Foreign Investors interested in acquiring California Real Estate are well advised to consider the costs, tax, and legal liabilities in addition to other return on investment considerations.
Transaction Costs Related to Acquiring and Selling Real Property
First, there is the cost of acquiring the real estate property, usually through a qualified real estate broker or real estate attorney. Usually the real estate broker charges a commission of 6%. If both the buyer and seller are represented by a broker it is divided 3% each. A real estate attorney on the other hand will charge by the hour, but depending on the size and complexity of the real estate transaction will be more qualified to handle the necessary due diligence and contract negotiations. Another major advantage is the confidentiality of the attorney-client relationship which is unavailable with real estate brokers.
Federal Income and Capital Gains Tax
Under the Foreign Investment in Real Property Tax Act ("FIRPTA") the federal tax liability on rental income from real property sale will either be a 30% withholding tax for a passive foreign investor (e.g. a net lease) or the ordinary progressive rates if effectively connected with the conduct of a trade or business in the United States. In the majority of cases it is more beneficial to elect taxation as an effectively connected business as it permits tax deductions, the most common being the depreciation deduction. Foreign real property investors are also advised to consult their country's bilateral Tax Treaty to determine if it prescribes any tax rate reductions. Regarding any federal capital gains tax obligation from the disposition of the real property, the buyer from the foreign property owner is charged with withholding 10% of the net proceeds. The state of California separately subjects the foreign property owner to a withholding tax of 7% from any rental income and at a minimum tax of 3 1/2 percent from the net proceeds upon any sale. The withholding tax is a prepayment which may be higher or lower than the ultimate tax liability. The withholding agent is usually the property management company for the rental income and the escrow company for any net gain upon sale. California taxes all income and capital gains based on the progressive income rate schedule which can reach up to 12.3 percent for an individual or pass through corporation which is in addition to any federal income and capital gains tax liability. The California Tax Franchise Board ("FTB") only gives limited recognition to any U.S. Tax Treaty and only applies the Tax Treaty within the context of Effectively Connected Income ("ECI"). Specifically, California will look to the doctrine of "Permanent Establishment" to determine if the foreign property owner is engaged in U.S. business or trade. For example, if a foreign property owner owns an apartment complex or hotel, it will unquestionably be deemed a permanent establishment and subject to California tax even if U.S. Tax Treaty indicates a reduced rate. On the other hand, if a foreign property owner holds an interest in a California storage facility which is used as a hub for international trade it may well not be ECI.
U.S. and County Transfer Tax
The I.R.S. imposes a gift tax (subject to annual exclusion of $14,000) on all transactions involving U.S. based real property. For example, if a foreign property owner transfers all or part of his interest in California real property to another non U.S. tax payer, upon recording the ownership change with the County Recorder's office, the transferor will be subject to a federal gift tax equal to the net proceeds based on a fair market value exceeding $14,000. Presently there is no gift tax imposed in California. In addition, the County in which the real property is located will charge a document transfer tax (fee) which is due upon change of ownership. The maximum allowable rate is 55 cents per $500 of assessed property value, less any liens and encumbrances.
County Property Assessment Tax
The County also collects an annual real property ad valorem tax not to exceed 1% based on the value at time of the purchase with annual increases restricted to an inflation factor not to exceed 2% per year. Property owners need to be extra careful when transferring all or part of the real property interest. A transfer to a non-exempt individual will result in an increase in the annual real property assessment tax.
Upon passing away, foreign real property owners are subject to the U.S. estate tax. There is a limited credit of $13,000 (amounting to an exemption of $60,000) with an estate tax of 40% on any amount in excess. Presently California does not impose an estate tax.
Risks of Lawsuits and Zoning Regulations
Foreign Investors must also be cognizant of California's more litigious environment compared to many other countries. Among the most common types of lawsuits against property owners are tenant habitability claims, personal injury claims, civil rights discrimination claims, and environmental hazard claims. Given these risks, Title Insurance, Property Insurance, General Liability Insurance, and property management services are indispensable. Due diligence is also required to ensure that local zoning regulations will permit the investment real property to be used as intended.
Home Country Tax on Foreign Property Ownership
Before acquiring any interest in California real property, the foreign investor has to consider the tax obligation in one's own country. Real property is a unique class of investments, often viewed as passive in nature, and may not be considered part of tax advantaged international trade. Also, if there is no U.S. Tax Treaty, extra consideration must be given to any potential double taxation and availability of foreign tax credits.
If you are a Foreign Investor interested in acquiring California Real Property, there are significant and complex tax, legal, and business cost considerations. For additional information on structuring a California real property investment, please contact the Law Offices of Hanlen J. Chang.
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