The recent downturn in US property market values combined with low mortgage interest rates has prompted many individuals to enter the real estate investment market. An investor will likely want to consider establishing a separate business structure under which to manage their real estate investments, for protection of liability and privacy. There are many different types of structures to consider, as each option has an effect on US tax for expats living abroad. Let’s take a look at a few options, under the assumption that an American living overseas is investing in US residential rental real estate.
For simplicity sake, some investors might want to avoid setting up a separate structure. From a tax perspective, this is a simple and straightforward approach. The activity of the rental real estate will be reported on the individual’s tax return, Forms 1040 and 1040NR for US residents and nonresidents, respectively. The downside to this approach is that the investor is not afforded any protection from legal action. Lawsuits or damages associated with the investment real estate could be assessed against the individual owner’s personal assets.
Limited Liability Company
The Limited Liability Company, or LLC, is the most popular entity for investment in US residential real estate. The LLC is relatively simple and affordable to establish and offers reasonable protection of liability. For LLCs with one owner, the LLC will be considered a “disregarded entity” and all of the activity will be reported on the individual’s personal US tax return. Therefore, there are no separate business taxes, nor the need for the increased accounting fees associated with a business tax return. For LLCs with multiple owners, the LLC will be considered a partnership and a Form 1065 (U.S. Return of Partnership Income) should be prepared each year to report the annual activity. The partnership will distribute a Schedule K-1 to each owner, reporting their share of net income or loss. This should be reported on their individual return. This structure may have the most beneficial effect on US tax for expats.
S Corporations are generally not recommended for US residential real estate investment for multiple reasons. While the income or loss from an S Corporation will flow through to the shareholder similar to an LLC, the shareholder’s ability to deduct the loss is limited to their basis in the company. It can also be very difficult to obtain a mortgage in the name of an S Corporation. Not everyone is permitted to invest in US S Corporations. For example, non resident aliens are excluded, as well as S Corporations and many trusts. S Corporations are required to file an annual business return. A Form 1120-S and the resulting income or loss flows through to the shareholders on a Schedule K-1.
C Corporations are considered an entity completely separate from its shareholders, so they provide great protection of liability. They offer investors the ability to control their individual taxable income by manipulating the amount and timing of distributed dividends. This can be beneficial because it allows shareholders to control their tax bracket, and tailor their income to their individual deductions/credits. One of the biggest disadvantages to C corporations is the impact of double taxation. Profits earned within the corporation are subject to taxation at the corporation level at a ~40% tax rate. Once they profits are distributed to shareholders in the form of dividends, they are taxed again at the individual level.
C Corporations are required to file an annual tax return via Form 1120. Unlike LLCs and S Corporations, the profits do not flow through to the shareholders until they are distributed as dividends.
Foreign residents investing in US real estate often find it easier to establish companies in their resident country. While this might be the best approach for foreign tax issues, it can often prompt additional US tax reporting requirements. It’s possible that by setting up a foreign company to invest in US real estate, the taxpayer could be subjecting themselves to taxation in two countries.
While foreign trusts are becoming increasingly popular mediums for investment in US real estate, they should be approached with caution. Many investment companies will market foreign trusts as a means for shifting income and assets offshore, thereby reducing taxes and increasing asset protection. While this is an attainable goal, it must be carefully planned. The IRS is very particular with regards to foreign trusts and their reporting requirements. Care should be taken to ensure that they are established in a manner that makes them worthwhile.
Choosing the type of entity under which to manage US real estate will depend upon the needs and desires of the individual investor. The above information discusses the Federal filing requirements, but state filings should also be a consideration. These will vary by state. While some states do not assess an income tax, they may make up for it with a different type of duty (franchise, commercial, property, etc).
Each entity has its own benefits. For the purposes of a small scale US residential real estate investor, we recommend the US of a US domestic LLC. They’re relatively easy to establish and affordable to maintain.
Have more questions about property types and the impact on US tax for expats?
If you would like a more in-depth look at property structures and buying property while abroad, our comprehensive tax guide is the perfect resource. If you would like us to prepare your expat tax return, please get in touch today!