THE INTERNATIONAL TAX ADVISOR

by:  Douglas J. Kingston, CPA/MBA  • Mailing Address: 16443 N 59th Place; Scottsdale, AZ 85254

• Telephone: +1 (602) 595-5885 (GMT-7) • E-Mail: doug@iTaxCPA.com • URL: http://www.iTaxCPA.com/

TAX ISSUES FOR AUSTRALIAN INVESTORS IN U.S. REAL ESTATE

 

Background

 

 

Rental Income and Expense

 

 

Gain on Disposition

 

 

Estate, Gift and Inheritance Taxes

 

 

How Does the Tax Treaty Affect You?

 

 

Sample Picture

 

It is important for French investors in the U.S. to review their estate plans in order to take advantage of the France-U.S. tax treaty.

 

Background

 

Both Australia and the U.S. impose income and estate and gift taxes – the necessary ingredients for double taxation of crossborder investment.  In order to facilitate the significant economic flows between the two countries, Australia and the U.S. have had tax treaties in force for many years (income and succession tax treaties since 1954). In general, a tax treaty is a written agreement between two countries providing uniform bilateral tax rules intended to avoid double taxation. Tax treaty provisions override each signatory country’s own “domestic” tax laws and may be invoked by the taxpayer if the treaty rule provides a lesser tax than the law of the taxing country.

 

U.S. tax rules applicable to foreign investors in U.S. real estate are generally less favorable than those applicable to U.S. citizens and residents. However, certain Australian investors are entitled to special U.S. (and Australian) tax benefits under Australia-U.S. tax treaties. This article focuses on some of the more common U.S. and Australian tax issues encountered by Australia-resident individual investors in U.S. real property. The following summary of U.S. tax rules assumes President Bush will sign intact the tax-cut plan passed by Congress on 26-May-2001.

 

Rental Income and Expense

 

Under U.S. domestic tax law, rental income derived from U.S. real property  is subject to a 30% withholding tax imposed on gross rents unreduced by expenses or losses. However, U.S. law provides foreign investors the option of timely filing U.S. tax returns and electing “net basis” taxation at regular rates up to 39.6% decreasing to 37.6 % by 2004 and 35% by 2006 (or, if greater, alternative minimum tax “AMT” rates up to 28%). Once the election is made, it can only be changed with IRS consent, and the election applies to all of the investor’s U.S. rental activities. Allowable tax deductions include related expenses and straight-line depreciation computed over 27.5 years for residential real property and 39 years for commercial real property. The Australia-U.S. income tax treaty provides no U.S. tax relief for real property rental income.

 

Under Australian domestic tax law, overseas net rental income of an individual resident and domiciled in Australia is subject to graduated tax at rates up to 47% with credit for U.S. income taxes paid. An Australian withholding tax liability of 10% may arise in respect of interest paid by an Australian resident to a non-resident lender (this includes mortgage interest paid to a U.S. lender). The Australia-U.S. income tax treaty does not exempt U.S. real estate rental income from Australian income tax as do several other countries’ treaties with the U.S.

 

Gain on Disposition

 

The Australia-U.S. income tax treaty does not override U.S. tax rules for gains derived from disposition of U.S. real property interests. Thus, an Australian investor’s net U.S. real property gain is generally subject to U.S. capital gains taxation under the regular tax or AMT rules. Taxable gain is computed based on original cost without adjustment for inflation. U.S. gains tax is limited to a maximum rate

 

Gain on Disposition (continued)

 

of 10% or 20% for property held more than 12 months (gain attributable to prior depreciation is taxed at a maximum rate of 25%). The 10% rate drops to 8% for dispositions after 2000 for property held more than 5 years. The 20% rate drops to 18% for dispositions after 2005 for property acquired after 2000 and held more than 5 years (a special deemed-sale election is available for tax year 2000 to qualify pre-2000 acquisitions for the 18% rate for post-2005 dispositions).

 

Under Australian domestic tax law, capital gains tax (CGT) applies to property acquired after 19-September-1985. For assets held at least 12 months, taxable gain is computed excluding 50% of the gain (or taking into account the original cost of the property adjusted for inflation to 30-September-1999 for property acquired before that date). Net gain is generally subject to a maximum tax rate of 24.25% with credit for U.S. income taxes paid. The Australia-U.S. income tax treaty does not include the favorable “exemption with progression rule” found in several other countries’ treaties with the U.S.

 

Estate, Gift and Inheritance Taxes

 

Under U.S. domestic tax law, the value of U.S. assets of a nonresident decedent or donor is subject to tax at graduated rates up to 55% (50% beginning 2002 gradually reduced to 45% in 2007) after exemption of only $US60,000 (by contrast a U.S. citizen or U.S. domiciled decedent is entitled to much larger exemption of $US675,000 increasing gradually from $US1 million in 2002 to $US3.5 million in 2009). Since the 1988 enactment of a harsh U.S. tax law change effecting both U.S. and foreign decedents, surviving spouses who are not U.S. citizens do not benefit from the unlimited marital deduction available to U.S. citizen surviving spouses (unless a special purpose “qualified domestic trust” is formed). The Australia-U.S. estate tax treaty increases the $US60,000 exemption by allowing a pro-rata portion of the larger exemption applicable to U.S. citizens and domiciliaries (the pro-rata portion is based on the value of the deceased Australian's U.S. estate over his/her worldwide estate). Unfortunately, the treaty does not provide any marital deduction relief for non-U.S. citizen surviving spouses. For deaths after 2009, the U.S. estate tax is repealed, a modified carryover basis applies to inherited property for income tax purposes, and the top gift tax rate is reduced to equal the top individual income tax rate.

 

Unlike the U.S., Australia does not impose an estate tax - its “estate duty” was repealed many years ago. Instead, Australia imposes its CGT which applies to sales or gifts of taxable property (but generally not to transfers at death). As a result, Australia’s estate and gift treaties with the U.S. are of dubious benefit with regard to directly-held U.S. real estate.

 

How Does the Tax Treaty Affect You?

 

This article considers U.S. Federal, but not U.S. state and local income and transfer taxes.  Also not discussed are alternatives for avoiding U.S. estate and gift taxes and probate by using a separate legal entity or entities to own U.S. real estate. Australian investors in U.S. real property should be aware of these issues and plan their investments accordingly in order to reap the maximum tax savings.

 

Douglas J. Kingston is an Arizona certified public accountant (CPA) specializing in international tax planning and compliance for U.S., Canadian, European, Latin American and Asian business and individual clients and may be reached by:

Telephone: (602) 595-5885 E-Mail: doug@iTaxCPA.com • URL: http://www.iTaxCPA.com/