Many of you in Florida, New York, California, and a good many other states have friends, neighbors, and acquaintances who are not U.S. citizens but who own U.S. real estate. If you counsel nonresident aliens (NRAs) on real estate matters, it is essential to understand how U.S. estate and income tax laws treat NRAs differently from citizens and U.S. residents. When an NRA owns a piece of U.S. real estate, the rules become more difficult and, if the NRA happens to die, then the rules become a lot more difficult. This piece briefly looks at those rules.
Who is the NRA?
First, it is important to know that a foreign person’s designation as a resident alien (or nonresident alien) is determined under different sets of rules for income tax purposes than it is for estate and gift tax purposes.
Under the income tax rules, whether or not a person is an NRA is pretty much a matter of mathematics. A foreign person (that is, one who is not a U.S. citizen) is presumed to be a nonresident. That presumption is overcome when the foreign person meets a certain time-in-the-U.S. threshold. A foreign person is a U.S. income tax resident when he or she is physically present in the United States for more than 182 days during the fiscal year or he or she is present for more than 182 weighted average days during a three-year period ending with the current year.
Take Susan Peterson, for example. She is Brazilian. In 2008, she was present in the United States for 180 days visiting her children and grandchildren, and so, for that year, she was not a U.S. tax resident. For the period 2009–11, she was present in the United States for 168 days, 144 days, and 100 days, respectively. To arrive at her weighted average figure, Susan counts one-sixth of 168 (28), one-third of 144 (48), and 100 and adds those figures. So, 28 + 48 + 100 = 176. Susan was not a tax resident for 2011, although if she had stayed in the United State for 107 days, rather than 100, she would have been a U.S. income tax resident for 2011.
The rule has a number of exceptions and variations, but the foregoing is the statutory rule. The main exception arises when the alien is from a treaty country, such as the U.K. or Sweden. If Susan were Swedish, she would look to the U.S./Swedish income tax treaty for the answer to whether or not she is a U.S. resident in any given year.
For estate and gift tax purposes, the rules describing a resident/nonresident, as mentioned, are different. Technically, we don’t speak in terms of “residency”; rather, the issue is whether the donor of a gift or a decedent was a “domiciliary” of the United States. That difference in rules means that an alien might be a resident for income tax purposes but a nondomiciliary for estate and gift tax purposes.
Whether or not an alien is a U.S. domiciliary turns on a combination of the alien’s intentions and actions. The “intention” part of the equations turns on whether the decedent, at the time of death, intended to be a permanent resident of the United States; that is, did he intend to return to his prior place of domicile, but he died before he could do so? The “action” part of the equation requires the alien to have actually been in the United States. That does not require him to have been here when he died, but he needs to have been here at some point to establish the United States as his domicile.
What is the U.S. Real Estate?
We pose that simple-looking question because, under U.S. income tax rules, things that we would normally identify as personal property might be treated by the Internal Revenue Code as real estate.
Standard Real Estate
Almost everyone, layman and lawyer alike, knows what most real estate is. When, however, we drift to the outer edges of the definition of “real estate,” our certainty becomes somewhat watered down. For example, an option to purchase real estate is, itself, an item of real estate; an easement is real estate; a license to extract minerals is real estate. A debt instrument that is secured by real estate is not, however, real estate.
Unusual Real Estate
In the tax law context, stock of a “U.S. real property holding company” is real estate. Additionally, personal property that is used in mining, farming, and forestry is real property, as is personal property used to improve real property, such as tractors, bulldozers, cement mixers, and the like!
Income Tax Issues
Buy and Holding
An NRA who owns U.S. real property usually receives income from that property. The NRA has a choice of entities to hold the property. She can hold it (1) in her own name; (2) in a local LLC; (3) through a partnership, limited or general; (4) through a corporation, domestic or foreign; or (5) in trust. Those choices have specific repercussions for the NRA, so she should give some thought to which of them works best for her.
Assuming that the NRA holds the property in her own name, she needs to determine whether or not she is in business under the income tax rules; if not, she should elect to be in business and then give her lessee/tenant a Form W-8 ECI so the tenant won’t withhold tax from the rental payments. Because she is actually engaged in a U.S. business through the real estate or will be treated as if she were so engaged, the NRA will be required to file a Form 1040NR each year and declare the rental income (less normal deductions) as income.
The NRA can hold the property through an LLC or partnership arrangement, as mentioned. If the property is a business (a shopping center, for example), then she will still need to file a Form 1040NR and also be aware of the withholding rules applicable to partnerships that have one or more foreign partners.
An NRA who sells U.S. real property is treated as being engaged in business for the year of the sale. The buyer of the property is required to withhold 10 percent of the selling price (irrespective of what the gain to the NRA might be), which the NRA treats as a prepayment of tax when he files his Form 1040NR for the year of the sale. That 10 percent will frequently exceed the amount of tax due on the sale, so the NRA will be entitled to a refund.
That withholding rule also applies to sales of stock of a U.S. real property holding corporation. So, for example, if John Smythe, a U.K. citizen and resident, sells for $5 million stock of a New York corporation that only owns an apartment building in Manhattan, the buyer is to withhold $500,000 and pay it to Uncle Sam. John has a bit of a problem if the debt on the apartment building exceeds $4.5 million because he will need to put his own money into the deal to allow it to close.
Estate and Gift Issues
Congress finally acted at the end of 2012 to bring some peace to the chaos that theretofore racked the estate and gift tax rules. Now, as of January 1, 2013, the maximum gift tax rate is 40 percent of the taxable gift. The annual exemption is $14,000 (adjusted for inflation) and the lifetime exemption is $5,250,000 (for 2013—adjusted for inflation).
NRAs and U.S. Gift Tax
Remember that as we discuss the gift and estate rules, although we refer to foreign persons as “NRAs” in the gift and estate context, we are really dealing with U.S. domicile, not residence. We refer to persons who are not U.S. domiciliaries, for simplicity’s sake, as NRAs.
An NRA (that is, a “nondomiciliary”) who makes a gift of “U.S. property” is subject to a U.S. gift tax if the gift is large enough. For an NRA donor, the annual exclusion is similar to the exclusion for U.S. donors, that is $13,000 per donee. The NRA, however, is not entitled to a lifetime exemption of any significance (unless the donor is entitled to one pursuant to an estate tax treaty that may exist between the donor’s country of residence and the United States).
An NRA is not entitled to a marital deduction for gifts made to a non-U.S. citizen. So, a gift of U.S. property by a husband to his noncitizen wife, whether or not a U.S. resident, is subject to gift tax. The NRA is, however, entitled to an annual exclusion for U.S. property gifts to his NRA spouse of $143,000 (adjusted for inflation), for 2013.
The key to determining whether an NRA is subject to U.S. gift tax on a gift is being able to identify the property given as “U.S. property.” U.S. property is any tangible (real or personal) property located within the United States at the time of the gift. So, for example, if a Hong Kong father gives his daughter a car that dad owns and that is located in Beverly Hills, dad very likely has a gift tax bill to pay.
Note that what is not included in the phrase “U.S. property” is any intangible item, such as stock of a domestic corporation or some form of debt instrument issued by a U.S. obligor. As a result of that quirk in the law, an NRA can give to his U.S. donee shares of stock in a domestic corporation or debt obligations of a U.S. person without incurring gift tax, even though those items would be included in his U.S. estate if they were bequeathed upon death.
When a U.S. person receives a gift from a foreign person, the donee needs to be mindful of the Code’s requirement to file a Form 3520 if the gift (or gifts) total $100,000 in any given year.
The estate of an NRA (that is, of a nondomiciliary) is subject to U.S. estate tax if the estate has enough U.S. property to trigger the tax law. As with gift tax, the question is whether or not the estate contains “U.S. property,” although the definition of that phrase is different for estate tax purposes than it is for gift tax purposes.
“U.S. property,” for estate tax purposes, includes any property located within the United States at the time of death. So, U.S. real estate, physical personal property, stock of a domestic corporation (a different rule from the gift tax rule), a debt obligation issued by a U.S. person, and a U.S. patent would all be included within the meaning of “U.S. property.”
Under those rules, an NRA who dies holding a portfolio of U.S. stocks would be subject to U.S. estate tax because those stocks would be U.S. property, even if the decedent owned the stock through a U.S. broker located in his home country.
The tax rates for an NRA’s estate are the same as they are for domestic decedents’ estates. As mentioned above, the maximum rate is 40 percent pursuant to IRC section 2001. The huge difference for NRA estates from estates of U.S. decedents is that the lifetime exemption of $5-million-plus available to U.S. decedent estates is not available to NRAs. Estates of NRAs are entitled to a deduction of $60,000, which translates to a unified credit of $13,000; for most NRA estates, that amount is really nothing.
Further, the marital deduction under the estate tax law depends entirely on the surviving spouse being a U.S. citizen. If the survivor is not a U.S. citizen, then, to obtain a marital deduction, the survivor will need to enter into a “qualified domestic trust,” which is designed to ensure that Uncle Sam gets the estate tax at some point down the line.
An NRA’s estate is subject to the generation-skipping tax (GST). That is a tax imposed on an estate when the bequest skips a generation (grandfather to grandchild, for example). The GST applies to the NRA’s estate, however, only if the property that is bequeathed to the second (or third) generation would itself be subject to either U.S. gift or estate tax. For example, assume that Young Rho, a Korean national, owns two apartment buildings, one in Los Angeles and one in Hong Kong. Mr. Rho dies, leaving both buildings to his granddaughter. The GST rules apply to the value of the Los Angeles apartment but not to the apartment in Hong Kong.
The purpose of this article is to remind you that transfers of real estate may be subject to either U.S. gift or estate tax. Whether or not a tax will actually be due will depend on the value of the real estate being transferred. As a practitioner, you need to know whether or not the gift/bequest is subject to tax in order to allow your client to plan properly. This article should also suggest to you that estate planning may well be in order for your alien clients, even if they are long- term residents.
Rufus v. Rhoades (firstname.lastname@example.org) consults with law firms, accounting firms, nonresident aliens, foreign corporations, and international trust companies. He is a widely published author of texts on international tax issues, including, along with co-author Marshall J. Langer, U.S. International Taxation and Tax Treaties (Matthew Bender 1996, updated quarterly).