liability protection and may be more favourable than purchasing insurance coverage, it can often lead to double/unfavourable tax consequences if the owner of the US LLC lives in another tax jurisdiction, such as the UK, who considers the LLC a corporation. Given the differing tax treatment of LLCs in the UK and US, it is highly advisable that an individual seeks specialist tax advice prior to acquiring an interest in an LLC to avoid any potential pitfalls that may arise.
As you can see, there are several topics to consider when investing in US real estate, which can quickly lead to complications without the relevant advice. Speaking to your US/UK tax advisor not only alleviates the risk of double taxation, but it may also mean you can effectively plan for your next investment without having to wait for a tax refund to be processed by the various tax authorities.
