Speaking to SMSF Adviser, Withers Bergman partner Marsha Dungog explained that with Joe Biden planning to increase the capital gains tax rate, this will have potential tax impacts for US property investments held by SMSFs.
Ms Dungog reminded advisers and trustees that Australian superannuation funds have no fixed classification under US tax laws. Consequently, when an SMSF invests in US real property, the US views it as an investment by a foreign grantor trust, which is treated for US tax purposes as a disregarded entity. The US real property asset owned by the SMSF is treated as directly held by the grantor of the trust, which would be, in most cases, the beneficial owner of the SMSF.
“Because it is more often than not treated as a foreign grantor trust which would be disregarded for US tax purposes, the real estate will be deemed to be owned by the beneficial owner of the SMSF, who would likely be an Australian resident. If that is the case, the real property will be subject to two types of US taxes when it’s sold. If they held the property for investment for more than a year, the first tax will be a US capital gains tax, which under Trump is currently 20 per cent,” she stated.
“[However], if you’re a foreign owner of US real estate, there will also be an additional withholding tax. The withholding tax is deducted from the sales proceeds of the property and remitted to the IRS by the buyer or escrow agent on closing the sale, and is meant to cover potential US taxes payable on the transaction (such as the capital gains tax in this instance).”
This tax, called the Foreign Investment in Real Property Tax Act (FIRPTA), she said, is aimed at non-US resident owners of US real estate.
“The withholding tax is meant to cover the exposure of capital gains tax, so there’s really just one tax that’s imposed. However, because the seller of the US property is a foreign person, the payment for this tax is collected by the buyer of the property or an escrow agent upon closing and remitted to the IRS. The FIRPTA rate could range from 10 to 15 per cent of the gross sales proceeds,” she explained.
There is a potential for over-withholding in these types of transactions, she said, because the capital gains tax is imposed on the gain recognised from the sale, whereas the FIRPTA tax is applied to the gross sales proceeds. In order to claim FIRPTA withholding tax remitted to the IRS, foreign sellers would need to file a US tax return to get a refund of what has been overpaid, she said. This would, in turn, require that foreign sellers have a US tax identification number or ITIN.
“Of course, Biden has proposed a top capital gains rate of 39.6 per cent for taxable incomes in excess of US$1 million. So it’s really a big thing because you’ll no longer have the benefit of a lower capital gains rate of 20 per cent under the Trump administration,” she cautioned.
Ms Dungog also noted that while qualified investment opportunity zones, which a lot of foreign investors like to invest in, have an exemption from capital gains tax where the property is held for a certain period, it is not clear whether they are exempt from FIRPTA withholding when the property is ultimately sold. In theory, one should be able to file an application with the IRS for a waiver of the FIRPTA withholding if the transaction giving rise to the capital gains tax is a non-recognition transaction from a US tax perspective.
The Biden win will also have implications for the estate tax exemption amount, she said, as the exemption threshold will drop below the current $11.58 million to $3.5 million, which was the exemption amount in 2009. This means that estates valued in excess of the exemption threshold in the year of death would be subject to US estate tax at 40 per cent rate.
Ms Dungog pointed out, however, that the full $11.58 million exemption amount, which sunsets in 2026 or possibly sooner, is only available to US citizens and those who are considered US-domiciled. Foreign persons with US-situs assets such as US real property have potential US estate tax exposure on the fair market value of such assets in the year of death.
However, estates of foreign decedents may be able to claim a portion of the estate tax exemption amount available to US citizens if there is an estate tax treaty between the US and their home country which provides for a pro-rata portion of the US estate tax exemption amount. Otherwise, the maximum credit that can be claimed to offset the estate tax amount under US domestic tax laws is US$60,000. It is important to note that the foreign estate must file an estate tax return to claim either the pro-rata portion of the US exemption amount under the tax treaty or the $60,000 credit.
The benefit of having it in an SMSF, she said, is that if the property is kept in the fund, it may not trigger the US estate tax if the SMSF has made an election to be classified for US tax purposes as a foreign corporation. Absent this election, an SMSF that is treated as a foreign grantor trust for US tax purposes risks exposure to US estate taxes when the beneficial individual owner of the SMSF dies. Of course, if the beneficial owner of the SMSF is a US citizen, the assets in the SMSF can avail of the full US estate tax exemption amount available to US citizens in the year of death.
“However, if foreign beneficiaries inherit the US real property and US estate taxes have not been paid on it, both the executor and beneficiary would be personally liable, there is still potential for the estate tax to come up in that context,” she warned.
Further, if no estate tax return is filed, then the beneficiaries of the foreign estate will have zero basis in the inherited US-situs real property (even if there is no estate tax owing).
“This can be problematic for beneficiaries who would like to sell inherited US-situs real property later on, because with zero basis they will not only lose the ability to take depreciation but also bear the full brunt of the appreciation in the US real property from the date of death to the subsequent sale date (which, again, would be likely subject to FIRPTA withholding if held directly by the foreign beneficiary).”
