by R. Scott Jones, Esq., GOLDSTEIN JONES LLP
The U.S. real estate market has arguabl y gained in investment appeal in the last twelve months or so due to the downturn in the market. Indeed, its lustre shines ever brightly for some foreign investors due to exchange rate considerations and the relatively low long- term federal capital gains rate at 15%. Even on a revenue basis, the deductibility of mortgage interest and real estate taxes (subject to Alternative Minimum Tax restrictions) is a compelling reason to buy for some foreign nationals living in the U.S. for a period of even just a few years.
Do the foreign national investors know, however, that the full value of their U.S. home could be exposed to U.S. federal estate tax rates of up to 45%! Are they aware that certain states also impose "death" taxes on assets situated within their state?
Domicile Reigns
Upon the death of one who is not "domiciled" in the U.S. (broadly defined to be someone whose permanent home is outside the U.S.) estate tax is imposed on all assets "situated" in the U.S. including but not limited to a principal residence or other real estate here. U.S. stock holdings and, if applicable, any U.S. pension or 401(k) investments may also be subject to estate tax. Estate tax definitions should not be confused with income tax treatment. It is perfectly possible – indeed common - for an individual regarded as resident for income tax purposes to be considered non-domiciled (sometimes similarly referred to as "nonresident") for estate tax purposes. So what's the issue?
What about the $2,000,000 individual estate tax exemption available to U.S. citizens and other U.S. estate tax residents (including most green card holders), and which will increase to $3,500,000 in 2009? Regrettably, foreign nationals not domiciled here do not qualify for any increase in exemption. Instead, the exemption available remains at a mere $60,000 with no legislative plans to increase the amount. Any applicable estate tax treaty between one's home country and the U.S. may help, but there are special conditions to the application of all such treaties. Moreover, notwithstanding such treaties (of which there are less than twenty, unlike the plethora of income tax treaties) in-country real estate investments often remain exposed to U.S. estate tax liability.
Ah, but what if that $1,000,000 home is fully leveraged by a full recourse mortgage (i.e. one for which you are personally liable when in default) - won't that eliminate the taxable estate? Unfortunately, no it will not. Estates of non-domiciliaries are allowed a deduction for recourse debts only to the extent of the ratio of U.S. assets to worldwide assets. So, if in addition to the U.S. home, the decedent held property and other estate taxable assets outside of the U.S. worth $2,000,000 (including life insurance proceeds), only 33% [1/(1+2)] of the mortgage would be deductible in computing the U.S. estate tax. Worse still, in order to obtain any deduction at all, the estate's executor must disclose to the Internal Revenue Service the fair market value of the decedent's worldwide assets. Such disclosure is often impractical and almost universally undesirable.
But for married persons, presumably these issues only come into play on the death of both spouses in a tragic common accident? Surely a spouse can bequeath assets to his/her spouse on a tax-free basis and avoid these problems? Once again, the 'normal' rules do not apply if the recipient spouse is a non-U.S. citizen. There is typically no escape from estate taxation via a transfer between spouses as there is no marital deduction for transfers to a non-U.S. citizen spouse. In fact, these rules apply whether the decedent spouse bequeathing the assets is a foreign national or a U.S. citizen. The rationale for the tax authorities is that, absent these rules, the estate tax deferred assets transferred to a non-U.S. citizen will leave the U.S. tax net, never to be recaptured.
The Corporate Dimension
In the international assignment context, such estate tax exposure faced by a foreign national assignee may not be his or hers alone. Many employers have international assignment tax policies in place that seek to apportion tax liabilities between the employer and the assignee. The methodologies run from laissez-faire to tax "protection" to tax "equalization" and variations thereon. The critical point here, however, is that the vast majority of such tax policies address the treatment of income, social security and other periodically imposed taxes. Generally, they do not even acknowledge transfer taxation issues, including the impact of estate and gift taxes. As remote as the possibility is, what happens if the unthinkable happens and an assignee dies while on assignment holding assets that create additional - and possibly significant - estate tax liabilities? Who is liable?
True, many employers' international assignment tax policies discourage the purchase of a principal residence in the assignment host location. However, it is unlikely that such a policy is an effective legal shield against some level of potential employer liability absent specific reference in a letter of assignment as to how such potential liabilities should be treated. An employer could very well be exposed to additional tax liabilities simply by omission. The value of coordination between employment counsel and tax counsel coupled with an effective communication strategy with assignees speaks for itself.