Owning real estate in another country provides many benefits for U.S. investors:
* A non-reportable offshore asset (if owned individually).
* A refuge in times of political or economic uncertainty.
* The possibility for profit from rental income or if the value of the property appreciates.
* In one country (St. Kitts and Nevis), purchase of "qualifying" real estate entitles you to acquire a second passport.
* Protection against foreign exchange controls. It's impossible for the U.S. government (or anyone else) to forcibly repatriate foreign real estate.
However, there are numerous possible missteps to avoid when you acquire real estate offshore. Among them are overpayment, fraud, bad title, conflicts of interest, problem tenants, squatter's rights, and developer bankruptcy. The best way to avoid these missteps is by dealing with a knowledgeable local real estate lawyer.
One often-overlooked pitfall is tax. Even if you avoid local tax, you may still be subject to tax in your home country. This is almost always the case for U.S. citizens and residents who own offshore real estate. I'll address the U.S. tax consequences of owning offshore real estate momentarily. But first, let's examine how other countries deal with real estate ownership by foreign investors.
Many Countries Restrict Foreign Real Estate Ownership
Foreigners often can pay more than locals for available real estate, driving up prices. Eventually, real estate may become so expensive that it's beyond the means of most local residents to buy it. And no country wants to be literally "owned" by foreign investors.
For those reasons, many countries impose restrictions on foreigners owning real estate. For instance, Mexico prohibits foreign nationals from owning certain categories of real estate within 100 kilometers of the country's borders or 50 kilometers of the coast. Austria and Panama extend tax advantages to local companies (which may be beneficially owned by foreigners) that don't exist for foreign owners.
A local lawyer can help you overcome restrictions or tax biases against foreign ownership. For instance, in Mexico, you may take title to real estate through a Mexican trust (Fideicomiso). In Panama, your attorney may create a corporation (Sociedad Anónima) (S.A.) for this purpose. Forming a local company or trust may also avoid a probate proceeding in that country at your death.
Forming a Foreign Trust to Hold Real Estate Has Profound U.S. Tax Consequences!
If you're a U.S. citizen or resident, when you form a foreign entity, you must inform the IRS about it. Failure to do so subjects you to draconian penalties.
For instance, when you fund a trust, you become its "grantor." As a U.S. grantor, when you fund a foreign trust, you must submit IRS Forms 3520 and 3520-A annually. (Technically, your trustee is supposed to file Form 3520-A, but you're ultimately responsible.) Expect to pay a minimum of $3,000-$5,000 each year for this service.
If your trust has an offshore bank account, you'll probably need to file a "foreign bank account report" or FBAR with the U.S. Treasury each year (Form TDF 90-22.1). Both you individually and the trust itself may need to file the FBAR.
Provided you meet these requirements, you generally pay tax on the trust's income or gain as if the trust didn't exist. For instance, if you hold offshore real estate for more than one year through a offshore trust and sell it for a profit, you generally pay long-term U.S. capital gains tax (currently 15%) on the gain.
Fortunately, you can credit the payment of any foreign CGT against your U.S. tax obligation. As long as you pay at least 15% CGT locally (or whatever rate applies in the United States when you sell), you're unlikely to owe additional U.S. CGT.
Hidden Traps in Foreign Corporations
U.S. persons who form foreign corporations become enmeshed in a labyrinth of tax laws and regulations designed to prevent multinational corporations from deferring income. Here's a highly simplified summary:
"U.S. shareholders" are U.S. natural persons, partnerships, corporations, trusts, and estates that own, respectively, 10% or greater interests in a foreign corporation. If such U.S. shareholders own more than 50% of the shares in an entity classified as a foreign corporation (e.g., a Panamanian S.A.), by vote or value, that entity is a controlled foreign corporation (CFC). For instance, a foreign corporation with six U.S. shareholders owning 10% each and four foreign shareholders owning 10% each is a CFC.
In general, U.S. shareholders in a CFC can't defer U.S. tax on its passive income. This may include rental income from real estate, although not what the IRS calls "actively managed real estate." In addition, in a CFC:
* The 15% tax rate on capital gains and dividends isn't available. All gains are taxed at your marginal rate.
* Investment losses can't be allocated against gains until the CFC is liquidated.
One way to avoid these unfavorable tax consequences is to elect to have the CFC taxed as a U.S. C-corporation. However, like a domestic C-corp, this results in double taxation. Another option is to file Form 8832 with the IRS and elect to have the CFC treated as a disregarded entity (if there is only one owner) or a partnership (if there are multiple owners). That way the gains and losses of the CFC flow through to the U.S. owners as if the CFC didn't exist.
Unfortunately, many foreign corporations are ineligible for this election. That includes most varieties of the Sociedad Anónima, including those in Panama and Uruguay.
You must also file IRS Form 5471 each year for any CFC (and for certain transactions in non-CFCs) in which you hold a 10% or greater ownership stake. In addition, you must file IRS Form 926 when you transfer property to a foreign corporation (CFC or otherwise) if you own 5% or more of its stock. Separate filing requirements apply if your CFC is taxed as a foreign partnership or foreign disregarded entity.
So…What's the Answer?
No "one size fits all" solution exists for purchasing offshore real estate. First, you need to understand how foreign buyers typically take title to real estate in the country where you're buying property. Then you need to tailor whatever structure you create for maximum tax efficiency in both that country and the United States.
Where local law permits, you may decide to purchase offshore real estate in your own name, rather than through a foreign entity. This avoids the ongoing expense and complexity of holding it through a foreign entity. Merely owning offshore real estate also doesn't trigger U.S. reporting requirements. But, be certain to create a legally binding local will or testament to convey the property to your heirs as simply and inexpensively as possible.
Finally…however you decide to purchase offshore real estate, be sure to get expert advice, both in the country you purchase it and in your home country. That way, you'll avoid unnecessary taxes, reporting penalties—and even criminal sanctions.
Buying Through Your Retirement Plan Avoids Some U.S. Tax Traps—but Creates Others
One way to avoid, or at least delay, the unpleasant U.S. tax consequences of offshore real estate ownership through a foreign entity is to create a self-directed IRA, 401(K), etc., and then have that plan create and own the entity that owns the real estate.
In theory, you avoid all U.S. tax until you begin taking distributions from the plan. However, you may still need to pay foreign tax on any income or gain. Foreign tax authorities are likely to impose tax on the underlying entity as if the plan didn't exist. And, you won't be able to deduct these tax payments against current U.S. tax obligations, since the plan isn't subject to current U.S. tax.
If you borrow money to finance the real estate, you may be subject to tax on the income or gain attributable to the amount borrowed (although there are ways to avoid this tax). And don't think you can simply borrow from yourself or your company—this may result in a "disqualified transaction" that could result in the IRA terminating your plan. In that event, you could be stuck with a huge tax bill, plus an early termination penalty if you're under 59 1/2.
Confused? We can help. Contact us to schedule a consultation.
Copyright © 2011 by Mark Nestmann
(An earlier version of this post was published by The Sovereign Society, https://banyanhill.com/)
