US Tax Issues: Ownership of Real Property Abroad

When purchasing a real property overseas, there are situations when it may prove advantageous or even necessary to do so through an offshore corporation, rather than owning the property individually. It is crucial to understand that this can also have significant US tax consequences for US persons. Fortunately, “checking the box” on Form 8832 provides a possible solution to this problem, taking advantage of the protections provided by the corporate entity while avoiding many of its tax repercussions.

Benefits of Corporate Ownership

Investment in real property through a vehicle offering limited liability, as opposed to direct ownership, offers numerous protections. Should any legal claims arise, such as in the case of tenant injury when renting out property owned through a corporation, the liability of a shareholder will be limited to their share of the corporate assets.

If, for example, a shareholder owns 35% of a corporation and the corporation is sued but cannot pay the debt, the shareholder may lose his entire 35% investment since the corporation’s property will be used to satisfy the debt owing. If debt is still owing to the injured party after the corporate property is fully liquidated, the shareholder’s personal assets remain safe.

Piercing the Corporate Veil

Courts in common law countries will generally treat a corporation and its shareholders as separate legal entities. Shareholders are not held personally liable for any actions a corporation may undertake or any debts it may incur, and their liability is limited to their stake in the corporate entity.

It is very important to note that this is not always the case, however, and under certain circumstances courts have been known to “pierce the corporate veil” and hold a corporation’s directors or shareholders personally liable. This is most often done in the case of close corporations with a small number of shareholders, where serious misconduct has occured and it is deemed that the corporate entity was formed primarily to abuse the protections it provides. Gross undercapitalization of a corporation, the absence or manipulation of its records, or individual shareholders treating company assets as their own are some situations where courts may put aside limited liability.

Owning Real Property in the United Arab Emirates

Laws in foreign countries may create additional risks associated with direct ownership of property. For example, those looking to purchase real estate in the United Arab Emirates often raise concerns regarding Article 17(5) of UAE Federal Law No. 2 of 1987, which states that “The law of the United Arab Emirates shall apply to wills made by aliens disposing of real property located in the State.” While these laws remain open to interpretation, this potentially allows UAE Sharia law to take precedence over a person’s will regarding the disposition of his realty. Under Sharia law, only one-third of an estate may be allocated as the owner sees fit. Purchasing real estate through a combined UAE and non-UAE corporate structure may possibly avoid these potential issues.

Tax Consequences – CFCs and PFICs

Corporate entities set up for the purpose of owning foreign real estate run the risk of being classified as a “Controlled Foreign Corporation” (CFC) or a “Passive Foreign Investment Company” (PFIC). The tax rules governing these entities are generally known as “anti-deferral” tax regimes and were enacted to prevent U.S. taxpayers from using foreign corporations to defer income taxes. Once a corporation is classified as either a CFC or a PFIC, very onerous tax consequences will follow, including very complex reporting obligations.

A foreign corporation is a CFC when more than 50 percent of its share value or voting power is controlled by US shareholders. If a U.S. shareholder controls less than 50 percent of a foreign corporation’s share value or voting power, it may instead be classified as a PFIC if one of the following applies:

i. More than 75 percent of the corporation’s gross income is comprised of so-called “passive income”;

ii. More than 50 percent of the value of its assets are held for the production of “passive income”.

Passive income generally includes capital gains, rent, interest, dividends and royalties.

Punitive Tax Rates

Whether a corporation is classified as a CFC or a PFIC, certain gains generated by the company will be taxed to the US shareholder as ordinary income. Depending on whether the CFC or PFIC regime applies, amounts can be taxed to the US shareholder at a rate up to 39.6% percent (plus a possible 3.8% Medicare surcharge also known as the “Net Investment Income Tax,” or NIIT), as opposed to the much more forgiving tax rates on long-term capital gains, which range from 0 to 20 percent depending on the filer’s tax bracket. Often (but not in all cases), the harsh bite of the anti-deferral rules will apply, directly or indirectly, to gains on sale of any real property owned by the company, and to any rental income that is not determined to be earned in the “active conduct of a trade or business,” a classification which can be very unpredictable.

In the case of a PFIC, additional taxes and compound interest charges apply in the event of disposition of the PFIC company stock or receipt by the shareholder of a so-called “excess distribution” from the corporation. While some of these consequences can be avoided by electing to treat a PFIC as a “qualified electing fund” (QEF), this carries additional accounting and reporting requirements and is not always a feasible option.

You can learn more about CFCs and PFICs in my earlier blog postings here, here, and here.

Additional information on the classification and reporting requirements of these entities can be found here for CFCs and here for PFICs.

Corporate Ownership Means Excluding Gains on Sale of “Principal Residence” is No Longer Possible

As discussed in the previous article here, Section 121 of the Internal Revenue Code allows for the exclusion of up to $250,000 in gains ($500,000 for married couples filing a joint return) arising from the sale of a “principal residence,” if certain requirements are met. One of these requirements is that the principal residence be owned and used directly by the taxpayer. When a property is owned by a corporation instead of an individual, the “use” test cannot be satisfied since the corporation-owner cannot live in the residence. Selling property that is owned through a corporation, even if it meets all other criteria of a principal residence, means being unable to take advantage of this significant exemption.

“Checking the Box” – The Best of Both Worlds

By “checking the box” on Form 8832 – Entity Classification Election, it is possible for a corporation with a single owner to be treated as a Foreign Disregarded Entity (FDE) for US income tax purposes. Utilizing this option enables the property the corporation holds to be taxed as if the individual owned it directly. In other words, the corporate entity is completely disregarded, but only for US tax purposes. The benefit of limited liability is not in any way affected by making a “check the box” election.

The election allows the taxpayer to limit their personal liability through the corporate form, and avoid any consequences that may result from personal ownership of property in foreign countries. At the same time, it avoids risking the punitive tax penalties of having the corporation classified as a CFC or PFIC. As the corporation is no longer treated as separate from its owner for tax purposes, it becomes possible to exclude $250,000 in gains from the sale of a principal residence owned by that corporation. Provision for use of this rule is specifically granted in the relevant Treasury Regulations under Section 121. Please see Treasury Regulations Section 1.121-1(c) (3) (ii) Certain single owner entities.

Some restrictions do apply, however. For example, certain corporations in various countries are treated as so-called “per se” corporations. These entities cannot check the box and they will always be treated as a corporation for US tax purposes. The “per se” corporations for each jurisdiction are generally listed on page 7 of the instructions to Form 8832.

As mentioned earlier, a corporation must have a single owner to be treated as an FDE. Married couples will have to list a company in only one of their names, or they can form two corporations owned separately by each spouse, with each corporation owning 50 percent of a property. There is also a time restriction, as the Form 8832 election must generally be made within 75 days of the date of incorporation. Lastly, FDEs can have complicated reporting requirements. If you elect to treat your company as an FDE, then you must file Form 8858. More information on this form can be found here.