Author: Hanlen Chang

The Law Offices of Hanlen J. Chang is located in San Francisco, California. Mr. Chang is a graduate of Southwestern Law School and UC Santa Barbara. Mr. Chang’s Legal Practice is focused on Estate Planning (with an international subspeciality), Business Law, and Real Estate. Mr. Chang is a member of the Bar Association of San Francisco – International Law & Practice Executive Committee.

Gift Tax: Advantage of Foreign Investment in U.S. Stocks and Bonds

One of the foreign investor’s favorite investments is U.S. real estate. However, from a tax planning perspective there are other asset categories to consider.

In the U.S. the “estate tax” refers to taxation upon death. The “gift tax” means transfer tax, and applies to gifts made while alive.

From a gift tax perspective, intangible assets such as U.S. stocks and bonds are a preferred asset.

In the U.S. the gift tax only applies to real property and tangible property. It does not apply to intangible property.

The advantage for a Non-Resident Alien (“NRA”) acquiring stocks and bonds is that it can be gifted to anyone, including other NRAs, family, or U.S. residents, all without incurring any U.S. tax liability. There may however still be a tax reporting requirement.

There is also an opportunity to avoid U.S. estate (“death”) taxation for the NRA. As long as the NRA investor holding the intangible property has advance notice and awareness of his or her failing health, he or she can gift the asset to the preferred recipient.

The NRA can also take precaution for a sudden or unexpected death. The most common solutions include life insurance and an Estate Plan, such as a Trust.

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San Francisco Bay Area Housing Supply to Remain Low For Foreseeable Future

If you were already discouraged by low housing inventory and supply in the San Francisco Bay Area, there is little reason to hope that it will improve for the foreseeable future.

Some factors include:

  • The two percent (2%) per annum Proposition 13 tax cap that encourages long term holding of California Real Estate;
  • New Federal Tax Law limiting mortgage deduction to $750,000, but grandfathering in pre-existing home owners $1,000,000 mortgage deduction;
  • New Federal Tax Law limiting State and Municipal real property tax deduction to $10,000 per year;
  • Rising Interest Rates making mortgage financing more expensive.

Other factors influencing selling v. holding include suitability as rental property and estate planning desire to pass on the real property “in kind” to your children who may inherit the pre-existing lower tax base.

In summation, why sell your home, if buying another home in the same area will significantly increase your financing costs and taxes.

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Benefits of Establishing a Business Entity Just Got Better

With the recent passage of the Tax Cuts and Jobs Act small business owners can now obtain a 20% deduction for the business income.

Common types of pass through entities include the Limited Liability Company, Subchapter “S” Corporation, and Professional Corporation.

Other considerations and advantages for establishing a business entity include:

  • Creditor and Liability Protection;
  • Declaring bankruptcy for the business;
  • Raising capital and debt financing;
  • More organized and efficient management and control for adding partners, members, shareholders, or interested parties;
  • Tax optionality and planning opportunities;
  • Credibility as legitimate and thriving business enterprise;
  • Privacy and Anonymity;
  • Dissolution and wind up of the business.

It is ill-advised to enter into an informal business arrangement with two or more members or interested parties, only to confront the inevitable complications regarding legal, regulatory, and tax compliance, profit sharing, management, and control.

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Naming a Foreign Relative as Trustee for a U.S. Trust

Introduction

In Metropolitan areas, such as the San Francisco Bay Area, it is common to have an estate planning client inquire about naming a foreign relative as Trustee or Co-Trustee.

Naming a Non-Resident Alien (“NRA”) relative as Trustee can cause the U.S. Trust to be re-characterized, for U.S. tax purposes, as a foreign trust due to the NRA’s exercise of substantial control of the Trustee powers.

If the goal is to maintain the Trust as a U.S. domiciled trust the requirements of Treas. Reg. Section 301.7701-7 of “court test” and “control test” must be satisfied.

Court Test

For this test to be satisfied a court within the United States must be able to exercise primary supervision over the administration of the Trust. There is a safe harbor if the following three requirements are met:

  • The trust instrument does not direct that the trust be administered outside the United States;
  • The trust in fact is administered exclusively in the United States;
  • The trust is not subject to an automatic migration provision described in Treas. Reg. Section 301.7701-7(c)(4)(ii).

Control Test

This test requires that one or more U.S. persons have the authority to control all substantial decisions of the trust. Treas. Reg. Section 301.7701-7(d)(1)(ii).

“Control” means “the power, by vote or otherwise, to make all of the substantial decisions of the trust, with no other person having the power to veto any of the substantial decisions.”

Tax Impact of Foreign Trust Status

Depending on the circumstances, capital gain realization may be imposed on the transfer of property to the “now foreign trust”, i.e. forced sale treatment.

One Year Period to Cure Unintended Loss of U.S. Trust Status

If a U.S. Trust becomes a Foreign Trust due to the nomination of a NRA Trustee, the Trust has 12 months from the date of cessation of U.S. Trust status to reassert U.S. status by satisfying the aforementioned requirements of the “court test” and “control test”.

Conclusion

While it is not impossible to have a NRA relative act as Co-Trustee, the NRA relative should never be nominated as sole acting Trustee.

Even if a NRA relative is nominated as Co-Trustee, the Trust terms must make clear that any tie breaking decision is made by the U.S. Co-Trustee.

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The Dangers of Naming a Foreign Relative a Co-Owner On Title to U.S. Real Property

A common occurrence is for a U.S. citizen or permanent resident to buy U.S. real estate with the assistance from a Non-Resident Alien (“NRA”) relative such as a parent, sibling, or grandparent.

Usually the initial contact person will be a real estate broker. In California, the vast majority of real estate brokers will use standard California Association of Realtor (“CAR”) forms.

It is important to know that the standard CAR disclaims  responsibility for any legal or tax advice. This obligation and risk is contractually put onto the purchaser or seller, meaning the purchaser or seller is obligated to separately consult and arrange for any legal or tax advice.

Since the real estate broker is being paid on commission, his or her main interest will be to complete the sale of the property as soon as possible. Any due diligence regarding the condition of the property, tax planning, or consideration of legal implications will be viewed by the realtor as a potential risk of causing the sale to be delayed or fall through.

One question that will have to be decided at the time of purchase is who and how to take the title to the real property. Often the NRA relative who is contributing money will want to have some control or interest and be named as co-owner to the real property.

The impact of this decision, without proper legal and tax planning, runs a significant risk of a surprise tax hit or legal claims. Depending on the objectives there may be alternate solutions to meet the objectives of the contributing NRA relative.

The best time to properly structure an acquisition or sale of California real property is prior to the acquisition, or immediately thereafter.  As one builds equity over time, the longer the wait, the higher the risk of the tax implication. Another factor is how the property is transferred, by gift or by sale, or a combination of both.

If you are a foreign investor interested in acquiring California real property, there are significant and complex tax, legal, and business cost considerations. You do not want to be caught unaware and wind up paying more money than is necessary, with less remaining for your family members.

For additional information on structuring a California real property investment, please contact the Law Offices of Hanlen J. Chang.

Additional information can also be found in this prior post.

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