There are countless law firms and tax firms that are dedicated to preparation of legal entities and tax filings to assist investors who are desirous to purchase and hold rental properties in the U.S. There are nearly as many websites touting their experience assisting clients in navigating the tax and legal waters.
I am not an attorney in either the US or the UK. I am not a tax professional in the US or the UK. I AM however a licensed real estate broker in the US that has purchased thousands of properties throughout the US and who has clients from all over the world who are purchasing rental properties from me. I see the product of THEIR research, I am able to observe how THEY have structured their tax and asset protection plans, and I have had numerous conversations with tax and legal professionals in both the US and the UK on what plan is the best for different investors.
The purpose of this brief discussion is for me to lay out in simple and brief terms, and outline of tax and legal for UK investors interested in purchasing US rental investment properties. It is by no means an attempt at an exhaustive examination of these subjects but a starting point. Much like the type of starting point that one would derive from initial research on the subject with real estate professionals.
How many properties will I buy? Will I be using partners?
In my opinion this is really the starting point for figuring out tax and legal decisions. Setting up LLC’s, S-Corps, Limited Partnerships, Limited Companies, Trusts can all be very expensive. Imagine a scenario where you spend $5000 to set up an elaborate US structure for property purchases and then only purchase one property and don’t even make that in rental income! My own personal rule of thumb is around the 5 property level…. let me show you why: This is the income tax pay scale for 2014 for the US. These are the tax rates you pay AFTER deducting expenses:
Typically one of the rental properties I sell will net $400-500 a month in rental income. On average that’s $5400 a year after deducting taxes, management and insurance. Once you deduct other business expenses from that income like a trip to the US to view the property that number could quickly drop to under $4000. If you are only buying two properties, you will only be paying the US government 10% on your income. It doesn’t make sense to spend thousands and thousands of dollars setting up a huge entity structure when you are only paying HUNDREDS of dollars each year in taxes.
If your intent is to invest with a partner then I have found that most investors have already created some type of partnership in the UK. I have seen no problem with using that partnership to BUY the US property.
To understand how your taxes will work as you bring the rental income home from the US to the UK, you first need to understand the Double Taxation Treaty.
1. DOUBLE TAXATION
Double Taxation Treaties are conventions between two countries that aim to eliminate the double taxation of income or gains arising in one territory and paid to residents of another territory. They work by dividing the tax rights each country claims by its domestic laws over the same income and gains.
The US and the UK have had a Double Taxation Treaty in place for a very long time. The best way to explain how it works is by using an example.
- You buy a rental property in the US that brings in $750 a month.
- Your monthly expense are: management: $75, taxes: $60, insurance: $50 for a total of $185
- At the end of the year you have brought in $9000 in rental income and $2220 in expenses for a net of $6800
- You file a state tax return in the state you own the property (tax rate will be from 0% in states like Texas… to 5% in other states) and you file a federal tax return. The combined tax you owe is 15% (10% to the federal government and 5% to the state) so you write out a check for 15% of your net $6800 in rental income or $1020.
- You then have your UK accountant file your return in the UK. You tell him that you made $6800 but have already paid $1020 to the US state and federal government.
- He does your taxes in the UK and tells you what tax rate you owe on that $6800. If, for example, you owe $25% taxes on the $6800 then you only have to write out a check to the UK for another $680 because you already paid $1020 of it to the US governments.
- If there wasn’t a double taxation treaty in place, you would have $6800 in rental income…. pay $1020 to the US government and then have $5060 left for the UK that you would owe taxes on.
The key to having this work easily is to work with a firm in the US that understands how this process works. We have a network of accountants that can handle all of the state and federal paperwork and filings for you for only a few hundred dollars a YEAR! You will need to make sure that your US tax professional is experienced and comfortable handling the foreign rental income but for the most part this is very straightforward and very easy to handle.
In my opinion the biggest factor in determining how extensive this should be set up is by how many properties you intend to purchase. There are 3 ways that I have seen investors structure their legals and taking title:
- Sole Proprietorship – This is buying the property in your own name. There is no problem in the US with a foreign individual owning property (like there are in other countries). Your name can go on the deed as the sole owner. This is something very common that I have seen for investors buying 1 or 2 properties.
- Using a UK Limited Company to buy the US property – If you already have a Limited Company set up in the UK, it is very easy to use that company to go on the title of the property. Our US title companies are very comfortable and familiar with this structure and there is no problem with using a UK limited company to purchase this property.
- Using a US company or corporation to buy the US property – Of course any US lawyer would LOVE to charge you to set up elaborate LLC’s and LLP’s and S or C corporations to buy US properties… however in my experience until you get over 5 properties this becomes very very expensive. Attorney will us limiting liability as one of the main reasons. They may discuss the litigious nature of the US business climate. However with respect to liability, I have found that a landlord insurance policy with $1M in liability coverage is much more important to limit and protect an investor from financial hardship than any entity. This has been my experience in practice of managing thousands of properties for 10 years. I have seen a greater probability of tornado damage or earthquake damage to properties than a liability lawsuit or claim.
Here is a summary of each type of US entity that I have seen and how it generally works:
LLC: Here are the key reasons that the LLC is more appropriate than a corporation for the ownership of real property:
* An LLC that has NOT elected to be taxed as a corporation is a partnership for federal tax purposes. The members (owners) in an LLC get both the benefit of protection from personal liability and the tax benefits of partnership tax law.
* The LLC provides the protection from personal liability to all members (including managers of the LLC), like a corporation.
* The general rule of “Do not hold real property in a corporation” does not apply to LLCs. While the sale of corporate property and liquidation of a corporation can generate two levels of tax on shareholders, the LLC taxed as a partnership exposes the owners to only one level of tax.
* Partnership tax treatment does present accounting and tax challenges for an LLC, such as the deemed liquidation of the LLC in the event 50% or more of the ownership is transferred within a 12-month period. However, the passive investment nature of real estate allows for planning and thoughtful implementation of any change so that potential tax problems can be addressed. SOURCE
* S-Corp: Successful small businesses will often choose a corporate tax structure to shield it from some taxes, with the S corporation and C corporation being the most common. In an S-corp, shareholders who work for the company can be paid a salary from the company and distribute all profits between shareholders as a dividend, which would be taxed as a capital gain and not be subject to employment taxes. The S-corp structure helps investors that “flip” properties by holding them less than one year. By filing as an S-corp, the investor could pay himself a fair salary, which is subject to income tax, and distribute the rest of the corporate profits as dividends that are taxed as a capital gain. Also, an LLC can elect to be taxed like an S-corp. SOURCE
* C-Corp: Shareholders in a C-corp face potential double-taxation, as the corporation has to pay taxes on its profits, which are taxed again when shareholders receive distributions of these profits and have to report them as income. Because of this, real estate investors often choose to be taxed like an LLC or S-corp. However, the Bigger Pockets real estate blog cautions that while there are some taxes to be saved with an S-corp, it also comes with more IRS scrutiny and can make an audit more likely. Also, it can be easier for a C-corp to qualify for bank financing, because the individual’s credit history isn’t reviewed, like it would be with an S-corp. SOURCE