Real Estate Investor in the U.S
In general, when a foreign investor invests his money in real estate in the U.S, whether for rental or sale purposes, the income from this investment is subject to tax in the U.S, since the asset is physically in the U.S and the income therefrom is generated on its soil.
The relevant taxable income is from rent, the sale of the property, in time, and its sale after its value increases.
In addition to the above, when the investor is an Israeli resident, he must also pay taxes in Israel, which taxes its residents based on their place of residence. Therefore, the investor will pay the tax in the U.S (if he is indeed subject to such tax) and will ask the Israeli tax authorities to be credited for this tax when reporting the profits of his investment in Israel and being asked thereby to pay the difference, as is often the case
Sound complicated? It certainly might be.
To understand how the U.S tax system works, we need to distinguish between several ways to structure an investment in U.S real estate, from which we could derive the relevant tax.
We would just like to note that in this article, we give a broad overview of the general principles in as a simplistic form as possible to understand the tax regime in the U.S. Due to the complexity of the matter, we recommend that you consult with experienced and skilled professionals to be given the best advice for your specific circumstances.
In addition, the numbers herein are for tax year 2022.
Main Methods to Structure an Investment in U.S Real Estate
1. Incorporate a company with other investors.
2. Incorporate a fully-owned (100%) company.
3. Purchase the property privately without incorporating a U.S company.
After choosing the desired investment structure, the property needs to be purchased.
So what is the difference between the different investment structures?
Investment Structure 1: Incorporate a U.S Company with Other Investors
[1}If you’ve decided to incorporate a U.S company, you should incorporate it in the same State in which the real-estate property you wish to purchase is situated.
As opposed to Israel, there are many different ways to incorporate in the U.S, the most common in the real-estate field (according to the circumstances of course) being an LLC = a Limited Liability Company, the shareholders of which are called “members”.
Its default is to be taxed as a partnership, which means that the company’s income flows through to its members who are taxed thereon, and not the company.
The company must prepare and file an annual tax return Form 1065 in the U.S, from which each member’s tax liability is derived.
At the end of every year, as part of the company’s tax filings, the members are all issued and given Schedule K-1 detailing that member’s income according to code.Each member is required to file a personal tax return in the U.S (Form 1040NR or 1040) according to his Schedule K-1.
Every company can choose its own tax method, but this is a complex matter we shall elaborate on in a future article.
After incorporating the company, an EIN (Employer Identification Number) must be issued.
After receiving the EIN, you could move on to purchasing the property under the company’s name.
Investment Structure 2: Incorporate a Fully-Owned (100%) U.S Company
If you’ve decided to set up a fully-owned company (LLC), with no members, then the company is defined as a transparent company that is a Disregarded Entity for tax purposes, therefore the company reports at an individual level, and tax liability is calculated without Schedule K-1 (Form 1040 or 1040NR).
However, as of 2017, the IRS requires LLCs that are wholly-owned by a foreign individual or company, to file an informative report on the company (Forms 1120+5472) every year.
If this is your chosen investment structure, you must incorporate the company (LLC) in the State in which the property is situated, and issue an EIN for the company.
After receiving the EIN, you could purchase the property under the company’s name.
Investment Structure 3: Purchase the Property Privately Without Incorporating a U.S Company.
If you’ve decided not to incorporate a company, but to purchase the property privately, you could purchase the property directly, without issuing an EIN (taxpayer identification number), since there is no company.
Even though there is no difference between purchasing a fully-owned (100%) company (LLC) and purchasing the property directly as an individual from a taxation point of view, it is generally recommended to purchase property under an LLC in order to benefit from the legal protection that a limited company enjoys in the U.S.
General Points of Emphasis:
All investment structures we described require each investor to file an individual tax return (Form 1040 or 1040NR), and the taxation method would eventually be identical in all of them, since the profit in these cases is always taxed at the individual’s level.
In order to file an individual tax return in the U.S you must be issued an ITIN (Individual Tax Identification Number) in the U.S by one of the IRS’ Certifying Acceptance Agents for this matter.
The next step – understanding the different taxes that apply to an individual
Since in all the various investment structures all income is always taxed at the individual’s level, you should be acquainted with the various types of taxes and their rates.
Type 1: Rental Income
Whether the property is managed by a management company or privately, and whether the property is held by an LLC or an individual – in any case the rental income must be included in the relevant tax return (Forms 1040, 1040NR or 1065), after deducting the property’s current expenses such as: management, cleaning, insurance, traveling to the property, service providers etc.
This all must take place under the supervision and approval of a U.S CPA.
It’s important to know that there is an additional important expense that many people forget to deduct – depreciation expenses, that must be calculated on an annual basis by a U.S CPA.
At the end of the process, the outcome is the net profit.
After additional deductions, the net profit will become taxable income and will be taxed at the individual’s level at tax rates that range between 10%-37%.
What is your tax rate?
|Taxable income||Tax rate|
|$0 – $10,275||10%|
One should remember that taxes in the U.S are progressive therefore there are additional tax rates in between these two extremes according to the taxable income level.
Type 2: Income from a Sale:
There is an age-old argument whether the profit from selling property should be classified as capital gains or ordinary income.
U.S tax courts are often required to decide on this matter, a subject we shall elaborate on in another article.
However, assuming that profit from the sale of real property is defined in the U.S as capital gains, there is a distinction between two cases:
1. Short term capital gains
If the sold property was held for a year or less, then the profit will be taxed as short term capital gains.
Meaning that it would be taxed at the same rates as though it were any ordinary income (a rate that is determined according to income level and can range between 10%-37%).
2. Long term capital gains Long term capital gains
if the sold property was held for a year or more, then the profit will be taxed as long term capital gains.
Meaning that special tax rates of 15%-20% will be imposed, while the higher tax rate of 20% will be imposed if that individual’s total income in that tax year exceeded $459,750.
If that individual’s income during that tax year did not exceed $41,675, the tax rate will be 0% (yes, you read correctly- 0%!).
That is the United States’ method to encourage investments in the country.
Please note Whether the capital gains are long or short terms, if there are accrued depreciation costs that were deducted over the years, that depreciation will be taxed at a 25% tax rate (depreciation recapture) at the time of sale, and this will be deducted from the capital gains.
If the profit was classified as profit from ordinary income, whether the activity is defined as a business activity or the sale is of a condominium, then the ordinary tax rates shall apply (between 10%-37%).
When the investor is a foreigner, the U.S tax authorities (the IRS) demand that tax be withheld at source, to secure the payment of his taxes.
Following are the main types of tax withholding:
1. Tax withholding at company (LLC) level
The company must withhold taxes on annual profits according to the following rates:
A. Long term capital gains – 20%
B. Short term capital gains / ordinary income – 37%
2. Tax withholding at the individual’s level
If there’s a management company that collects the payments from the tenants for the property owner, it might withhold taxes at a 30% rate.
If no such tax is withheld, you must pay estimated tax payments throughout the years as an individual, and it is important to consult with a U.S CPA on this matter.
3. Tax withholding after the property is sold
After a foreign investor sells property in the U.S, the buyer withholds 15% of the total sum of the sale and not of the profit.
In any event, when you file an individual tax return at the end of the year (Form 1040NR), you report the withheld taxes.
If more tax than necessary was withheld (which is often the case), the taxpayer will be given a tax refund.
Additional Taxes that Every Investor Must Know Of
Federal and Local Taxation
The above is all in respect of federal taxes, but it is important to know that also most States in the U.S charge between 3%-13% tax in addition to federal taxes – with no distinction between capital gains or ordinary income.
However, there are a small number of States that do not charge any State taxes.
Another factor that may affect a foreign investor in the U.S is Estate Tax.
If on the day of the investor’s demise he owns property or rights to a property or if he is a shareholder of a U.S company that holds an asset with a market value of over $60,000 on the day of his demise, then any dollar above that sum will be taxed at a 40% tax rate for federal Estate taxes.
There are several ways to avoid paying Estate taxes in the U.S, and a U.S CPA should be consulted on this matter.
This matter may be intricate and complex, therefore we recommend that you contact our offices and we would be happy to assist you.
Our firm has expertise regarding all aspects of U.S taxation, including preparing and filing U.S tax returns of all types.
In addition, we are certified by the IRS (Certifying Acceptance Agent) therefore we could incorporate U.S companies and issue EINs for companies and ITINs for individuals.
Our firm’s advantage and added value is its comprehensive ability to handle all of our clients’ needs from A to Z, both on the Israeli side and in the U.S.
To do so, our firm works closely with an Israeli CPA firm with an American and international orientation.
As a result, we save our client the need to run around between two separate firms and two different countries, providing a “one-stop-shop” that handles all his needs.
- This article uses the masculine form, but is of course addressed to all genders equally and without difference.
The above is not intended to convey or constitute tax advice or an opinion on any matter.
The above should not be applied in any manner to evade or defeat any penalty that may be imposed by the IRS or any other legal authority in the U.S or the payment thereof.