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 JAPANESE 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 Japanese investors in the U.S. to review their estate plans in order to take advantage of the Japan-U.S. tax treaty.

 

Background

 

Japanese investors have traditionally been major investors in U.S. real estate and, in view of Japan’s continued economic recovery, will undoubtedly increase investment in the U.S. market.  This article focuses on some of the U.S. and Japanese tax issues encountered by Japan-resident investors in U.S. real estate.

 

Both Japan and the U.S. impose income, 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, Japan and the U.S. have long ago negotiated tax treaties (the income tax treaty in 1971 and the estate tax treaty in 1954).  Although both are very “old” by today’s standards, no re-negotiation is expected anytime soon.  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 tax laws and may be invoked by the taxpayer if the treaty rule provides a lesser tax than domestic law of the taxing country.

 

Rental Income and Expense

 

The Japan-U.S. income tax treaty does not override U.S. tax rules for rental income derived from U.S. real property.  Under U.S. domestic tax law, U.S. rental income 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 graduated tax rates of up to 39.6% under the regular tax system, or if greater, 28% under the alternative minimum tax (AMT) system (these are the rates for individual taxpayers – the corresponding corporate tax rates are 35% and 20%, respectively).  Once the election is made, it can only be revoked for subsequent years with IRS consent, and the election applies to all of the investor’s U.S. real property rentals.  In addition to “ordinary and necessary” expenses (such as mortgage interest, property tax, insurance, repairs and management fees), allowable tax deductions include straight-line depreciation computed over 27.5 years for residential property and 39 years for commercial property.

 

Under Japanese domestic tax law, a Japanese resident’s overseas net rental income is subject to national tax at rates up to 50%, plus local “inhabitant” tax at rates up to 11%, with credit for foreign country income taxes paid (these are the rates for individual taxpayers – the corporate tax rate is about 48%, on average, combining national and local taxes).  The Japan-U.S. income tax treaty does not override Japanese domestic law with respect to U.S. real estate income (thus, Japanese investors do not benefit from home-country tax exemption as do investors from certain other countries, most notably European).

 

Gain on Disposition

 

The Japan-U.S. income tax treaty does not override

 

 

Gain on Disposition (continued)

 

U.S. tax rules for U.S. real estate gains.  Thus, a Japanese investor’s net U.S. real estate gain is subject to U.S. taxation under the greater of regular or AMT capital gains taxes.  Under both of these U.S. tax regimes, individual investors benefit from a reduced capital gains tax generally limited to a maximum rate of 20% for property held more than 12 months (however, gain attributable to prior depreciation is taxed at a maximum rate of 25%).  Corporation tax rates are the same for gains as for net rental income.

 

Under Japanese domestic tax law, a Japanese resident’s U.S. real estate gain is also subject to Japanese capital gains tax.  Individual investors benefit from a reduced 25% national and 7.5% local tax rates for investments held more than 5 years, but corporate investors’ gains are taxed at the same rates applicable to net rental income.  Under domestic tax law and the treaty, U.S. taxes are credited against Japanese tax on U.S. real estate income and gain.

 

Estate, Gift and Inheritance Taxes

 

Under U.S. domestic tax law, the value of U.S. assets of a nonresident decedent is subject to tax at graduated rates up to 55% after exemption of only $US60,000 (not the $US650,000 increasing to $US1 million by the year 2006 available to U.S. citizens and residents).  However, under the Japan-U.S. estate tax treaty, the larger exemption is available to Japanese resident decedents “prorated” on the basis of their U.S. assets divided by their worldwide assets.  The Japan-U.S. estate tax treaty does not provide the unlimited marital deduction only available for transfers to a surviving U.S. citizen spouse. 

 

Because U.S. estate and gift taxes apply to U.S. real estate owned directly by Japanese individuals, such investors should acquire ownership through a non-U.S. corporation instead of acquiring such property directly (or through a directly-owned U.S. corporation).  By using a foreign corporation to acquire the U.S. property, transfer of the foreign corporation shares would be U.S. estate and gift tax-free.

 

Under domestic tax law, Japan imposes inheritance and gift taxes at graduated rates up to 70% of the value of worldwide assets inherited or received by gift by an individual domiciled in Japan (after an allowance of ¥50 million plus ¥10 million times the number of statutory heirs).  The Japan-U.S. estate tax treaty provides a credit for U.S. estate and gift taxes against Japanese inheritance and gift taxes for property considered located in the U.S. under source rules provided in the treaty.

 

How Does the Tax Treaty Affect You?

 

This article considers U.S. Federal, but not U.S. state and local, income and transfer taxes.  Japanese investors in U.S. real estate should be aware of the benefits available under the Japan-U.S. income and estate tax treaties, 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) 595-5885E-Mail: doug@iTaxCPA.com • URL: http://www.iTaxCPA.com/