Tax Planning for Foreign Investors
Foreign investor tax planning.
While many foreigners with investments in the US remain abroad, a good number decide to immigrate to the US to oversee their investments. Most expat/inpat guides focus on the tax implications after moving to the US, but few emphasize the importance of tax planning prior to immigrating. The US is one of the few countries that taxes its residents on worldwide income, and it’s important that foreign investors (or any immigrants) plan their finances accordingly before coming to the US.
A foreigner (or “alien”) who comes to the US on a permanent residence visa (or “green card”) or meets the substantial presence test is considered a US resident for tax purposes. The date that the alien meets the substantial presence test is the residency start date. A US resident is taxed on worldwide income on the US tax return. Consider this carefully. If you’re a resident and have a rental property in your home country, you’ll pay taxes on the rent in the US. You’ll also pay taxes on any gain from the sale of the property. Likewise, if you receive income from a foreign partnership or corporation, that income will be taxed in the US. Virtually all foreign income you earn or assets you sell abroad will be taxable in the US.
There are various forms of tax relief available to alleviate some of the effects of double taxation, such as foreign tax credits and tax treaties.
In addition to paying taxes on foreign income, the IRS requires extensive reporting of foreign assets and interests.
The objective of any foreigner intending to come to the US permanently or for an extended period of time should be to plan these tax and reporting requirements in mind.
Accelerate Gains by Liquidating Assets
If you own stock as a nonresident alien before your residency date and have gain, you may consider selling that stock and repurchasing it. This will allow you a higher basis in the stock. For example, if you own 100 shares in Acme Corp that you purchased for $500,000 and are now worth $1,000,000, you have a gain of $500,000. If you were to sell these shares prior to your residency start date, you would not be subject to tax on the gain in the US; but if sold after the residency start date, those gains would be subject to tax. If you were to sell the 100 shares in Acme for $1,000,000 and repurchase them for $1,000,000, you would have a basis of $1,000,000 should you decide to keep those shares after acquiring residency. Note that this does not apply to investments in REITs.
As a nonresident alien, you are only subject to tax on Effectively Connected Income (ECI) and FDAPI. ECI arises from operating a business in the US, gain on the sale of real property, or the sale of stock in a US corporation that invests in real estate. FDAP income is interest, dividends, rents, and royalties.
A individual who owns a privately held foreign corporation can liquidate the corporation prior to US residency to avoid paying gain. Of course, that would only be an option if the individual is no longer interested in keeping the foreign corporation active.
Another option would be to force a deemed liquidation by making an election to treat the foreign corporation as a pass-through entity such as a partnership prior to the residency date. This has the same effect as if the company sold its assets, giving it up stepped up basis.
A nonresident owning other assets with potential gain can sell an asset to a trust or family members to obtain a stepped up basis in the asset. The asset can be sold for a promissory note.
If an individual has foreign-source income that can be accelerated, such as receivables, deferred compensation plans, life insurance, annuities, or any type of periodic payments, the individual should consider receiving an advance payment or accelerating receipt of the income prior to US residency. This can also be done by selling an interest in the asset via a promissory note.
Deferring Loss Recognition and Payment of Deductible Expenses
Many foreign investors may be carrying a loss in their investment portfolios. Capital losses are deductible to US residents, so it may make sense to delay selling these investments until the residency period.
Additionally, US residents are allowed various personal, investment, and business deductions that are not available to nonresidents. It can be an enormous tax benefit to withhold payment on particular expenses until after the residency date. For example, a nonresident has an expensive surgery costing $50,000. If the nonresident pays that bill, it is not deductible on the personal tax return. However, a resident would be allowed to claim that expense as a deduction if it exceeds certain limits.
Passive Foreign Investment Companies
If you own shares in a foreign corporation and 75% or more of that foreign corporation’s gross income is passive income or 50% or more of that corporation’s assets produce or could produce passive income, then you have an investment in a Passive Foreign Investment Company (PFIC). If you own shares in a foreign mutual fund, you likely have multiple PFIC investments within that fund. Without going into detail, residents with investments in PFICs face extremely burdensome tax and reporting requirements. Unless those investments are doing excellent and worth keeping, I would highly advise anyone to sell these investments prior to US residency.
To illustrate the tax savings that can be achieved through advance tax planning, consider a simple example. A non-US citizen immigrates from UAE to the US on an investor visa. He leaves behind a residential property in UAE worth $2,000,000 that he purchased for $1,000,000. 5 years after he immigrates to the US, he decides to sell the property, resulting in a gain of $1,000,000.
As a US permanent resident, he now owes the following in taxes as a result of that sale:
- 20% capital gains tax: $200,000
- Section 988 foreign currency transaction: If there’s a foreign mortgage, he will pay a tax on any mortgage repayment gain at his marginal tax rate
In this specific example, the investor could have completely eliminated these taxes with proper planning prior to coming to the US. Even after moving to the US, he could have minimized his taxes through a Section 121 exclusion for part of the gain. Now imagine the tax burden if he were to own additional foreign assets including stock, land, partnership interest, etc. This is why tax planning is vital for anyone immigrating to the US or intending to reside in the US for more than 6 months.