US Property Taxation

US Property Taxation

Buying Property in the USA

DAVID TREITEL discusses the practical tax implications that arise when individuals own property in the United States.

IN A CASE reported in July 2004, the United States Tax Court denied the claims of a British citizen to several deductions on his US income tax return in relation to a rental property in that country (Bijlani v Commissioner, T.C. Summary Opinion 2004-96; Docket No 5850-02S). The decision was not kind; Mr Bijlani had claimed expenses that turned out to be non-deductible. The judgment (on the Internet at www.ustaxcourt.gov/InOpHistoric/biglani.sum.WPD.pdf) recommends that 'the petitioner would be well advised to consult a United States tax expert before filing future non-resident returns'. This article focuses on these US issues, since these are the least familiar to the majority of readers of Taxation.

Typical British individuals who require this kind of tax planning will be UK resident and domiciled individuals who buy holiday homes in the States. The taxation of US real property is governed by the location of the property. Therefore, any property in the US will always be subject to tax under US federal and state tax régimes, whether income tax on rental income, capital gains tax on sale, or estate and gift tax on transfers.

Mike and Jane are a typical example of people currently undertaking American property purchases from the UK. They are both British, resident and ordinarily resident, and domiciled within the UK. A married couple in their fifties, they are thinking of buying a second home in Florida (although they might be tempted by an alternative of buying in California or New York). They intend to use the home for a few weeks each year, hoping eventually to stay for up to six months a year after Mike has taken early retirement.

Mike and Jane will need to consider a range of US and UK tax issues. They plan on renting out the house during the weeks they are not there. Should it be owned jointly or in one spouse's name? Do they need to file an income tax return in the US each year? What kind of expenses could they claim? Indeed what is going to happen should the property be sold, or on Mike or Jane's death?

Becoming US resident?

Generally speaking, becoming US resident is not an advantage because this exposes worldwide income and gains to US tax. The US tax position of a non-US citizen depends on whether that individual is a resident alien or a non-resident alien. Mike and Jane are both currently non-resident aliens so, unless they become resident aliens, they will only be subject to US tax on US situs income and assets. Conversely, US persons are subject to US taxes on worldwide income.

A US person for the purposes of US income tax rules includes all US citizens and permanent residents (green card holders), regardless of where they are living. The definition of US persons might include non-US citizens (e.g. British citizens such as Mike and Jane) if they have a green card or are considered resident aliens under the 183-day substantial presence test of section 7701(b) of the Internal Revenue Code, discussed in the article 'Am I There Yet' on page 69 of this week's issue of Taxation.

Closer connection test

It may be wise, therefore, for both Mike and Jane to plan to spend no more than 120 days in the US in any year, so that they do not become US resident under the substantial presence test, thus potentially subjecting their worldwide income to US tax. (Example 1 below illustrates this.)

However, because they could spend greater amounts of time in the US after Mike's retirement, they may exceed these limits. Even if they meet the substantial presence test, they could still be treated as non-US resident in a year if:

a) they are present in the US for fewer than 183 days in any single year;

b) they continue to retain a tax home in a foreign country (for example, by continuing to be resident in the UK); and

c) they continue to maintain closer connections to the country that is their tax home than they do to the US.

If, in any year, either Mike or Jane were to become resident under the substantial presence test and did not satisfy the closer connection test, they would then become subject to US tax on worldwide income from the time that they become US resident.

In the majority of cases, this would mean subjecting more income to tax than would be taxable in the UK because, for example, income from PEPs, ISAs, TESSAs and National Savings products are all taxable on US persons, even though these may be free of UK tax. Nonetheless, it can be advantageous in some circumstances to plan so that an individual who is dually resident in both the UK and the US is treaty resident in the US as against the UK (for example, by keeping a permanent home in the US as against the UK).

Reasons why an individual might choose to be treated as US resident as against UK resident often revolve around enabling a claim for the split year basis in the UK, perhaps to avoid paying higher-rate UK tax. Additionally, US marginal tax rates are currently slightly lower than UK rates, and the US allows more deductions (such as mortgage interest) than the UK. Therefore, once Mike has retired it may be worth reviewing whether spending more time in the US might reduce their overall tax liabilities.

Individual taxpayer identification numbers

The ITIN (individual taxpayer identification number) is a tax processing number issued by the Internal Revenue Service to individuals who are unable to obtain a social security number, but who file tax returns. Mike and Jane may be asked to provide these numbers when they buy their new home.

In the past, ITINs were issued regardless of a person's immigration status. The rules changed in December 2003 so that in most cases it is now not possible to request an ITIN until the first tax return reporting rental income is filed. The Internal Revenue Service changed the procedures again in February 2004, so that on the sale of a US property the seller can apply for an ITIN prior to sale if an application for reduced withholding tax under the Foreign Investment in Real Property Tax Act is also submitted (see discussion below).

Because these procedures were altered recently, there is still confusion as to what banks and mortgage lenders will require in terms of tax identification numbers. Mike and Jane may find as a consequence that it is difficult, for example, to open a US bank account for some time and should be prepared for this eventuality.

Rental income and expenditure

In general, a non-resident alien is subject to US tax on income that is effectively connected with a US trade or business and on US source investment income that is not effectively connected with a US trade or business. Ordinarily, income from rental of real property is treated as income that is not effectively connected to a US trade or business with the gross rents subject to tax at a flat rate of 30 per cent and no deduction allowed for expenses.

Most taxpayers elect under Internal Revenue Code, section 871(d), to treat rental income as effectively connected to the conduct of a trade or business in the US. If Mike and Jane make this election, it will allow them to claim expenses (including depreciation discussed below) against the rental income so that US tax is only paid if they make an overall rental profit. It will also allow them to claim personal exemptions (similar to the UK personal allowance) and permit the net rental profits to be taxed at graduated rates (currently up to 35%).

Just as in the UK, it is then possible to deduct expenses against the rental income. However, unlike the UK, the US does not insist on an accruals method of accounting, so in most cases income is reported on a cash basis and expenses are deductible in the year in which they are paid.

Typical expenses that are allowable for US tax purposes are similar to those in the UK; such as advertising, cleaning and maintenance, commissions and management fees, insurance, legal and professional fees, mortgage interest, real estate tax, repairs, state income tax, travel for inspection and utilities.

Article 24 of the double taxation agreement (relief from double taxation) states that the UK will give credit for US tax where the UK tax is 'computed by reference to the same profits, income or chargeable gains by reference to which the US tax is computed'. The US tax calculated for US tax purposes, which Mike and Jane will want to claim as a credit on their UK tax returns, may, however, not be on the same measure of income that is being charged to UK tax, so may not all be allowable in the UK. For example, the 25% tax charge which recovers depreciation in a year of sale would not be creditable in the UK because the UK would not be taxing the same income.

So what can they depreciate?

Unlike the UK, it is not possible to claim a wear and tear allowance in the US. Instead, a deduction for depreciation of a building (but not land) is taken as an expense deductible annually from rental income. Real property in the US is typically depreciated on a straight-line basis over a period of 27.5 years, but one can elect for a longer period of 40 years. Depreciation is calculated on the lower of the initial cost of the property or the fair market value of the property when first available for rent and is deductible from that date. There will, however, be an additional tax in the year of sale of the property equal to 25% of the depreciation claimable on the property throughout the time it was held out for rent.

In many cases, taking the deduction allowed for depreciation will increase the annual rental loss. These rental losses will be treated as passive activity losses and can only be set against income from any other US source passive activities in the same or any future year. Unused rental losses are carried forward indefinitely until the property is sold. It is, therefore, frequently worth electing for the 40-year depreciation period so as to have a lower 25% tax charge in the year of sale, although this decision would vary from case to case.

Property not rented for profit

If Mike and Jane decide to rent the property on a 'not for profit' basis to their family and friends, then deductible rental expenses would be limited to the rental income each year.

Mike and Jane will need to pro-rate deductible expenses to the days rented if, during the year, Mike, Jane or any family member uses the property personally for the greater of either 14 days or ten per cent of the total days it is rented to others at a fair market rental. In Mike and Jane's case, this restriction to allowable expenses will probably be relatively small until after Mike's retirement.

Tax return filing

A non-resident alien in receipt of rental income is required to file an annual federal non-resident alien income tax return, Form 1040NR.

If Mike and Jane plan to own the property jointly (as is commonly recommended for UK income and capital gains tax purposes), then both will be required to file separate federal and state returns, each reporting their share of the income and expenses (inclusive of depreciation). Although most married Americans file a joint tax return, non-resident aliens are not permitted to file these. Each tax return (together with payment of tax) for the previous calendar year will be due by 15 April of each following year. If timely tax returns are not filed electing to claim deductions, the Tax Court has held that a non-resident alien owning rental properties is not entitled to deductions at all (Guillermo Baez Espinoza, 107 TC No 9 (1996)).

Capital gains

US tax will arise if a capital gain is realised when the property is sold. The gain is taxed as if the individual were engaged in trade or business in the US (whether or not this has been elected for income tax purposes). Currently, the rate of tax on long term capital gains (assets held for more than twelve months) is 15%. This rate of tax is fixed until 31 December 2008 (although it could vary from as early as January 2005 given that Senator Kerry's tax proposals would raise the top capital gains tax rate from 15% to 39.6%).

As in the UK, costs deductible in calculating the gain include the original purchase price, costs of buying and selling, realtors' fees and improvements. Unlike the UK, there is no indexation, taper relief, residential letting exemption, or annual capital gains tax exemption. There is also no equivalent of the special business asset taper relief afforded by the UK to holiday lettings. Because these exemptions and reliefs do not exist, US capital gains tax may often be greater than UK tax chargeable on rental properties.

For Mike and Jane, any gain on the sale of the home will also be taxable in the UK. Because the asset is denominated in dollars, there may be a gain in dollars while there is a loss in sterling, or vice versa. This frequently leads to differences in the amounts charged to tax by the two countries.

FIRPTA

When Mike and Jane come to sell, they will find that the disposal of US property by a non-resident is subject to withholding under FIRPTA (the Foreign Investment in Real Property Tax Act). FIRPTA withholding tax is equal to 10% of the gross proceeds of the sale (whether or not there is a gain) on the transfer of real property by a non-resident alien. Where 10% of gross proceeds is greater than the tax liability on the gain, an application can be made to the Internal Revenue Service for a reduced level of withholding. Any withholding that is made will be allowed as a credit on the tax return in the year in which the disposal of the property is reported (which will be required whether or not an election for reduced withholding was made).

What state is it in?

Because the US has a federal system, it is up to each state (and in some cases cities and local municipalities) to decide which kinds of tax they wish to charge. The majority of states (with important exceptions such as Florida, Texas and Nevada) have an income tax, and so would require annual income tax returns. Some states also have estate taxes. In ascertaining the amount of tax due to any state, there are three rules to bear in mind.

 

• Each state will have its own rules to decide who is resident there. In some cases residence is based on presence or number of days, while in others domicile is the deciding factor. Mike and Jane would be best advised to review state tax rules before deciding which state would suit them best.

 




 

• Income and gains from real property are taxable in all states that have an income tax.

 




 

• While the US and UK have entered into both income and death tax conventions, from a state tax perspective this will be of little consequence because these agreements were not with state governments. This frequently means that income which is exempt from federal tax under the terms of a double tax treaty remains taxable at a state level.

 

US gift tax

Non-resident aliens are subject to gift taxes for gifts of tangible property situated in the US. Gift tax is payable on gifts made during lifetime and is imposed at graduated rates up to 48% on assets in excess of the exempt amount. The exempt amount is currently $112,000 in respect of gifts to a spouse and $11,000 to other donees.

If Mike and Jane decide to gift the property to their children during their lifetimes, or to change from an equal ownership to different percentage interests over a period of years, gift tax can be avoided provided the value of the interest given up each year is within the annual exempt amount for gifts to a spouse or the somewhat more limited exemption for gifts to other donees.

US estate tax

For estate tax purposes, an individual has to be domiciled outside the US to be classified as a US non-resident. For a non-resident, gross estate includes all US situs property at death. Generally, the fair market value of the property is included in the gross estate and is taxable at graduated rates up to 48% (reducing to 0% in 2010, but only for that year, after which it is scheduled to increase again). A non-resident alien only has an exemption amount of $60,000 for estate tax purposes (Internal Revenue Code, section 2102(c)(1)).

US citizens are treated more generously by being given an unlimited marital deduction for both estate and gift tax. In other words, a spouse can gift, or pass at death, an unlimited amount of property without incurring any tax, as long as the recipient is a US citizen. There is no marital deduction available to non-US citizens, which may lead to tax on the death of the first spouse and again on the death of the surviving spouse. Therefore, death of a non-US individual owning US real estate can lead to a significant tax liability.

There are several structures which, depending on circumstances, can reduce US estate tax exposure. These range from straightforwardly holding in individual names, with sufficient life insurance written in trust to cover tax, through to ownership by US or non-US holding companies.

Corporate ownership does have some attractions, in that it avoids FIRPTA withholding tax, but adds benefit in kind issues (both in the UK and the US) if the owner stays at the property. It also introduces a potential for double taxation, both at the corporate level and then again to the individual shareholder when a distribution is paid.

Conclusion

According to the Tax Court, Mr Bijlani would have benefited from more complete advice at the outset. As with Mike and Jane, he was a British citizen and a non-resident alien for US tax purposes. His tax return claimed deductions against a rental property, which were disallowed because deductions are generally only allowed to non-resident individuals if the deductions relate to income that is connected with the conduct of a trade or business in the US.

Mike and Jane, and others like them, can reduce their exposure to US tax through tax planning as they acquire property in the US. Such planning includes deciding on an appropriate structure at the outset, taking into account US income tax, US residence rules, state tax, estate and gift tax, potential capital gains, and interactions with UK rules.

David Treitel is a senior manager at Buzzacott Livingstone, specialists in US tax, and can be contacted at treiteld@ustax.co.uk or on 020 7556 1400.

--------------------

For a comprehensive review of tax vacancies in London, the South East and Nationwide please call 020 7257 6500 or visit www.purerecruitment.com The leading specialist tax recruiter.

Issue: 3980 / Categories: