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Tax Planning For Chinese Investors in the U.S. Real Estate Market

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As a result of the increasing inflow of Chinese capital in the U.S. economy, Chinese investors have started to see the US real estate market as a potentially profitable sector over the past few years. The investment has been as high as approximately $10 billion in various markets and sectors. A major chunk of this investment goes into the real estate market with an estimated USD 4.3 billion.

If you are a foreign investor in U.S. real estate, and need tax planning advise, please call us at 407-344-1012, or email us at info@freedomtaxfl.com.

USA’s real estate market has always been an attractive investment block for foreign investors for many years. In 2013 alone, $92.2 billion worth of real estate market out of a total worth of $1.2 trillion was held by foreign investors, making them owners of about 7% of the total real estate market share. China occupied first place then in terms of foreign sales according to the United States Dollar value; a whooping $22 billion. It still holds a significant place in the sales and purchases of real estate in the USA. The focus is on all categories of real estate; commercial, which includes offices, retail and industrial properties; residential, including houses and apartments; and hospitality, which includes hotels.

A recent survey conducted by the Association of Foreign Investors in Real Estate indicated that a majority of the participants in the mentioned survey were interested in ncreasing their investment in USA’s real estate market. As many as 81% saw USA as a potentially beneficial market for real estate investment.

Valuation Modeling Norms in the U.S.

Every country has its own norms and criteria of valuation of a property. In the U.S.A., property is valued in the following manner:

Office

Office properties are strictly considered to be suburban or classified to be a central business district (CBD) property. Investors are more likely to follow income or market approaches when it comes to the valuation of office real estate. Furthermore, for classifying the property into multi-tenant offices, the cash flow method is applied to valuate offices in this case.

Industrial

In the industrial sector, real estate can be categorized to be flex/R&D or a warehouse. The investment return is estimated by the quality of the credit and length of lease time period. The valuation approaches considered include all 3 methods but income and market approach, in most cases, is given preference. The reason behind considering all three approaches is that this sector includes build-to-suit properties too which do not have many comparables.

Retail

The categories reserved for retail real estate include:

  • Strip centre
  • In-line
  • Power centre
  • Regional mall

The property is valued on different asset class criteria and this also makes a difference in what input or assumptions can be made. This is based on the quality of the store or tenant. Though, in the end, either market or income approach is taken to valuate retail property.

Multifamily

The valuation of multifamily property depends on the affordability of the housing and the income, either high or low, as compared to the prevalent rate of the market. Since market comparables are available, the approach taken is usually market or income-based. Nursing homes and student living facilities are also often categorized in this, which they shouldn’t.

If you are a foreign investor in U.S. real estate, and need tax planning advise, please call us at 407-344-1012, or email us at info@freedomtaxfl.com.

Addressing the Tax Challenges Commonly Faced by Chinese Investors

Though the number of foreign investors interested in investing in the US real estate market is increasing, they also have to face some tax impediments. These hindrances are mostly related to US income and tax payment. Taking that into consideration, the main challenges can be identified to be:

Taxation under Effectively Connected Income (ECI) Rules

This is the catch: the profits earned through real estate transactions are taxed for non-US residents, even though gains from other sectors of business and investment are not taxed. In the case of the real estate sector, the profits are taxed under the rules and regulations of Effectively Connected Income (ECI). These gains not only include the profit earned from sale of US real estate but also include its rental income, both of which are subjected to ECI rules. The rules of ECI do not call for application of any exceptional entitlement. The non-US investors have to pay the same amount of taxes as any other residential tax payer would, with the addition of filing US federal and state income tax returns in just the same way as locals do. There is no difference in the amount or percentage of taxes to be paid under ECI policies.

Foreign Investment in Real Property Tax Act (FIRPTA)

To ensure a fair and well justified sale and rental of US real estate to foreign investors, the Foreign Investment in Real Property Tax Act (FIRPTA) has a set of strict policies that impose taxes on the disposition of US property held in the name of foreign investors. This law was enacted in 1980 and was amended in 1986 to include section 897. This section, termed as the Internal Revenue Code of 1986, treats the gains earned on disposition of US real estate as Effectively Connected Income (ECI).

Non-US Regulatory Concerns

The much interested Chinese investors also need to worry about regulatory concerns. The tax issues are ever present but matters like reporting their investments and incomes back home is also be a matter of concern for them.

Better Tax Planning for Chinese Investors

The main issue that Chinese investors face when investing money in the US real estate market is the direct investment which is subject to Foreign Investment in Real Property Tax Act (FIRPTA), also known as Section 897. What this section basivcally proposes is that any gain earned by a foreign investor on any US real estate property will be treated as any other gain earned by a resident on any US business or trade transaction. The amount of taxes paid by the foreign investor would be similar to that paid by a citizen and filing of US federal and state income tax returns would be done in the same manner as well.

Here is what the Chinese investors can do to improve their tax planning when investing in American real estate:

If you are a foreign investor in U.S. real estate, and need tax planning advise, please call us at 407-344-1012, or email us at info@freedomtaxfl.com.

Invest as a Lender

You can make a smarter move by investing in USA’s booming real estate as a lender instead of as a partner in property holding corporations. This can give you a chance to have the loan secured. The collateral does not make it a US real property interest and, hence, a non-participating loan is not subjected to FIRTPA regulations. Investors can also save FIRPTA taxation on an appreciation loan as a US real estate property is not liable under it when it comes to interest and principal amount. If the loans are deemed as debt for US federal income tax purposes, then these strategies can effectively give way for a lesser taxed investment and allows foreign investors to be a part of US real estate market

The taxation would be done in a manner which is the same as it is done when normally levied on other US property interests. A loan, by principal, is considered US real estate property interest if it participates or shares in the appreciative process of a property. If the interest is further qualified as a portfolio investment and the foreign investor is defined, they will be exempted under Code Section 892 in case of foreign government and the US tax Treaty, whichever is applicable.

Foreign Investment as Offshore Blocker

Another option Chinese investors can choose to take to lessen their tax burden is to invest as a shareholder in a domestic corporation as well as a lender to it instead of stepping into the real estate market as an equity investor. This way, your funds will be indirectly invested into the US real estate fund or the US real estate itself by the domestic corporation.

Real Estate Investment Trusts

Real Estate Investment Trust, or (REIT) in short, is a corporation that either owns or finances real estate properties that produce income. They can be a considerable option in case of tax planning for Chinese Investors. They are a good means to reduce US federal income taxation to a minimum or to completely avoid it. Once an REIT meets the requirements of tests, like asset, total income, nature of ownership and distribution, it can evade US federal income taxes which might otherwise be levied on foreign investors even though it itself would be seen as a corporation. Apart from a few exceptions, the rest of the profits from REITs will be subjected to FIRPTA laws.

If the ownership of a foreign investor in publicly traded REIT is at 5% or below, it will not be taxed according to FIRPTA regulations. They will be taxed under the regular conditions as there are for residents. The condition is also the same with 0% withholding and a period of one year calculated from the date of confirmation of the contract till the distribution date.

An REIT that has 50% of the share of stock in the name of resident owners would also be exempted from FIRPTA taxations under two conditions. These two conditions are;

  1. Five year period that comes to an end on the date of the transaction in question
  2. The period of existence of REIT

Among these two conditions, whichever is the shortest will be considered. This case of 50% ownership by US residents is called “domestically controlled” status.

Many foreign investors can also have their taxes exempted if they use private REITs as a holding unit. Though the US tax-exempt investors are able to obtain benefit from the fractions rule as well as the firm’s qualification under such a norm, they are not subjected to FIRPTA taxations.

What companies or funds might do is that they may acquire US real estate interests and hold them under REIT. This would attract foreign investors, in this case, Chinese investors. Furthermore, such an investment can be ended by the sale of the REIT by the fund holding party.

However, it must be noted that any sale of US real estate interest by the REIT will be subjected to FIRPTA taxations for non-US investors without any difference, whether the REIT has the status of being domestically controlled or non-controlled.

Some Extra Tips

Some extra things that Chinese investors must be aware of and consider include the norms and formalities regarding

  • Gift tax
  • Income tax
  • Estate tax

You can find various entity structures to minimize the taxations that Chinese investors would have to pay as a result of being foreign investors in US real property.

Planning accordingly could help them make a tax efficient investment.

Then, there are tax laws as well, which at times, may complicate situations for investors from China and other foreign countries for that matter if they are interested in making an investment in US real Estate market. They may also complicate the procedure of filing for taxes which vary across the states. Each state has its own tax filing procedures and may also have additional taxes which can further increase the burden on the investors.

Things may get complicated back home as well. Chinese investors will have to make sure that their tax planning and investments do not create problems in their home country or complicate matters when the laws from the two countries are brought against each other. In such cases, your country may give tax credits to pay taxes on US real estate interests but they also might tax you on profits. This may give rise to a double-taxation situation for you.

Chinese investors should consider the services of firms or individuals who are experienced in these matters and have a shrewd understanding of the possible complexities of taxations on investment in real estate. The taxation rates vary from country to country and state to state. The nature of business and investment also makes a huge difference. An expert who knows how the interaction of laws from the two countries would unfold, how investments may get complicated and what would be required to be done to make a sound business move and a beneficial transaction will be needed in this kind of investment.

Conclusion:

The American economy is a Greenland for foreign investors. The growth is not so drastic but still, is very strong and potentially welcoming for foreign investors, particularly the Chinese. They are growing exponentially and trying to target all the significant markets around the globe. This offers an opportunity for both, the US real estate market as well as the Chinese investors, to reach for the sky and make the most of the advantages and opportunities. However, the catch for US real estate is the inflow of Chinese capital which gives a significant weightage to the American economy. Though the American real estate market poses many challenges and has quite a number of impediments for Chinese investors, with the focus on right assets and market portions to invest in and the creation of the best suitable tax payment structures, these challenges can be overcome and many gains can be enjoyed by Chinese investors. Taxation is a complicated problem and needs to be dealt with very intelligently but once that is planned smartly, the rest of the process would be a very beneficial move for these foreign investors.

If you are a foreign investor in U.S. real estate, and need tax planning advise, please call us at 407-344-1012, or email us at info@freedomtaxfl.com.

Robert AcevedoTax Planning For Chinese Investors in the U.S. Real Estate Market

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