The Internal Revenue Code contains numerous traps for the unwary
foreign investor in U.S. real estate or businesses. The tax law
provisions applicable to nonresident foreign investors are very
often quite different - and more onerous - than the familiar tax
rules applicable to U.S. citizens and foreign residents in the
United States. This article identifies a few of the most common
areas where nonresident foreign investors may need specialized tax
advice to avoid costly mistakes.
Nonresident foreign investors are subject to estate tax rules
that are far less favorable than those applicable to U.S. citizens
An estate of a U.S. citizen or resident is subject to an estate
tax based upon the value of the worldwide property, tangible and
intangible, owned by the decedent on the date of death or over
which he or she has certain rights or powers. The current estate
tax rate for 2015 is 40 percent for taxable estates in excess of a
$5.34 million exemption, which is adjusted annually for inflation.
A U.S. estate may also deduct from the taxable estate a marital
deduction equal to the value of property left to a surviving
spouse. The amount of lifetime taxable gifts during the decedent's
life is also included in calculating the gross estate.
The gross estate of a nonresident foreign investor includes all
tangible and intangible property situated in the U.S. (U.S.
property), in which the decedent has an interest at the time of his
death, or over which he has certain rights or powers. The estate is
taxed at rates ranging from 26 percent to 40 percent of the value
of estates in excess of a $60,000 exemption (the 40 percent rate
applies to taxable estates over $1 million in value). Moreover, the
estate of a nonresident foreigner is generally not allowed a
marital deduction unless the surviving spouse is a U.S. citizen.
Taxable gifts are not included in the gross estate, but are
Similarly, nonresident foreign investors are subject to gift tax
rules that are far less favorable than those applicable to U.S.
citizens and residents.
U.S. persons are subject to a federal gift tax on gifts made of
their worldwide assets, tangible and intangible. The gift tax is
imposed on the donor; donees are not subject to gift or
income tax on the receipt of the gift. Taxable gifts are taxed at
rates ranging from 18 percent (for taxable gifts not in excess of
$10,000) to 40 percent (for taxable gifts in excess of $1 million)
on the fair market value of gifts made worldwide. An annual
exclusion of $14,000 per donee (for 2014) is allowed for gifts of
non-trust present interests; spouses may elect to make joint gifts
(split 50/50 between spouses). A lifetime exemption of $5.43
million, combined with the estate tax exception, is allowed.
A nonresident foreign national is subject to a federal gift tax
on gifts of real estate and tangible personal property and
cash located in the United States. Intangible assets such as
corporate stock and partnership interests are not subject to tax.
An annual exclusion of $14,000, adjusted for inflation, is allowed
per donee. Joint gifts with spouses are not allowed unless
the spouse is a U.S. person. Gifts to spouses are not entitled to
the marital deduction unless the spouse is a U.S. citizen, but an
inflation-adjusted annual $140,000 exclusion is allowed for gifts
to a non-citizen spouse. No other exemption is allowed for lifetime
gifts, although gift taxes paid may be credited against the estate
The tax code imposes a number of special withholding taxes on
U.S. source income received by nonresident foreign nationals.
Rents, dividends, interest, royalties and other "fixed or
determinable annual or periodic income" (FDAP) received by
nonresident foreign nationals are taxed at a flat rate of 30
percent on the gross amount received determined without
deductions, unless these amounts "effectively connected" with a
U.S. trade or business conducted by the taxpayer. This tax must be
withheld at the source by the payor, and - although referred to as
the "withholding tax" - is a true tax, not a credit against income
taxes. In some cases, tax treaties reduce or eliminate the
withholding rates for certain classes of income.
Net income "effectively connected" with a U.S. business
conducted by a nonresident foreign national is taxed at customary
U.S. personal and corporate income tax rates. A special election
permits income from real estate activities to be classified as
"effectively connected" and thus taxed on a net - rather than a
gross - basis.
Income of a nonresident foreign investor in a U.S. partnership
is subject to withholding at a 39.6 percent rate for individuals
(35 percent for corporations). Unlike the 30 percent tax on FDAP,
amounts withheld by the partnership are credited against the income
tax payable by the foreign partner and are potentially refundable,
in a manner similar to the familiar withholding from U.S. employee
Income of a nonresident foreign investor from the sale or
disposition of U.S. real property interests is subject to FIRPTA
withholding at the rate of 10 percent of the gross proceeds of
sale. This amount is withheld at the source by the buyer and is
creditable and potentially deductible like the partnership
withholding discussed above. The amount withheld may be greater
than the capital gain tax imposed on the seller and sometimes
greater than the net cash received by the investor.
No S Corporation Election
Nonresident foreign investors cannot take advantage of the
benefits provided by the S corporation classification, since stock
ownership by a nonresident foreign investor will terminate the
corporation's S corporation election.
Branch Profits Tax
Foreign corporations engaged in business in the U.S. are subject
to a "branch profits tax," a second tax in addition to the regular
U.S. corporate income tax. This tax is equal to 30 percent of the
corporation's "dividend equivalent amount," and effectively imposes
a 30 percent tax on corporate income deemed distributed as
a dividend to its foreign shareholders.
U.S. and foreign corporations which pay interest to foreign
lenders may not deduct the interest payments if the interest income
is not taxable to the recipient or to the extent it is reduced by a
The foregoing discussion is only a general summary of a complex
topic, and is subject to numerous qualifications and exceptions. In
many cases, the severity of the tax rules applicable to foreign
investors can be mitigated by competent pre-investment tax advice
and proper structuring of the investment transaction.
For a more complete discussion of this topic, please see the
publication "Tax Guide for Foreign Investors in U.S. Residential
Real Estate" available on the Davis Malm & D'Agostine, P.C.
website (www.davismalm.com) or upon request.