In the midst of an unprecedented commercial real estate boom, some
investors, particularly those from outside the United States, believe assets
currently on the market reflect bargain-basement prices. As these opportunities
spring up throughout the country, international investors are eyeing these
properties and purchasing at a record pace. To better serve this rapidly
growing market, U.S.
commercial real estate professionals should become familiar with the tax
benefits available to inbound international real estate investors.
The U.S. taxes
corporations that own U.S.
real estate differently depending upon whether the real estate's owner is an
international or domestic corporation. There also are tax similarities and
differences between individual international investors and U.S. investors.
Non-corporate U.S. and
international investors who are not considered real estate dealers or
developers both generally pay capital gains tax on profit from the sale of U.S. investment
real estate. These taxes can be as low as 15 percent on long-term capital
gains. Domestic and international corporations also pay tax on the sale of capital
assets, as much as 35 percent federal income tax, along with state corporate
income taxes that range between 5 percent and 10 percent.
The major negative difference in taxes applies only to international
corporations that may earn profits in U.S. real estate. Unlike domestic
corporations, these international corporations may be required to pay 30
percent branch profits tax on undistributed and reinvested U.S. profits in
addition to federal and state taxes.
The remaining differences favor international investors in both the
interest of tax fairness and to promote inbound investment in the U.S. These
tax-free interest income
generated from U.S. real estate-related cash flow through the use of portfolio
interest loans, which are loans from an international investor to U.S.
individuals, corporations, partnerships, or trusts, so long as the
international investor creditor does not directly or indirectly own 10 percent
or more of the U.S. debtor;
stock in an
international corporation that owns U.S. real estate is not taxable on the sale
of shares in that corporation; and
that form a corporation to own U.S. real estate can avoid a second tax on
distributions of corporate profits by liquidating the corporation after it has
paid U.S. corporate taxes prior to distributing dividends.
Planning Is Important
These tax differences can result in lower taxes for international
investors if careful plans are made or significantly higher taxes if mistakes
are made. The following example illustrates effective tax planning that makes
use of a portfolio interest loan.
Assume a nonresident alien individual, or a citizen of a foreign country
that is considered a nonresident for U.S. income tax purposes, establishes an
international corporation (international investor) that organizes a
Florida-based corporation (domestic corporation) that owns real estate in
Florida that was purchased 20 years ago for $1 million. The investment's
current value is $11 million.
If the international investor sells the real estate, a $10 million gain
will result in total corporate taxes of 38 percent, or $3.8 million. This would
leave a net distribution of $7.2 million to the international investor after
sale and liquidation of the Florida
company. No additional shareholder-level tax is due upon liquidation.
Now assume that instead of selling the real estate the international
investor sells a U.S.
investor 3 percent of the shares of the domestic corporation for a price of
approximately $200,000, or 3 percent of $7.2 million. Instead of selling the
real estate to a third party and liquidating the corporation, the corporation
enters into a 1031 exchange to acquire $11 million of replacement real estate
in the form of a triple-net-lease building with an annual return of
approximately 6.5 percent for a cash flow of $700,000 per year.
Assume further that sometime after the sale of the shares to the U.S. investor,
all of the international investor's shares in the corporation, 97 percent, are
repurchased by the domestic corporation in exchange for the domestic
corporation's portfolio interest installment note equal to a value of $7
million with interest of 10 percent for 10 years.
After the redemption, the U.S. investor's ownership of 3
percent of the domestic corporation represents 100 percent of all issued shares
and total ownership of the domestic corporation. The international investor
owns the note representing an indebtedness of the domestic corporation for $7
The 1031 replacement property is held by the domestic corporation for 10
years and appreciates in value by 3 percent per year resulting in a fair-market
value of $14.3 million after 10 years. The U.S. investor then elects
S-corporation tax status once he or she owns 100 percent of the domestic corporation.
At the end of the 10-year period, this allows the S-corporation's shareholder
to sell the replacement property as a long-term capital gain asset paying a 15
percent tax rate for total taxes of approximately $2 million.
What can commercial real estate advisers glean from this example? Over
the 10-year period the international investor receives $7 million in tax-free
interest. The corporation pays little in income tax since the interest is
generally deductible, subject to certain special rules, turning the investment
into a tax-free 10 percent return in U.S. real estate with a large cash
payment on the due date of the note.
As a result of the replacement property's sale, the international
investor's loan is paid at a tax cost of approximately $2.5 million (35 percent
of $7 million), resulting in an additional net distribution of approximately
$4.5 million to the international investor for a total of $11.5 million.
Also, there is an additional profit of $5.3 million ($14.3 million sales
price minus $2 million in U.S.
taxes minus $2.5 international investor taxes minus $4.5 million distribution
to the international investor) that is left to be distributed to the U.S. investor,
the international investor, or both.
Finally, during the 10-year period, the corporation will produce net
after-tax cash flow totaling approximately $16.8 million for the two investors.
While these general tax rules affect inbound international investors,
there are many requirements and specifications that must be considered in each
transaction. In addition, some international investors may be citizens of
countries that have tax treaties with the U.S., which may provide a similar,
though better, tax environment for the international investor. Consult a
qualified tax professional to ensure inbound investment transactions are
structured properly to maximize the tax advantages.