Tax, Trusts & Estates Law Monitor : Estate Planning Lawyer & Attorney : Cole Schotz Meisel Forman & Leonard Law Firm : NJ, Mid-Atlantic Gift Tax & Trust Issues

It is fairly common for foreigners to invest in US real estate. Before doing so, however, they should consider the income, gift and estate tax implications of such investments and possible tax structuring (entities, trusts, etc.) to minimize exposure.

A foreigner may purchase US situs real estate directly and own the property or properties in his or her individual name, though this creates income tax reporting and withholding issues. In addition, if the foreign owner then dies, his or her US situs real estate is subject to US estate tax, often an unpleasant surprise for the surviving family members. This tax result is exacerbated because, generally speaking, foreigners do not get the benefit of a unified credit.

Example: Charles, a Japanese citizen, buys a New York City rental apartment valued at $2 million. He dies 10 years later when the property is worth $4 million. Absent other circumstances, Charles’ US situs property is subject to US estate tax. Assuming a 45% tax rate and no exemption, federal estate tax of $1.8 million will be due nine months from Charles’ date of death. New York estate tax would be additional. (Note that the federal estate tax is currently repealed, so these figures in this example apply only if/when the federal estate tax is re-enacted).

There are a number of steps that foreigners and their families should consider if faced with the situation of a foreign decedent owning US property, including:

Treaty relief.  If the US has an estate tax treaty with the decedent’s home country, the decedent may be entitled to a greater unified credit. A common treaty provision gives a nonresident alien decedent a unified credit equal to a fraction of the unified credit available to US persons. The fraction is equal to the percentage of the decedent’s US situs property over the decedent’s worldwide property. The greater unified credit permitted under a treaty can mitigate the estate tax exposure.

Post mortem QDOT.  A surviving spouse (often an nonresident alien too) can create a qualified domestic trust (“QDOT”) and transfer to it inherited US situs real estate. With a proper structure and a QDOT election in place, property passing to a nonresident alien spouse will qualify for the estate tax marital deduction. The effect of this is to defer the estate tax until the death of the surviving spouse, though it does not avoid the estate tax altogether.

Pre-death planning. There are any number of steps that could be taken prior to death to avoid US estate tax. Some common considerations include (1) annual exclusion gifts of interests in the property which will qualify for the gift tax annual exclusion, (2) transferring the real estate to a US corporation, since the shares of a US corporation – considered intangible assets whose situs is the domicile of the owner – are not subject to estate tax in a nonresident alien’s estate, or (3) transferring the real estate to another entity, the ownership of which will not be subject to US estate tax. Before taking any of these steps, the property owner should look into the income tax considerations (including FIRPTA), gift tax considerations, and reporting requirements that can be quite onerous. These approaches also should be considered for a surviving spouse’s portion of jointly owned property.

Conclusion. When a foreigner dies owning US situs real estate, the executor or surviving family members can consider a number of steps to reduce the US estate tax exposure.
 

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For the first time in almost 100 years, a federal estate tax does not exist.  On January 1, the federal estate and generation skipping transfer taxes were eliminated, but only for one year.  Click here to read about the current legislative uncertainty.

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The following letter was recently distributed to clients and friends of Cole Schotz:

Dear Clients and Friends:

Due to Congressional inaction in the final weeks of 2009, the Federal estate tax has been repealed for individuals dying in 2010 and the generation-skipping transfer (“GST”) tax has been repealed for generation-skipping transfers made in 2010. However, current law provides that the estate tax and GST tax will be restored as of January 1, 2011 with only a $1 million applicable exclusion and a $1 million GST exemption, indexed since 1998 for inflation, as compared to the $3.5 million applicable exclusion and GST tax exemption that had been in effect in 2009. The Federal gift tax remains in place (though at a lower tax rate) with a $1 million exemption and will not change except as to certain specialized trusts.

It was widely anticipated in the tax and estate planning community at large that Congress would take action before the end of 2009 to prevent this result. Therefore, virtually all tax professionals determined that it was unnecessary for clients to undertake a review of their estate planning documents prior to the end of 2009. Since Congress did not act, however, it is important for you to be aware of this situation which will likely be resolved in one of the following ways:

1. Congress could pass legislation which reinstates the estate tax and GST tax with specified exemption amounts that would be retroactive to January 1, 2010;
2. Congress could pass such legislation that would be effective as of a later date; or
3. Legislation will not be passed in 2010, in which case, there would be no estate or GST tax in effect until January 1, 2011, when those taxes would be reinstated with a top estate and GST tax rate of 55%, an applicable exclusion amount of $1 million and a GST exemption of $1 million, indexed since 1998 for inflation.

Of course, other scenarios are always possible as Congress’ action or inaction is impossible to predict. We will closely follow all discussions in Congress, review all proposed bills, and advise you when legislation has been enacted. We also will post updates to our tax blog (www.taxtrustsandestateslawmonitor.com) on these matters as they break.

While the prevailing view is that Congress will address these issues and retroactively restore the estate and GST taxes effective as of January 1, 2010, there is no guarantee that this will occur. Therefore, it is important that you are aware that the current state of the law, with repeal in place, could create unintended results as to how your assets will pass at the time of your death and could result in adverse tax consequences. Whether your particular situation is impacted and, if so, in what manner, depends on the particular wording in your Wills, Trusts and other estate planning documents and on your family and financial circumstances.

Examples of only a few of the situations that could produce unintended results include (i) an allocation of assets between the children of a current or prior marriage and a surviving spouse and (ii) an allocation of assets between children and grandchildren, where such allocations are based on tax concepts that were in effect when your Wills were executed but are no longer in effect under current law. In both of these cases, assets may be distributed in a way that you did not intend. The potential tax consequences that could result if the repeal stays in effect are literally too numerous to mention here, and must be explored on an individual basis.

Another change that applies only in 2010 relates to the tax basis of inherited assets. Under the law in effect prior to 2010 and again in 2011, the tax basis of inherited assets generally changes to the value of those assets on the date of the decedent’s death. Under the law now in effect, however, the basis in inherited assets remains the same with two limited exceptions: (i) up to a $1.3 million increase in basis will apply to assets passing to beneficiaries on a decedent’s death and (ii) up to an additional $3 million increase in basis will apply to assets passing to a surviving spouse.

Given that the potential tax and distribution impact could be significant, we suggest that you contact a member of our Tax, Trusts and Estate Department to review the effect of this change in law on your estate plan, whether or not we drafted your estate planning documents.

Best wishes for a happy and healthy new year.

Very truly yours,

Cole, Schotz, Meisel, Forman & Leonard, P.A.

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