Do foreign nationals pay real estate tax?

This Article is intended to provide general information only, and should not be relied on in taking any position relative to real estate taxes. All decisions with respect to real estate taxes should be made on an individual basis in consultation with appropriate tax and legal advisors.

U.S.-based real estate can be an especially attractive investment for high-net-worth foreign nationals seeking to protect family wealth. The U.S. real estate market offers a wide range of residential and commercial investment opportunities, with robust protections for property owners – whether or not they are American citizens. However, the U.S. tax system can be quite complex and challenging to negotiate for foreign nationals involved in real estate transactions. Professional advice based on your specific situation is always recommended; this article can provide a general overview of key tax implications to consider, including:

• Your tax status as a foreign national

• The type of real estate earnings

• The tax jurisdiction – federal, state, or local

• Whether there is a tax treaty with your country of residence

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. Residency and identification as a foreign national are crucial for tax purposes, as they determine the applicability of FIRPTA (see below) and other tax obligations, based on the "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.

• Generally, nonresident aliens are only taxed on U.S.-sourced income — excluding their U.S-sourced non-real estate capital gains, for which they are not taxed. However, if a non-resident alien is present in the U.S. for 183 days or more during the taxable year, there is a 30% tax imposed on their net U.S-sourced capital gains.

If you are planning to transfer a U.S. real estate asset to a family member, real estate tax consequences can be further complicated by IRS "domiciliary rules" and the estate tax disparity: Individuals 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. This matters when the time comes to transfer U.S. assets to other family members, because 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.

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

As an example, say that you are non-domiciled and own a house in the U.S. that your son or daughter lives in. If you plan to leave them that property in your will, your estate could be responsible for capital gains, FIRPTA withholdings, and estate taxes up to 40% on the value of that house over $60,000. And gifting the property to them beforehand won’t solve the issue: gifts are taxed at the same rate and subject to the same general rules as estate taxes – and notably, are paid by the person giving the gift, not the person receiving it. (For more on this issue, see “Mitigating estate taxes on real estate capital gains” below.)

How are different types of real estate earnings taxed?

For the purposes of this article, we’ll focus on the two main types of real estate earnings: Rental income, and capital gains from the sale of a property.

Taxes on rental income

The IRS defines income from rent as Fixed, Determinable, Annual, or Periodical (FDAP) Income. These passive earnings are ordinarily taxed at a flat 30%. However, foreign nationals can choose to have this income treated as "Effectively Connected Income" (i.e., business-connected income), making a Section 871(d) election. This allows the owner to deduct expenses such as maintenance, mortgage interest income, and local property taxes, so that taxes are only owed on the net income from the property.

Taxes on real estate capital gains

While they may pay taxes abroad, nonresident foreign nationals are generally exempt from U.S. taxes on capital gains, i.e., profits on the sale of assets like stocks or a business. However, there is a notable exception for real estate. If a property has been held for less than one year, any profits are taxed as ordinary income; if held for more than one year, it is taxed at a (generally lower) long-term capital gains tax rate, which is typically 15% or 20% (but can be 0% in certain situations).

Mandatory FIRPTA withholdings on real estate transactions for foreign nationals

The Foreign Investment in Real Property Tax Act – 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 entire sale price on U.S. property sold or transferred by a foreign national to another owner – even if the property was sold for no gain or at a loss. 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.

What about real estate taxes at the state and local level?

The issues and rules discussed above relate to taxes levied at the federal (or national) level. However, taxes in the United States can be imposed at the state and local levels as well. This certainly holds true for real estate: each property is an immovable asset situated in a specific state or territory (such as Puerto Rico, Guam, or the District of Columbia)*.

A foreign national investing in U.S. real estate needs to take these local taxes into account as well. Property tax rates are generally set by each state as a percentage of a property’s assessed value, but there are wide variations from state to state, ranging from 0.28% in Hawaii to 2.49% in New Jersey², and there can also be local rate variations among different locales in the same state. While property taxes are generally the same for foreign nationals and U.S. citizens, many states with high levels of second home ownership (for example, Vermont) offer tax discounts for state residents, which effectively raises rates for non-state residents – whether they reside in New York or New Guinea.

Finally, most states impose some form of taxes on real estate transactions, ranging from capital gains taxes to things like “recording fees,” “transfer taxes,” and even “stamp taxes,” which are essentially different names for sales taxes.

A tax treaty could lower your tax liability

The United States has tax treaties with dozens of foreign countries, which can help simplify compliance and reporting rules and importantly, help foreign nationals reduce the chances of being taxed twice on the same income.

However, it’s important to note that each treaty is unique, with rules and benefits that can vary significantly. Some may cover capital gains on real estate transactions, but others may focus on earned income or estate taxes. To better understand the tax treaty implications for your situation, you should seek appropriate legal and accounting advice for the specific jurisdictions in which you reside and have assets.

Lessening the impact of estate taxes on real estate capital gains

If you own property in the U.S. that you want to transfer to a family member but are concerned about estate taxes on family wealth, consider looking into using U.S. life insurance ownership as a way to help overcome the estate tax disparity.

Nonresident life insurance can help mitigate 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 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 help provide the liquidity needed to cover potential capital gains or estate taxes and smooth the process of transferring real estate or other assets to your heirs without forcing a sale.

Permanent cash value 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.³ An individual or survivorship life insurance (couple’s) policy can build US-denominated cash value⁴ 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.⁵ This can provide an additional layer of protection for foreign nationals' assets.