Introduction

When a foreign investor considers the tax implications of an investment in U.S. real estate, it typically focuses on U.S. federal income taxes and ignores state and local taxes. There are a number of reasons for this, first and foremost of which is that the federal tax rates are substantially higher than those charged by states and localities. The maximum federal income tax rate applicable to corporate and individual investors is 35 percent. Moreover, in the case of corporations, there is a second level of tax applicable to distributions (or deemed distributions) to shareholders that is imposed at the rate of 30 percent unless reduced by tax treaty.

State and local income taxes rates, on the other hand, although they vary from jurisdiction to jurisdiction, are in most cases less than one-quarter of the federal rates. They are also deductible in computing federal taxable income, making the effective rate lower still. However, taxes on net income are not the only types of taxes that are levied by state and local governments. Some states have taxes based on gross income and still others have taxes based upon a corporation’s capital employed in that state. While almost all states have sales and use taxes which apply to the sale or use of tangible personal property therein, some states also have taxes on various types of services. Some jurisdictions also impose a tax on rents paid with respect to real estate located within their boundaries.

Another type of tax that is imposed by many states and some cities and counties is a real estate transfer or recording tax. This type of tax is typically expressed as a percentage of the consideration received in connection with a transfer of real estate.

The final major category of state and local taxes is ad valorem real estate taxes, which are imposed at specified rates against the value of real estate located within the jurisdictional limits of the particular taxing authority.

The important thing to keep in mind about state and local taxes within the context of foreign investment in U.S. real estate is that when all the different types of taxes are taken into account, the overall burden can be significant, and, perhaps more importantly, many of the categories of state and local taxes are payable regardless of whether the taxpayer is actually making a profit. It should also be noted that income tax treaties to which the United States is a party (which prescribe reduced rates of tax on certain types of income and attempt to eliminate instances of double taxation) do not typically apply to state and local taxes. A final consideration is that except for certain limitations contained in the U.S. Constitution, states and localities are not required to be uniform in their various taxing regimes. This can create both pitfalls and opportunities, but if an investor devotes some attention to state and local tax planning, it will usually be rewarded.

U.S. Constitution

The power of states and their political subdivisions to levy taxes is derived from the U.S. Constitution which confers specific powers upon the federal government and permits any powers not so conferred to be exercised by the states. The Constitution also contains certain provisions which limit the powers of both the federal and state governments. These provisions include the right to equal protection under the law as well as the right not to be deprived of life, liberty and property without due process of law. The due process clause is the principal protection against unlimited state taxation in that it requires a certain minimum level of contact between a person and a state seeking to impose a tax on that person and also requires that a state tax only that portion of a person’s activities that are fairly attributable to that state. The courts have also cited the federal government’s exclusive authority to regulate interstate and foreign commerce in limiting the exercise of state taxing power.

State Income Taxes

Just about every state imposes some type of corporate and individual income tax. The principal focus of this discussion will be upon corporate income taxes, since most foreign investors do their investing through corporations. Maximum state corporate tax rates generally range from around 5 percent to 10 percent. While income taxes are for the most part imposed at the state level, some of the larger cities, New York City being an example, impose them as well.

In order to be subjected to a state’s corporate income tax, a corporation must typically be deemed to be “doing business” therein or own income-producing tangible property located therein. The ownership of a direct interest in income-producing real estate within a particular state will almost always supply a sufficient nexus for that state to tax the owning corporation. However, the indirect ownership of such real estate, such as through another corporation, will not usually result in the shareholder corporation being subject to tax. While the corporation that actually owns the real estate will itself be subject to tax, it may be possible to reduce that corporation’s taxable income by making tax-deductible payments (such as interest) to the shareholder corporation.

Ownership of real estate through non-corporate entities such as partnerships, limited liability companies (LLCs) and trusts presents more complicated issues. Some states impose a tax on the income of the entity itself. Others tax the owners of the entity on their share of the entity’s income attributable to the real estate located within the state. Still others differentiate between the nature of the ownership interest in the entity. For example, some states do not tax the holder of a limited partnership interest on its share of partnership income but do tax general partners. The rules with respect to holders of LLC interests are also lacking in uniformity from state to state, although the overwhelming majority of the states now follow the federal income tax classification rules for such entities.

As noted earlier, the variations in tax rules in the different states can present some tax-saving opportunities. One significant opportunity is the use of related-party debt. This mechanism has traditionally been used to reduce federal income taxes when the lender is a foreign entity resident in a country having a tax treaty with the United States that provides for a reduced rate of withholding tax on interest payments. This advantage was curtailed somewhat by “earnings stripping” legislation enacted in the late 1980s but is still widely used. A variation on this strategy is to establish a U.S. corporation in a state (like Delaware) which does not tax passive income as long as the recipient corporation is not actually conducting an active business there and then to have that company lend money to the company which owns the real estate. Some states (Ohio, being an example) have enacted laws designed to limit the deductibility of interest on related party debt. Other states have tried to deal with this issue by applying unitary tax or combined reporting concepts or treating the loans as sham transactions that should be ignored. It is fair to say, though, that most states have not been as aggressive as they could be in dealing with the issue. If a foreign investor owns real estate in jurisdictions in which related party debt can generate state tax savings, it will in most cases be necessary to use a separate corporation to own the real estate rather than a tax-transparent entity like a partnership or an LLC. This can create a somewhat more complicated structure from a federal income tax standpoint but not significantly so because of the ability to include the fiscal results of related domestic companies in a consolidated federal income tax return.

If a corporation owns real estate in more than one state, its tax liability to each state is determined by applying “allocation” and “apportionment” rules. Allocation involves attributing all of the income from a particular activity, such as the ownership of real estate, to the state in which that activity occurs. Apportionment involves multiplying a corporation’s entire taxable income times a fraction represented by that percentage of the corporation’s overall sales, payroll and property attributable to a particular state. Some states count each factor equally, some double-count certain factors, typically sales, and some states use fewer than three. Some factors, like payroll, can be manipulated by, for example, hiring a management company to perform building services rather than using direct employees. The property factor is usually averaged in some way throughout the year. This can present tax-planning opportunities if a company plans to dispose of more than one property during a particular year. Disposition of a property in a state having a high tax rate early in the year and disposition of property having a lower tax rate later in the year will likely yield a lower overall state tax burden than if the order of sale is reversed.

A very simple example of the difference between allocation and apportionment would be a case in which a taxpayer owns property in two different states, State X and State Y. Assume that both states tax income at the same rate, 5 percent, but that State X allocates all of the income from real estate to the state in which the real estate is located, and State Y uses a three-factor apportionment method. Finally, assume that the taxpayer has equal amounts of sales, payroll and property attributable to each state and that the property in State X is sold for a $100 gain in the same year that the property in State Y is sold for a $200 gain. The tax payable in State X would be $5, 5 percent of the $100 of gain allocable to that state. The tax in State Y would be $7.50, representing 5 percent of the 50 percent of the taxpayer’s total taxable income of $300 that is apportionable to that state. In this example, the overall tax rate is 4.167 percent, even though the tax rates in both states are 5 percent.

On the other hand, an effective tax rate higher than 5 percent would result if the gains attributable to the properties located in each state were interchanged. The tax payable in State X would be $10, 5 percent of the $200 gain allocable to that state. The State Y tax liability would still be $7.50 (5 percent times 50 percent of the taxpayer’s total taxable income of $300) for an overall effective tax rate of 5.833 percent.

Tax loss carryforwards are usually determined differently at the state and local level than at the federal level. For example, some jurisdictions have shorter carryforward periods than those permitted for federal tax losses. In addition, most jurisdictions permit only losses attributable to activities carried on therein to be used against income allocated or apportioned thereto. This can lead to situations in which an investor with activities in more than one state will have a much higher overall state income tax liability in proportion to its federal income tax liability than might otherwise be expected. If, for example, an investor owns properties in Illinois and New York and disposes of the property in Illinois in 2000 at a $100 loss and disposes of the property in New York in 2001 at a $100 gain, its federal taxable income in 2001 will be fully offset by the $100 loss carryforward from 2000, but its New York income tax liability will only be partially offset because not all of the loss carryforward will have been attributable to New York activities.

Another issue that can arise in connection with real estate investment is whether income from the sale of an interest in real estate constitutes “business” or “non-business” income. Many state and local tax systems differentiate between the two types of income, taxing business income on an apportionment basis and non-business income on an allocation basis. If allocation is used, the income from the sale of a direct interest in real estate will typically be attributed in its entirety to the state in which the real estate is located, but income from the sale of an indirect interest, such as an interest in a partnership or an LLC, may be taxed in the owner’s state of “commercial domicile”, which is usually where its management is located.

It may be possible under certain circumstances to locate a corporation’s management in one of the few states that does not impose any corporate income tax or in a state in which certain types of management activities do not cause a corporation to be subject to tax. Still another possibility is to locate the corporation’s management in a state that taxes on an apportionment basis only so that the only factor attributable to that state will be the payroll factor.

Many foreign investors invest in U.S. real estate through real estate investment trusts (REITs). Although a REIT is subject to federal income tax, it is entitled to deduct distributions to its shareholders from its federal taxable income. The shareholders themselves are subject to tax on the distributions. The state tax treatment of REITs and their shareholders is not uniform, but most states permit deductions for distributions to shareholders regardless of whether the shareholders are subject to that state’s tax on the distributions themselves.

State Capital Taxes

A number of states impose a tax based upon a corporation’s capital deemed to be employed therein. Some of these states only impose the capital tax when it results in a higher tax than the otherwise applicable income tax. Capital is typically determined by subtracting the corporation’s liabilities from its assets, but a multitude of methods for valuing assets can be found. Some states use accounting book value. Some use fair market value. Others use a multiple of the assessed value for ad valorem taxes. Still others use a multiple of earnings over a specified period of time. A few states use a combination of these methods.

The definition of deductible liabilities does not have as many variations, but some states do not permit liabilities to related persons to be taken into account. Some states also treat deficits in retained earnings as liabilities. Like corporate income taxes, taxes on capital are subject to apportionment based on the corporation’s activities in a particular state.

State Taxes on Gross Income

The most prevalent state tax on gross income is the sales tax. Sales tax is traditionally imposed on receipts from sales of tangible personal property to the ultimate user of the property, but it has been expanded in some states to fees received for the provision of services. Sales taxes can also take the form of a tax on rents or on the provision of utilities to tenants. In most cases, taxes on sales are the responsibility of the purchaser of the property or service.

A few states impose gross receipts taxes that must be borne by the seller. Cities and other local taxing authorities often impose gross receipts taxes, sometimes called license or privilege taxes, on certain types of businesses carried on within their boundaries.

A final type of gross receipts tax which is of particular relevance to real estate investors is a tax imposed on the consideration received in connection with transfers of real estate. These taxes are referred to as real estate transfer taxes, recording fees, deed stamps and the like and vary in rate from less than 1 percent of the sales price to as much as 3 percent. The tax incidence typically falls on the seller, but in some jurisdictions the tax is split between the seller and the purchaser.

States or cities having higher transfer tax rates often have a parallel regime under which consideration received for transfers of controlling interests in entities owning real estate therein will also be subject to transfer tax. Since these indirect taxes are not collected by the officials who record deeds, as in the case of direct transfers of real estate, they are not as easy to enforce, especially when the change of control is several steps removed from the entity which actually owns the real estate.

Finally, some states impose recording taxes on other types of real-estate-related documents such as long-term leases and mortgages.

Ad Valorem Property Taxes

Owners of real estate located just about anywhere in the United States must deal with ad valorem property taxes. These taxes are levied by local taxing jurisdictions such as counties, cities and special purpose districts to finance services of a local nature, such as schools and fire and police protection. They are imposed at rates which tend to fluctuate every year depending upon budgetary requirements. These tax rates are then applied against the value of real property (and sometimes personal property) located within the taxing jurisdiction.

While all property taxes are based upon the value of the property being taxed, the manner in which that value is determined varies widely from jurisdiction to jurisdiction. Since the valuation of real estate is a somewhat subjective exercise, taxpayers often initiate legal proceedings to challenge valuations assigned to their properties.

It is a fairly uniform practice across the country for tenants to bear the expense of property taxes in leases of commercial real estate. This can be accomplished by having the tenant pay the taxes directly, either into an escrow account or to the taxing authority itself, or having the tenant pay additional rent when property taxes increase (the tax rate at the time of the lease having been incorporated into the base rent).

Conclusion

While often overlooked in an analysis of the economics of U.S. real estate investments, state and local taxes can have a real impact on the overall return that is achieved. However, the lack of uniformity among the states in their rules governing the taxation of multi-state activities creates opportunities to manage the state and local tax components of an investment that are, in many cases, not available at the federal income tax level.