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Foreign Residence? Don’t Lose Your Tax Benefits

Part III: Disregarded Entity – Corporate Ownership Destroys Tax Benefits For Foreign “Principal Residence”

Parts I and II of this blog post explored the basics of a so-called “disregarded entity” and how it is sometimes used in tax planning. 

I have often seen expatriates owning real property in foreign countries through a corporate structure. This structure is often used even to hold the principal residence. Limiting liability is not really a motivating factor with a property when it will be used as a residence (as opposed to being rented).  Rather, this structure may be put in place for obtaining a tax advantage in the foreign country or in an attempt to try and avoid application of the Sharia laws of inheritance that might apply to real property located in a Muslim jurisdiction. Whatever the reason, understanding the US tax consequences of this decision must be carefully considered and proper planning must be undertaken to take into account the US tax issues. 

As discussed in the last blog post, for example, the benefit of low capital gains tax rates can be lost when a US owner holds a property through a foreign corporation. In addition, this structure can destroy the opportunity to exclude gain on sale of a principal residence or use mortgage interest deductions.

Excluding Gain on Sale of Foreign Residence

As discussed in one of my earlier blogs here, Section 121 of the Internal Revenue Code allows for the exclusion of up to $250,000 in gains ($500,000 for married couples filing a joint return) arising from the sale of a “principal residence,” if certain requirements are met.  One of these requirements is that the principal residence be owned and used directly by the taxpayer.  When a property is owned by a corporation instead of an individual, the “use” test cannot be satisfied since the corporation-owner cannot live in the residence.  Selling property that is owned through a corporation, even if it meets all other criteria of a principal residence, means being unable to take advantage of this significant exemption. 

Mortgage Interest Deductions

Certain interest that is paid on “acquisition” or “home equity” indebtedness with respect to any “qualified residence” can be deducted for US income tax purposes.  In order to obtain the deduction, the law requires among other things that the debt relate to the taxpayer’s “qualified residence.”  A qualified residence is generally the principal residence of the taxpayer and one other residence owned by the taxpayer (e.g., a vacation home).  Ownership by a foreign corporation, rather than the individual, would preclude meeting the requirements for taking interest deductions. 

By “checking the box” (CTB) on Form 8832 – Entity Classification Election, it is possible for a corporation with a single owner to be treated as a Foreign Disregarded Entity, FDE, for US income tax purposes.  Utilizing this option enables the property the corporation holds to be taxed as if the individual owned it directly – thus allowing the taxpayer to benefit from the mortgage interest deductions and the exclusion of gain when the residence is sold.  For example, by checking the box, the individual will both “own” and “use” the property as his principal residence.  Provision for use of this rule is specifically granted in the relevant Treasury Regulations under Section 121. Please see Treasury Regulations Section 1.121-1(c) (3) (ii) Certain single owner entities

In other words, the corporate entity is completely disregarded, but only for US tax purposes. So, for example, assuming local law tax benefits would arise if the property were owned by a local corporation, these would be preserved without the deleterious US tax consequences.  In the proper circumstances, “checking the box” can truly result in the best of both worlds. Some restrictions do apply, however.   For example, certain corporations in various countries are treated as so-called “per se” corporations. These entities cannot check the box and they will always be treated as a corporation for US tax purposes. The “per se” corporations for each jurisdiction are generally listed on page 7 of the instructions to Form 8832.  

Don’t Blow the Timing

Advance planning is critical since the CTB election to have the corporation treated as a FDE must be made in a timely fashion. The election must be made on Form 8832 within 75 days of the date of formation of the corporation.  Late election relief might be possible if certain requirements are satisfied.

If the CTB election is made to treat the corporation as a FDE, the US person must file Form 8858, which is also a complex tax form.

 

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