As U.S. real property faces unprecedented declines in value, many foreign investors have purchased vacation residences in the U.S. Non resident aliens (NRAs) owning U.S. residence need to be cognizant of the estate tax implications of such ownership and aware of the wealth transfer opportunities available to mitigate any U.S. estate taxes levied upon their deaths. One such planning opportunity, known as a Qualified Personal Residence Trust (“QPRT”), allows a NRA to exclude the value of a principal residence from inclusion within his or her U.S. taxable estate.
The federal government imposes taxes on the estate of any deceased person who is a resident of the U.S. or who leaves property located within the U.S. The estates of U.S. citizens and non-U.S. citizen residents are taxed identically under the Internal Revenue Code. For non-citizen residents the applicable exemption is now $5 million. However, for a non-resident non-citizen NRA the applicable exemption continues to be limited to $60,000. Thus, estate taxes are due when a NRA’s estate transfers U.S. situs assets above $60,000. With the applicable exemption remaining so low for a NRA, it is important to consider tax minimization strategies when real estate is involved.
NRAs are subject to U.S. gift tax only on transfers of real or tangible personal property situated in the U.S. (There are exceptions to this general rule.) One might argue that a NRA may find 2012 a strategic year to make a gift due to the diminished gift tax rate of 35%. But in fact there are ways around incurring a gift tax that can be easily employed. For instance, a NRA may convert his or her U.S. real property into an intangible asset by contributing the property to a U.S. corporation and gifting the interests in the entity. But even this seemingly straightforward strategy may have its technical drawbacks.
The good news is that NRAs can utilize many of the same basic estate planning tools used for U.S. citizens, including the QPRT. Here is how the QPRT works:
Normally if you give something away during your lifetime, a gift tax may be payable based on the fair market value at the time of the gift. But, there is an exception that applies to a gift of your personal residence. A transfer of a personal residence is taxed at only a fraction of its fair market value if it is made to a special type of trust called a QPRT. If you place your residence into a QPRT, the IRS rules allow the residence to be valued at an amount far less than its current fair market value because of your retained interest in the residence (the right to live there for a specified number of years). The longer the term of the trust, the smaller the amount of the gift, because the beneficiaries will be receiving the property at a more remote date.
Here is an example of how the trust works; Mr. Lee is a 58-year-old non-U.S. citizen who does not reside in the U.S. and who has two children. Mr. Lee purchased a U.S. vacation home in Aspen, Colorado for $1,000,000 which is appreciating at 3% a year. If we assume that Mr. Lee dies in 2042 at age 88 with no additional U.S. assets and that the tax rates in effect for 2012 remain in place for 2042, then under the current law the Aspen property will trigger estate taxes of $960,068.
To minimize this tax bite, Mr. Lee can establish a 20-year QPRT now and pay some up-front gift taxes to avoid the imposition of a larger estate tax at death. A transfer of the Aspen residence into the QPRT will generate a taxable gift of $481,390 and a present gift tax due in the amount of $149,473. Why so little? Because, it will be 20 years before title will pass to Mr. Lee’s children; and, in the interim, Mr. Lee has a retained value for use of the premises. It is this retained value that diminishes the amount of the gift. All growth in the value of the residence also escapes estate taxes. The caveat is if Mr. Lee dies before the trust has ended, the residence will be included in his taxable estate.
The QPRT is an example of a well respected estate planning strategy, but one which may not be prudent for all non-citizens as not all foreign jurisdictions recognize trust structures. Other solutions for the non-citizen homeowner concerned about U.S. federal estate taxes include having the owner purchase life insurance as a means of having a tax-free source of funds to satisfy the payment for the expected tax liability or having the purchaser finance the acquisition through non-recourse debt. If the debt is non-recourse, then only the value of the property, less the mortgage or indebtedness, need be returned as part of the value of the gross estate. If the debt is with recourse, then the full value of the property is includible in the estate, and the deduction is limited to a proportionate amount of the debt based on a ratio of the value of the gross estate situated in the U.S. to the value of the gross estate situated worldwide.