US real estate markets, particularly California, reportedly cooled in the post-pandemic years. With relatively cool summer temperatures in San Diego, Los Angeles, San Francisco, and the rest of coastal California compared to the 2022 record high temperatures across Europe and Asia, will Global Warming (renamed “Climate Change” during the Bush presidency) reignite California as the premier real estate market for global investment? We believe the answer is a resounding yes. Global climate change models show coastal California as being one of the least impacted regions on the planet.
Land and building costs on a per square meter basis (or sq. ft. for the U.S.) in California are still lower than can be found in much of Europe, Japan, Canada, and other regions. As temperatures on average continue to rise across much of Africa, Southern Europe, the Middle East, and Mid and Southeast Asia, migration by necessity will move north and west. The instability in what was the former Soviet Bloc will continue to drive that migration into middle and northern Europe. Whether one is looking for a stable investment market or a comfortable residence, at least for the expanding summer months, coastal California will pop up on every international investor’s radar. As this summer demonstrated, moving to Europe might just be jumping from the fire onto the grill.
So, what does it take for a non-U.S. investor to buy and own real estate in California? The answer is a carefully planned investment structure. A non-U.S. individual investing in U.S. real estate would generally be subject to negative tax consequences, including withholding tax on rental income and distributions made outside the U.S., additional withholding tax on sale of the property, U.S. income tax on rents, and U.S. inheritance tax upon transfer of the property after death. However, if the investment is structured properly, investors can avoid withholding and inheritance taxes and minimise the income tax that would otherwise apply.
The most common non-U.S. investor structure is what is known as a “blocker” structure, which has become increasingly popular in part as a result of tax reforms in the U.S., which reduced the corporate tax rate from 35% to 21%.
This structure involves creating a U.S. corporation (the “Blocker Corp”) to hold the property. It is referred to as the “Blocker Corp” because it is used to block withholding and inheritance tax. The Blocker Corp typically has two classes of stock: voting stock owned by a friendly, but not “related” person, and non-voting stock owned by a non-U.S. entity. The non-U.S. entity is owned by the foreign investor(s). Stock of the non-U.S. entity that owns the Blocker Corp will not be treated as U.S. property for purposes of U.S. inheritance tax. Therefore, if this structure is used, death of the foreign investor will not trigger U.S. inheritance tax.
While the Blocker Corp pays taxes on its income, including rents received and gains from sale of property, once the Blocker Corp has liquidated its investments in U.S. real property, the disposition of stock after the property is sold is not treated as a sale of real property, but is instead treated as a sale of an investment security. It is, therefore, not subject to capital gains tax, unless modified by treaty between the U.S. and the investor’s country of residence.
In addition, by funding the Blocker Corp. with equity and a debt instrument, interest paid on the debt instrument can be deductible to the Blocker Corp against its rental income and exempt from U.S. income tax or withholding tax to the non-U.S. investor receiving the interest payments, unless such tax is imposed by treaty.
International investors may also consider investing in U.S. real estate through a domestically-controlled Real Estate Investment Trust (REIT). A REIT is an entity otherwise taxable as a U.S. corporation that elects REIT status and is permitted a tax deduction for dividends paid to its shareholders. A REIT is “domestically controlled” if more than 50% of the stock is owned by U.S. persons. A major advantage to investing through a domestically-controlled REIT is that the investor can sell the stock in the REIT without incurring federal income tax under the Foreign Investment in Real Property Tax Act. In addition, because the REIT is eligible for a deduction for dividends paid, it will generally have little or no U.S. federal income tax liability. However, REITS are designed for passive investors and thus provide investors with significantly less control over their investments.
Either structure discussed above can be used to mitigate the tax consequences of non-U.S. investors investing in U.S. real estate. California in particular is a desirable real estate market for both U.S. and non-U.S. investors, given its comparably mild temperatures, strong job market, and high rental demand. California is also an appealing location for real estate investment due to Proposition 13, an amendment to the California Constitution, which limits the property tax rate to one percent of the assessed value of the real property. Proposition 13 also provides that a property’s assessed value can rise by no more than two percent per year unless a change in ownership or new construction occurs. All of these factors certainly position California as a premier real estate market for global investment.
