The repercussions of the sub-prime crisis on real estate prices in the United States, along with the ever-increasing real estate prices in Israel, have made the American market a hub for real estate investments for many Israelis. And so, the Bank of Israel estimates that approximately 3 billion NIS will be invested by Israelis in the United States in 2020.
Have you also considered investing in real estate channels in the United States? If you have, it is important that in the early stages of examining each investment opportunity to take into account tax considerations and form a tax plan suitable for your needs. As with any investment, tax aspects and tax planning are cardinals for ensuring investment feasibility: these may decide the scales between a great success of the investment and its utter failure.
This is especially true when investing in real estate in the United States. Real estate investments in the United States are subject to several taxation channels: federal tax, state tax applicable by the country in which the property is located, the municipal tax applicable by municipal affiliation, estate tax, branch tax, and Israeli income tax. Naturally, additional taxes may apply depending on the individual circumstances of the investment. Thus, unfamiliarity with the tens of thousands of American taxation rules may risk your investment.
In the following article we will not address state and municipal taxes (important as they may be) but focus specifically on the federal income tax, the estate tax, the branch tax, and the Israeli income tax. We will address the various taxation routes while reviewing the various alternatives available to the investor.
Choosing the Real Estate Investment Structure
The importance of making an informed choice regarding the form through which the investment is organized and made is well known. The form of organization and the structure of holding the property will determine the tax burden that will be involved in the investment – different taxation will apply to an individual, foreign company, or local company. Rigorous tax planning will examine the impact of these differences on investment feasibility and will help choose the form of investment that will yield the highest profits.
Possible Holding Options when Purchasing Real Estate
Investing as an individual
Purchasing real estate directly, the buyer is a private individual who owns the property himself. An investor who does not hold U.S. citizenship will be required to file a tax return to the tax authorities using Form 1040NR.
Investing in this way does not require fee payments and filing complex company reports and thus, saves additional costs that might lower the profit. The tax thresholds that will apply to this investment are the same tax thresholds that apply to other private individuals – those tax thresholds are lower in compresence to the tax rates applicable to companies.
On the other hand, investing as an individual might require paying estate tax and of course does not provide the legal protection that companies enjoy – unlike companies, the responsibility of a private investor is not limited to the amount of the investment alone, and all of his assets are subject to claims.
Investment through L.L.C – Limited liability company
Establishing a limited liability company and making investments through it. This is a legal hybrid that combines limited liability that characterizes a company, along with total transparency in terms of taxation.
An L.L.C is not a taxable legal entity. From the tax point of view, the company is defined as transparent so that the tax liability of the company is personally direct to its owners who will pay the relevant tax as individuals or as a company, according to the case. Naturally, when a company is owned by a single individual, it will be taxed as if it is the investment of a private individual. It should be emphasized that legally, and despite the taxation transparency, the company is a separate legal entity, and therefore limits the liability of the partners to the sum of their investment in the company.
Despite the obvious advantages, there are also disadvantages in choosing this form of organizing. First, the Israeli income tax does not automatically receive the transparency in question, and as a result, a double tax may be paid, and/or no credit will be given for paying taxes in the United States. Second, an L.LC is also exposed to estate tax.
Investment through American company C-CORP
Indirect investment through a local company.
This investment will be taxed according to U.S. corporate tax rates, and because the shares are in the United States will be subject to the American estate tax. All through the 2018 tax reform has reduced the corporate tax rate, the tax rate that will apply to a private individual will usually be lower. On the other hand, investing through a local company allows for the deduction of tax liability expenses.
Investing through a foreign company
Indirect investment in real estate through a foreign company (Israeli or otherwise). This investment is also subject to companies’ taxation and is even taxed on transferring funds to foreign countries. The major advantage is an exemption from estate tax.
U.S. Taxation on Real Estate Investments Depending on the form of Investment
* The table does not refer to the applicability of other possible taxes such as the state tax, city tax, etc., but these taxes will inevitably apply as well.
If so, each of these investment types is taxed differently. We will now turn to examine the differences in taxation.
Taxation of Real Estate Investments – Current Income
American tax law distinguishes not only the various forms of holding the properties (as described above) but also between the different nature of the income: whether it is current income (reported from rents) or whether it is capital gain (profit from the sale of the assets).
When real estate generates profits from rental receipts, the investor can choose one of the two taxation routes:
- Uniform tax rate – Income from rent paid to foreign investors is generally classified as FDAP (Fix, Determinable Annual or Periodical) income, which is taxed at a flat rate of 30% of income.
- Taxing rental receipts as if they were business revenue.
The default is, as noted, a 30% tax deduction. Not only is it a very high tax rate, but in this situation, it is not even possible to deduct rental expenses from the income.
Proper tax planning will allow the tax rates to be minimized by defining rental receipts as income from a business (revenues that are effectively connected with the conduct of a trade or business, abbreviation ECI), and deducting rental expenses from them. Taxation rates on ECI income will be determined as follows:
- A private investor or L.L.C that is not held by a company – will apply the marginal tax rates applicable to an individual. These tax rates vary according to fixed income levels and usually range between 10-37%.
- In the case of an investment through a company (foreign or C-CORP) – corporate tax rates will apply to the income. After the tax reform of 2018, the tax rate is 21%.
Besides, there is a possible tax benefit for transparent taxable partnerships– L.L.C. Since the reduction of corporate tax rates under the 2018 tax reform is not relevant to L.L.C (which is transparent for tax purposes), the reform has applied a tax deduction benefit of 20% of L.L.C revenues.
An L.L.C whose income has been defined as business income, and whose partners’ joint annual revenue does not exceed $315,000, will receive a deduction of 20% of that income. A partnership with an income that exceeds this amount will receive a benefit in one of the following rates- the lower between them:
- 50% of the general work wages of the partnership employees.
- 25% of the wages paid +2.5% of the base for U.S. taxation (cost of depreciable assets).
Tax rates applicable to current income from real estate businesses
Taxation of Real Estate Investments – Profit from Selling a Property
As we said before, real estate may generate profits not only from rent but also through the profit from its sale – capital gain. The taxation on a capital gain depends on the duration of holding in the property and the structure of the holding in the investment.
Capital gains for investments made by companies – whether a local company or a foreign company – will be taxed according to the tax rates applicable to companies. The same is true for an L.L.C. company owned by a local or foreign company.
In contrast, capital gains on an individual or L.L.C. investment that is not held through a company will be taxed at the marginal tax rates applicable to individuals. If that the asset has been held by the same investor for more than one year, the tax on capital gains will be smaller: the gain on the depreciation component will be taxed at a rate of 25%, while the remaining profit will be taxed at a rate of only 15%.
The aforesaid is of course true as long as the profit is classified as capital gain and not as income. Income will be taxed as detailed above.
When it comes to capital gains from real estate, another issue to consider is the possibility of deferring capital gains tax through an exchange procedure.
Taxation on capital gain income
An estate tax is a tax that applies when transferring a person’s assets at the time of his death. The applicability of the estate tax in the United States is widespread and its rate is the highest in the world. Thus, not only Are American citizens exposed to the applicable tax but also foreign nationals. The estate tax will apply to any person – even a foreign citizen if at the time of his death he held assets in the United States exceeding the value of $60,000. This tax can reach a rate of up to 35%, an astronomical rate by all accounts. Estate Tax
This means that the amount that might be deducted by the estate tax is tremendous: even an Israeli citizen who holds real estate in the United States is subject to it and might lose a great deal of his investment. Therefore, professional tax planning is extremely important and will tailor a solution to every case, ensuring minimal tax liability.
Though investing in real estate offers significant benefits, such investments- whether done directly as an individual or through an LLC – entail monetary risks due to estate tax. In such cases when the assets will be considered as assets located within the territories of the United States and will be taxed accordingly.
Since the foreign company’s shares are considered an asset outside the United States, the estate tax does not apply to them. At the time of his death, the investor’s assets will not be subject to estate taxation. Despite this advantage, the disadvantages of investing through a foreign company must be addressed. As we explained, a foreign company will be taxed according to corporate tax rates, rates that are in most cases higher than the marginal tax rates of individuals. Similarly, a foreign company will not benefit from lower capital gains tax rates and will be subject to the applicability of branch tax when the money is passed on from the United States, and to an Israeli dividend when transferring the money to an investor in Israel.
How can we cope with such issues? Sometimes there is an advantage in using a foreign trust or life insurance, this depends on the specific circumstances of the investor and the investment. Of course, we will be happy to assist you and recommend an optimal solution for you.
The branch tax is a tax that applies to foreign companies when they want to take profits out of the company’s operating cycle. For example, when an Israeli company operating in the United States wants to divide its profits through dividends, it will have to pay in addition to the corporate tax, a branch tax.
The branch tax applies to the revenue withholding the corporate tax applicable to them. Its rate is 30% but according to the treaty Israel signed with the United States, the rate has been reduced and currently stands at 12.5%.
Branch tax can be avoided by repeatedly investing the profits and sometimes by providing a loan from the foreign company to an L.L.C s owned company by the investor. The tax is not imposed in the year the company ceases to operate, and therefore the liquidation of the company will erase the tax debt.
Income Tax in Israel on Income from Real Estate Investments in the United States
An Israeli citizen investing in the United States is taxed both in the country where the income was generated – the United States and in Israel. First, the tax will be paid in the United States, then in Israel. As a result, it is of great importance to receive a credit for the foreign tax paid in the United States.
And so, the Income Tax Ordinance states that a credit will be received for “foreign taxes” where an Israeli resident paid tax to a foreign country for income he produced in that country.
However, even here there is a certain complexity that may – in the absence of professional tax planning – result in double taxation.
Investing as an individual
When it comes to an investment by a private individual, things are relatively simple, and the applicant will be able to choose between two taxation routes:
- Marginal tax rate – taxation of income at the marginal tax rate set according to the income of the applicant. On this route, the applicant will be able to offset expenses and receive a tax credit for the taxes paid in the United States.
- Fixed tax rate – – taxation of income at a rate of 15%, without the ability to offset expenses or receive a tax credit for foreign taxes.
Investment as a C-CORP
As for C-Corp taxation, things are simple as well – the foreign corporation will be taxed as a company, which itself charges its profits following the two-step taxation system: beyond the corporate tax, when dividing the profits into Israeli shareholders, additional tax will be necessary.
Investing through L.L.C
Investment through an L.L.C is more complex.
As noted above, the law in the United States treats L.L.C taxation as transparent. However, as far as the Israeli Tax Authority is concerned, it is a regular company– the law in Israel does not recognize this association as transparent in terms of taxation. This means that in the United States the owners of the company are taxed as individuals, while in Israel it will be taxed as a corporation. Thus, the L.L.C. will be liable to pay tax only when distributing the profits to its Israeli residents, without the possibility of getting credit on the tax paid in the United States.
For years there has been a complete lack of clarity in this matter, but in the past two years, two constituent rulings have been issued on the subject – rulings that attempted to correct the asymmetry between the law in the United States and Isreal.
The court upheld the Tax Authority position that L.L.C is a corporation for all matters in terms of Israeli law, including the matter of tax liability. The court ruled that the taxpayer producing income from L.L.C. has two options:
- Defining the company as “opaque”: or then the company will be taxed only when a dividend is distributed. Under this alternative, the applicant will not be able to offset the tax he paid in the United States against the tax obligation for dividend distribution.
- Defining the company as “transparent”: The taxpayer will pay full tax for the income from the company but will be able to offset the tax paid in other countries. According to this alternative, no tax will be imposed on the application when a dividend is distributed.
The court also ruled that L.L.C companies owned by the same taxpayer, could not offset profits and losses between them.
Despite the court’s recent decisions, many questions remain open. And so, and in light of the lack of clarity in this area, the need for comprehensive and professional tax planning remains.
Real estate investments in the United States have become very profitable and are not a domain reserved solely to tycoons. Despite the feasibility of investing in the United States (due to low real estate prices, etc.), any such investment requires careful examination of taxation aspects.
The subjects addressed in this article are just the tip of the iceberg, and there is much more to learn about U.S. taxation provisions and foreign real estate investments. This is a complicated and complex taxation subject, which includes tens of thousands of provisions and rules. The routing between these instructions requires great knowledge and expertise. Lack of tax planning or inadequate tax planning can cost you tens if not hundreds of thousands of dollars and harm the viability of the transaction.
When it comes to real estate investment in the United States – comprehensive tax planning is necessary.
Our team consists of experts, who are familiar with all the secrets of American taxation. We are at your disposal and will be happy to provide counseling.