Entries Tagged 'Federal tax' ↓

This is for the members of my Foreign Investment in U.S. Real Estate Class earlier this week in San Francisco.

We talked about the “net election.”   Here’s the detail I promised.

The law

To learn everything about this, read Treasury Regulations Section 1.871-10.  (PDF).

The effect

Rental income earned by a nonresident owner of U.S. real estate (human or corporation, it doesn’t matter) is taxed harshly by default — 30% of gross rent received is the tax, with no deduction for business expenses.  You know, the little things.  Stuff like mortgage interest, depreciation, property tax, management fees.  That kind of stuff.

By making the election you can change the Federal taxation to the normal method:  the nonresident real estate owner would be taxed on gross rent collected less allowable expenses.

The choice does not require a lot of thought.  “30% off the top?  or 30%-ish off the bottom?”

(Note that this is for Federal income tax, not California income tax).

How to do it

You make this election by attaching a statement to the income tax return.

Here’s what the Regulations require:

An election made under this section without the consent of the Commissioner shall be made for a taxable year by filing with the income tax return required under section 6012 and the regulations thereunder for such taxable year a statement to the effect that the election is being made. This statement shall include (a) a complete schedule of all real property, or any interest in real property, of which the taxpayer is titular or beneficial owner, which is located in the United States, (b) an indication of the extent to which the taxpayer has direct or beneficial ownership in each such item of real property, or interest in real property, (c) the location of the real property or interest therein, (d) a description of any substantial improvements on any such property, and (e) an identification of any taxable year or years in respect of which a revocation or new election under this section has previously occurred. This statement may not be filed with any return under section 6851 and the regulations thereunder.

When it’s effective

It’s effective for the year that you filed, and goes forward into the future until you toggle it off.

And yes you can go back in time, file an amended return, and make it effective then.  If you are within the statute of limitations for claiming a refund, you can file this election.

Memo to all personnel

Do it.

For all of the people who were in my “Foreign Investment in U.S. Real Estate” class yesterday in San Francisco (I taught a 1-day course sponsored by the California Society of CPAs Education Foundation), here is one of the things I promised to deliver.

Tax Court Opinion

The Estate of Fung attached (warning: PDF) are from the United States Tax Court, and the affirming opinion from the Ninth Circuit Court of Appeals.

The problem, with easy math

The idea here is to describe the pickle facing heirs of a nonresident alien who has the bad judgment to die while owning U.S. real estate.

Let’s say the nonresident owns real estate and there’s a mortgage on the property.  Let’s make up some numbers.  The property is worth $5,000,000, and the mortgage is $4,000,000.  The nonresident dies.  What’s the estate tax?

Example 1:  nonrecourse debt

If the mortgage is truly nonrecourse (meaning the lender can ONLY go after the property in the event of a default, and can never go after the borrower personally), then the estate tax is calculated on the nonresident’s equity in the property, $1,000,000.

For the sake of our example, let’s say the applicable estate tax rate is 40%.  The heirs sell the property, pay off the mortgage, give Uncle Sam $400,000 ($1,000,000 equity times 40% tax rate = $400,000 estate tax), and go home with $600,000.

Example 2:  recourse debt

If the mortgage is recourse (meaning the lender has the option of going after the borrower for personal liability on the debt in the event of a default), then the estate tax is calculated on $5,000,000 — the gross value of the real estate, without deducting the mortgage.

The heir sell the property.  Pay off the mortgage ($4,000,000).  They have $1,000,000 of cash left over.  Now they tote up the estate tax on a $5,000,000 asset at 40% = $2,000,000.  Note the conundrum:  the mortgage plus the estate tax liability adds up to a bigger number than the cash on hand.  The heirs get nothing.

My God!  Is there no mercy?

Seems insane, doesn’t it?  Well, in fact there is a way to get that mortgage to help reduce the estate tax.

On the nonresident dead guy’s estate tax return (Form 706NA) (warning:  PDF) the executor will report the nonresident dead guy’s worldwide balance sheet.  (!)  Then there is some higher math involved.  The details of the higher math are unimportant for our purposes–we’re just talking concepts here.  But if you’re looking for specifics, look at the instructions for Schedule B of Form 706NA.

The idea is that since the nonresident dead guy only has U.S. estate tax on his U.S. assets, you have to do a pro-rata allocation of debt based on a fraction that looks like U.S. assets (numerator) divided by worldwide assets (denominator).

The answer is usually pretty grim.  Usually your nonresident dead guy has LOTS of assets outside the United States, and only a little bit in the United States.  This means that when you pro-rate that $4,000,000 mortgage, it’s not going to end up being all that big of a deduction from the gross estate in order to arrive at the taxable estate.

Which means that the tax savings for going through this exercise are likely to be relatively small.

And the heirs aren’t going to want to tell the U.S. government all about nonresident dead guy’s worldwide assets.  Maybe they don’t want to spend the money for accounting and legal fees to do this.  Maybe they’re just not interested in doing all of the necessary work.  But more likely it is because of a healthy desire for privacy.

Action plan

If you have a situation like this (nonresident owner of U.S. real estate, and mortgage on the real estate) first look at the loan documents very carefully, and come to a professional conclusion as to whether it is a recourse mortgage or a nonrecourse mortgage.

If you have a recourse mortgage, do a quickie spreadsheet to calculate out the value of reporting worldwide income in order to use the mortgage to reduce the size of the taxable estate.  Tell your (alive) nonresident alien investor or the (dead) nonresident alien investor’s heirs that number.  Let them tell you whether they’re willing to report worldwide assets on Form 706NA.

I’m guessing the answer is “Not!”

Thanks

Thanks to all of you who came to the course.  Please keep in touch.  Subscribe to the RSS feed here so you’ll get updates of stuff we talked about.

The IRS has a new version of Form TD F 90-22.1.  You have to use it for all filings after December 31, 2008.  More (including editorializing) later, but for the moment here is the link to the form on the IRS website.  http://www.irs.gov/pub/irs-pdf/f90221.pdf

Sorry the link isn’t prettier but WordPress is acting funny.  Couldn’t be that I’m using Firefox with all sorts of plug-ins, could it?  NoScript, AdBlock, etc. etc.

The fallout starts. Apparently 195 Germans confessed to tax evasion. There are 20 uncomfortable Australians. The United States is getting into the act and has a list of 100 American taxpayers they are looking at.

To summarize the business plan:

1. Some people figured that they could hide money, lie about it, and not pay tax.
2. They stuck the money in Lichtenstein banks.
3. Real, grown-up countries (Germany, U. K., and who knows who else in in on this), by apparent bribery, bought the services of someone who was willing to break the laws of Lichtenstein and steal bank data that revealed everything about.
4. ???
5. Profit! (For the tax collectors in Germany, the United Kingdom, the U. S., and elsewhere).

Unlike the underpants gnomes‘ business plan, THIS business plan worked.

Possible countermeasures for people like this, who are yet undiscovered:

• Jump up and down and say “It’s not right! The government can’t do illegal stuff like that!” (Response: So what? Cat. Bag. Out.)
• Sit tight and do nothing. (Response: Inevitable merely postponed. Pain handed to your kids because you won’t deal with it.)
• Run away to Panama. (Saw that happen last week for a U. S. citizen I know. He is a fugitive for the rest of his life.)
• Be a grown up and clean up your mess. (Why make a money problem into a jail problem?)

Calm down. It only applies to a small group of people (who, incidentally, are our customers). Probably not you. Who? Nonresidents have high U.S.-source long term capital gains.

The AMT rules can create alternative minimum taxable income greater than the actual capital gain. Translated into English: Imagine making $100 of capital gain in real money and having the IRS say your tax should be calculated as if you made $110.

Let’s just say that the people who wrote the Internal Revenue Code didn’t bother to synchronize the Alternative Minimum Tax rules with the rest of the Code. The explicit tax rate applicable to nonresidents is cheerfully ignored for AMT purposes.

Let’s also say that this is yet another instance the Lazy Penalty applies. Interpretation: don’t blindly using an income tax return preparation program without understanding–REALLY understanding–what is happening.

Congratulations to David Nguyen for looking at this, thinking “Hey, this ain’t right!” and figuring it out. He even went to the effort of spending quality time on the phone with the Internal Revenue Service.

The IRS has new rules in effect (”Circular 230″) Government regulations inexorably introduce bureacracy and risk-avoidance into business. A business will over time change from an entrepeneurial activity creating value for its customers into a risk-avoidance paper factory. We’re seeing a little of this happen right now in the tax realm.

After the jump you’ll find a copy of a letter that will be going out to all of our clients in the next few days. Continue reading →