Dear Friends, Colleagues, and Clients,
You decide to purchase a second home outside the U.S., a place to bring your friends and family for special occasions and holidays. Many countries preclude foreigners from holding title to the real estate directly, so your local realtor advises you to take title in a trust. If this is, or could be, your situation, please read on.
In March of 2010, Obama signed into law the Hiring Incentives to Restore Employment Act (“HIRE Act”), which I wrote about in a previous Client Alert. The HIRE Act includes a new set of provisions known as the Foreign Account Tax Compliance Act (“FATCA”). You will begin to see the FATCA rules applied in a myriad of ways, as its application will be far reaching.
There is a very insidious aspect of the FATCA provisions that may ensnare unsuspecting U.S. taxpayers into an income tax nightmare. Specifically, the FATCA rules apply to “foreign trusts.” The HIRE Act, from which FATCA derives its provisions, amended IRC Section 643(i) so that the “uncompensated use” of foreign trust property (e.g., yachts, planes, and vacation homes) by the trust’s U.S. beneficiary or such beneficiary’s U.S. relatives, would be considered a taxable payment to that U.S. person in an amount equal to the fair market value (“FMV”) of the use. Let’s examine how this new law will work in practice:
Let’s say you desired to purchase a beachfront home or condo in beautiful Cabo San Lucas, Mexico. Due to the current market conditions, you find a great deal on a beachfront villa and pay $2M for property worth $4M in a good market. Under Mexican law, because your property is located within 35 miles of the coast, you must take title to your property in a Mexican trust called a Fedeicomiso (a very popular vehicle for U.S. persons to own real estate in Mexico.) During the first year of ownership, you and your family spend 100 days in your beautiful villa on the sea. Assume a similar villa rents for $1000 per night.
Because your villa must be held in a Fedeicomiso or foreign trust, the FATCA provisions of the HIRE Act apply and treat your use of the villa as a “distribution” from the foreign trust. As a result, you are required to report as income, in the year you used your villa, your “uncompensated use” of the property in the sum of $100,000 ($1000/day for 100 days). Equally as nutty, each of your houseguests to whom you are related must report as income the same $1000 per day amount for each day they joined you at your villa. Assuming you and your family members are subject to a federal tax rate of 30%, every day of use will cost each of you an extra $300 per day. Moreover, if you live in a state that has adopted the HIRE Act’s framework into its own state law, you can also expect to pay additional state income tax.
IRC Section 6048(b) requires the filing of special IRS Form 3520 to report the “uncompensated use” of foreign trust property. Failure to timely and accurately file this form carries with it a penalty of up to 35% of the “distributed” amount. Thus, not only does the HIRE Act mandate that you report the extra income, it also imposes an additional penalty for failing to report that you have such a trust.
Some tax experts believe that the result described above is an erroneous interpretation of the new law, concluding that a Fedeicomiso that holds no income and only contains property held for investment purposes or for personal use by a beneficiary (nonrental property) will not be subject to these onerous rules. 1 “bright line” test as to whether the foregoing interpretation of the HIRE Act will be applied in this manner by the IRS. Until the Treasury issues regulations to clarify the HIRE Act’s application to the Fedeicomiso, or Congress passes a Technical Corrections Bill, anyone considering the purchase of Mexican real property, or anyone who currently owns property in Mexico held in a Fedeicomiso, should obtain a legal opinion from a competent tax lawyer as to the application of the HIRE Act.
The above result could not be what Congress and Obama intended when they passed this new law. This will be a big problem for U.S. taxpayers and foreign nationals who wish to purchase real estate in a foreign country where owning the property in one’s name is not permitted. Whatever you decide, don’t act without consulting a tax lawyer competent in this area.
Caveat Emptor — Buyer Beware.
1 See Blog by Don D. Nelson, Attorney/CPA, “U.S.(American) Income Tax for Expatriates, Permanent Residents and Nonresidents,” July 31, 2010.
Jeffrey M. Verdon Law Group, LLC