Capital gains tax on real estate

The Foreign Investment in Real Property Tax Act – FIRPTA

FIRPTA was enacted in 1980 to help ensure foreign nationals – who may not have other U.S. assets or economic ties – pay capital gains taxes on their profits from any real estate transactions. Although there are some exceptions, the act requires a mandatory 15% withholding of the sale price on U.S. property sold or transferred by a foreign national to another owner. This helps ensure a tax return is filed, and the IRS can collect the appropriate taxes, even when the seller is not a U.S. resident. Importantly, this 15% withholding tax still applies if the property is transferred to a family member as a gift or as part of the owner's estate in the event of their death.

Who is a foreign national for tax purposes?

Generally speaking, a foreign national is any individual who is not a citizen or resident of the United States. This definition encompasses nonresident aliens, foreign corporations, and certain foreign partnerships and trusts. Residency and identification as a foreign national is crucial for tax purposes, as it determines the applicability of FIRPTA and other tax obligations, based on a fairly straightforward "substantial presence" measure:

• Resident aliens are typically subject to tax on their worldwide income, much like U.S. citizens - including expat Americans who live abroad and never set foot in the U.S.

• Nonresident aliens, however, are typically only taxed on US-sourced income (other than non-real estate capital gains)

Tax consequences may be further complicated by domiciliary rules and the estate tax disparity

However, the U.S. Internal Revenue Service has a different set of seemingly contradictory "domiciliary" rules for estate tax purposes. For example, individuals present in the U.S. on nonresident visas (such as G-4 visas) may be considered U.S.-domiciled for estate and gift tax purposes, even though they are considered nonresidents for U.S. income tax purposes. Why does that matter? Because when the time comes to transfer U.S. assets to other family members, there's a significant estate tax disparity^.1

• Generally speaking, a U.S. citizen or foreign national domiciled in the United States gets a $13,610,000 million estate tax exemption (2024); after that amount, their estate is responsible for up to a 40% tax.^2,3

• Non-domiciled foreign nationals get just a $60,000 exemption -- and are responsible for up to 40% of estate taxes above that amount.⁴

So, for example, if you are U.S. domiciled and own a house that your son or daughter lives in with their family, your estate can typically be passed on to them without paying any capital gains or estate taxes (unless the exemption is used for other assets). However, the estate of non-domiciled (i.e., nonresident) foreign national could be responsible for capital gains, FIRPTA withholdings, and estate taxes up to 40% on the value of that house over $60,000. Again, tax rules for foreign nationals can be difficult to navigate, and your specific situation may be affected by a tax treaty or other factors. You should consult with a qualified tax professional to ensure you understand the tax implications of any real estate transaction.

Mitigating capital gains and estate taxes on real estate

Generally speaking, in the U.S., there are two categories of taxation that apply to foreign nationals' income:

1. Fixed, Determinable, Annual, or Periodical (FDAP) Income: This encompasses primarily passive income like rent, dividends, and interest income, which are typically taxed at a flat 30%. Rental income from U.S. property owned by foreign nationals is classified under FDAP, subjecting it to this flat tax rate.

2. Effectively Connected Income (ECI): Capital gains for real estate sales fall under this category, which is for income connected to a U.S. trade or business. As such, ECI allows individuals to claim certain deductions and credits, potentially reducing the impact of capital gains tax. This provision is particularly relevant for foreign nationals as it can significantly affect the net tax liability from the sale of U.S. property.

Using U.S. life insurance to help overcome the estate tax disparity

Life insurance can help minimize tax consequences and facilitate the transfer of assets to heirs because death benefit payments are generally exempt from federal estate taxes. That also means that that money is transferred to beneficiaries without going through the probate process, which can be time-consuming for a large estate. These features could make life insurance an attractive wealth-transfer vehicle for many foreign nationals with U.S.-based assets.

U.S.-denominated life insurance can provide the liquidity needed to cover potential capital gains or estate taxes without having to sell all or a portion of these holdings, helping preserve the value of an asset or property for heirs without forcing a sale.

Cash value found in permanent life insurance can provide a number of other advantages when it comes to tax and estate planning and family wealth preservation:

• Portfolio diversification and risk mitigation
  Permanent, whole life insurance builds cash value at a guaranteed rate and is among the more conservative financial products available. A policy can build US-denominated cash value⁵ that can be accessed while the policyholder is still alive, acting as a potentially effective hedge against economic downturns in one's home country, fluctuating exchange rates, and other forms of geopolitical risk.

• Asset protection
  Life insurance policies are generally protected from creditors and bankruptcy. This can provide an additional layer of protection for foreign nationals' assets.