As foreign investors energize South Florida’s current real estate boom, many of these investors, as well as developers and property owners, are adopting a variety of effective legal solutions to an array of banking and tax challenges.
Some challenges to the developer are common to any property transaction. Will the investor come through with the funds? What happens if additional capital is needed? How are emergency decisions made? Where and how are disputes resolved? With foreign-based capital sources, meeting these challenges requires extra security measures and legal creativity to accomplish all parties’ goals.
Other obstacles are specific to the source of money itself. U.S. banks are reticent in lending to some types of projects in which foreign funds are the primary equity driving the project. Regulatory requirements under the Bank Secrecy Act and USA Patriot Act add a higher burden for loan approval and ongoing mandatory reporting that many regional and local institutions are unwilling or not staffed to undertake.
Federal Deposit Insurance Corp.-supervised institutions must formally incorporate a customer-information program and customer due diligence into their written board-approved anti-money laundering program. With proper advice and professional assistance, these hurdles are not insurmountable, but can delay the closing of a loan and the investor’s ability to move funds into the US.
The investors also face their own issues. Deals often are presented by “promoters” who are not licensed Florida brokers and have no experience in real estate due diligence. Investors do not always seek or get appropriately knowledgeable and experienced accountants or legal counsel. As a result, the foreign investors are unaware of the potential tax risks imposed by deal structures or methods of moving funds from their home countries, or particular legal requirements for projects such as condominiums, hotels or timeshares.
Properties that are considered “foreign-owned” are subject to additional limitations under the Foreign Investment in Real Property Tax Act, or FIRPTA. A buyer must withhold 10 percent of the sale price for the IRS to ensure that U.S. taxes are paid on the sale of a foreign-owned property. This obligation also indirectly impacts a project loan by reducing the maximum loan-to-value ratio to account for withholding of 10 percent of the purchase price on a sale, reducing the amount available to satisfy the loan. As with the other risks mentioned, creative deal structuring can avoid this concern.
In addition to the FIRPTA rules that apply with respect to foreign persons buying and selling real property located in the United States, significant issues exist for such foreign persons when it comes to both U.S. income and estate taxes. While certain structures for purchasing and holding real estate may be beneficial for U.S. estate tax purposes, such structures often result in increased U.S. income taxes upon the ultimate disposition of the relevant real estate. The converse of this is also true in that certain structures that are beneficial for U.S. income tax purposes may not be the best option when it comes to U.S. estate taxes.
As real estate located in the U.S. is viewed as a “U.S. situs” asset for U.S. estate tax purposes, a foreign individual who dies holding U.S. real estate in his/her individual name can be subject to U.S. estate taxes at rates up to 40 percent with only the benefit of a $60,000 exemption (unlike the current $5.34 million exemption afforded U.S. persons). This can result in an extremely large estate tax liability as such tax is determined with respect to the fair market value of the property at the time of death rather than just the appreciation since purchase. On the other hand, if an individual were to sell such real state prior to his/her death, he/she can often receive the benefit of the reduced long-term capital gains rates in the same manner as a U.S. person, if the property is held for more than one year.
In an effort to avoid the potentially harsh U.S. estate tax regime relating to foreign persons, offshore corporations are often formed by foreign buyers of real estate which, either directly or indirectly via a wholly owned U.S. corporation, purchase and hold the real estate. If structured properly, this mechanism can help to avoid both U.S. estate taxes as well as the FIRPTA rules discussed above, but the use of a corporation eliminates the availability of the reduced individual capital gains rates and subjects all gain to regular corporate tax rates.
Numerous other structures outside of individual or corporate ownership exist as well as other techniques for reducing U.S. taxes, but these must be evaluated on a case-by-case basis. Consequently, it is important that foreign purchasers of U.S. real estate consult with qualified counsel to discuss their goals and personal situations prior to closing on the purchase of any real estate in the U.S., as structuring the purchase of U.S. real estate is not a “one size fits all” proposition. Many factors will determine the best structure for a particular buyer, including the buyer’s age, intended use and holding period, risk profile, desire for anonymity with respect to the U.S. tax system, and country of origin (as an applicable tax treaty may apply).
Where will the South Florida real estate market be three years from now? Even economists are reticent to guess, but one thing is certain. Foreign real estate investment in South Florida is here to stay and should be welcomed for the long-term health of our economy. Smart planning can help both local and foreign developers, property owners and investors manage the risks and opportunities.