The United States is a singularly attractive location for real estate investors from around the world. In the past few years, Israeli investors are also showing growing interest in opportunities to purchase profit yielding real estate in the United States.
But not everybody takes into account the subject of taxes in the United States, that could, in certain cases, make the investment less profitable. This is why the following guide is dedicated to reviewing the subject of federal taxation and what it means in relation to investments in profit yielding real estate in the United States.
Why is it important to understand the significance of federal taxation when considering making investments in the United States?
The United States is a federation comprised of 50 states, which means that in the case of property tax, capital gains, and taxes in general, there could be significant differences between the requirements of the law, depending on the state the deal is made in.
To illustrate the point the tax collected on ongoing revenue made from rent money in the state of New York, is not necessarily the same as that collected in Florida. This is also true for capital gains tax collected on selling property, which tends to change from state to state and could completely affect the profitability of an investment.
Tax considerations are significant to the selection of the type of investment, the funding solutions, and the holding structure of the property which is why it is important to understand the significance of federal taxation when considering any kind of investment in the United States.
What is federal taxation?
Federal taxation is the tax that is imposed by the federal tax authority in the United States, known also as the IRS. This is the equivalent of the income tax in Israel. The federal taxation supervises the incomes of all citizens of the United States in each state as a federation.
The federal tax is also the base for the amount of income on which state tax and city tax is owed, taxes on which we will expand later. On the subject of investing in profit yielding real estate properties, it is important to know that federal tax is imposed on income made from rent as well as capital gains made from selling real estate properties, in the cases of Israelis acting as foreign investors in the United States as well.
Federal taxation and the requirement to report
The American constitution gives every federal government the authority to collect different types of taxes from the citizens and residents of the United States.
Federal taxation comes into effect in that every American resident or citizen is required to report on their income to the IRS, regardless of the question of whether or not this income was generated inside the United States or outside it. The report requirement applies and stands when it comes to a citizen of the United States or a green card holder not actively living within the United States as well.
Local taxation added on to federal taxes
When you are planning on purchasing a profit yielding property in the United States, you must consider that in addition to federal tax, the income generated from your property will most likely be taxed with state tax and city tax, as follows:
As states, each of the American federation states has its own unique tax laws. In fact, in 9 states the is no individual tax, and in some of those no corporate taxes. This is while 2 of these 9 states do have taxes on revenue from investments (accepted as interest and dividends).
Either way, when there is tax on the specific states level in the United States, it is collected from the investor in addition to federal tax, depending on the location of the property in the United States.
Besides federal tax and state tax, the United States has a city tax as well, varying from city to city. In this manner, for example, when a real estate investor purchases real estate in the city of Philadelphia which is in the state of Pennsylvania, they are required to pay a federal tax to the IRS, a state tax to the state of Pennsylvania, as well as a city tac to the city of Philadelphia.
Even though usually the tax rate is not very high in percentage, added up it come to a sum that is difficult to ignore, and especially when it’s collected on a regular basis.
The bright spot in the structure of the many tiered structure of the United States taxing system is that the taxes paid on the state and city levels, are usually deductible on the federal level, and in this way lowering the amount owed in federal taxes.
All this and more, the tax treaty between the United States and Israel allows for consideration of federal taxation and in certain cases state taxation as well, in order to prevent double taxation.
Federal taxation of income from rent
Article 7 of the tax treaty between the United States and Israel states that the first right for taxation is given to the country where the profit yielding property is located, and only after that is the country of origin of the investor allowed to tax them (residual tax rights).
The meaning of this actually is the if a citizen and resident of Israel who does not reside in the United States or is registered as an American citizen, purchases an apartment in the United States that generates income for them from rent, they will be required to pay first and foremost federal tax to the United States and only then – to the Israeli tax authority, when utilizing the tax treaty will allow the prevention of double taxation.
Since in the United States, as stated, there is state tax and city tax in addition to federal tax, derived from the location of the property, it is possible to remove different expenses that are involved in owning a profit yielding property from the total tax owing income, such as: funding expenses, deprecation, maintenance costs, management expenses, property tax payments, and the like.
The deduction of these expenses could greatly influence the profitability of the investment.
Federal taxation on capital gains from selling real estate
In the case of capital gains earned from selling real estate federal taxation will take place in the United States, as well as state taxation and in some cases city taxation as well.
Similar to the case of taxation of income from profit yielding property in the United States, here also a lowering of total taxes owed could be possible, but in this case, this has to do with the amount of time the property has been owned by the seller and the way it was handled:
- Property that was in ownership for 12 months or more:
- When the total amount of income generated is lower than the sum of 40 thousand dollars – it will be taxed at a rate of 0 percent.
- When the total amount of income generated is between 40 thousand dollars and 441,450 dollars – it will be taxed at a rate of 15 percent.
- When the total amount of income generated is over 441,450 dollars – it will be taxed at a rate of 20 percent.
- Property that was owned less than 12 months, will be taxed at the regular marginal tax rate (which are not beneficiary) that, in the United States can reach that maximum tax bracket standing at 37 percent. In addition, capital gains for a profit yielding property in the United States, on the amount delegated to deprecation, will be taxed according to a high tax bracket of 25 percent.
When it comes to capital gains from selling a profit yielding property, here also the first rights on federal tax are given to the United States, if it’s in reference to a property within its borders. This while the tax laws in the state of Israel allow the Israeli investor to receive a refund on tax paid on behalf of the property to the United States.
How can the amount of taxes owed be lowered when dealing with the United States?
One of the more popular ways to lower the burden of the tax collected in high tax rate states, is to essentially reroute the income out of the tax heavy states and into an entity outside of these states.
In this way, for example, charging a real estate project for a broker’s fee, maintenance fee, consultants fee, and other related expenses, while these services are supplied by bodies located outside of the state where the property is located – could lower the amount of tax owed.
Although, in spite of what is stated above, every case must be individually examined, and must be verified that these tax plans don’t clash with the local tax laws in the state in the United States that your investment is located in.
For individual advisement in the subject of federal tax and help in building a tax plan in the United States using professional tools – contact the team at the Mas America website for details.