Investment Constraints 4: Structures

An entrepreneur starting a new business has a choice to make – how should she structure the business legally. In Australia, there are actually four alternatives to choose from: sole proprietorship, partnership, company or trust. The reasons for choosing a company or trust often include limiting legal liability, protecting personal assets, or ease of sharing or transferring ownership. And, in the wake of recent caps on superannuation contributions, more financial planners are recommending family trusts to hold savings that cannot be put into the superannuation system. What are these structures? How do they work in a purely Australian context? And what problems or challenges might arise when a US taxpayer tries to do exactly what her Australian neighbour would find optimal?

This is the fourth instalment in our series of posts discussing the ways US tax laws constrain the investment choices of US taxpayers living in Australia. These are the areas we will be covering:

  1. Superannuation
  2. Homeownership
  3. Real Estate
  4. Australian Managed Funds
  5. Australian Shares
  6. Business Ownership Structures
  7. Investing in the US
  8. Record keeping

This series (and everything on this website) is general information only. I am not a lawyer, tax professional, or financial planner, just someone who has learned about US tax and wants to pass on general knowledge. Many areas of tax law are interdependent, so changes in one area may have unintended consequences in another. You should consult a professional who can consider your own personal circumstances before taking any action. Continue reading “Investment Constraints 4: Structures”

Investment Constraints 3: Equity

60% of Australians own equity based investments (listed or non-listed) outside of institutional superannuation accounts, and 37% of Australians own listed shares (2017 ASX Australian Investor Study). There are two main ways to invest in equity – purchase shares directly on the share market or purchase a slice of a portfolio managed by a professional portfolio manager. For Australian investors who are claimed by the US, the US tax implications of these two choices are quite different.

This is the third instalment in our series of posts discussing the ways US tax laws constrain the investment choices of US taxpayers living in Australia. These are the areas we will be covering:

  1. Superannuation
  2. Homeownership
  3. Real Estate
  4. Australian Managed Funds
  5. Australian Shares
  6. Business Ownership Structures
  7. Investing in the US
  8. Record keeping

This series (and everything on this website) is general information only. I am not a lawyer, tax professional, or financial planner, just someone who has learned about US tax and wants to pass on general knowledge. Many areas of tax law are interdependent, so changes in one area may have unintended consequences in another. You should consult a professional who can consider your own personal circumstances before taking any action. Continue reading “Investment Constraints 3: Equity”

Investment Constraints 2: Real Property

Last week we started a series of posts discussing the ways US tax laws constrain the investment choices of US taxpayers living in Australia. These are the areas we will be covering:

  1. Superannuation
  2. Homeownership
  3. Real Estate
  4. Australian Managed Funds
  5. Australian Shares
  6. Business Ownership Structures
  7. Investing in the US
  8. Record keeping

This series (and everything on this website) is general information only. I am not a lawyer, tax professional, or financial planner, just someone who has learned about US tax and wants to pass on general knowledge. Many areas of tax law are interdependent, so changes in one area may have unintended consequences in another. You should consult a professional who can consider your own personal circumstances before taking any action.

2. Homeownership

In both Australia and the US, homeownership is a major savings vehicle for many households. Each country provides tax incentives for homeowners, but not the same tax incentives. In the US, home mortgage interest is tax-deductible and when the home is sold the first US$250,000 (per taxpayer) is excluded from taxable income. In Australia, all of the gain on a personal residence is excluded from taxable income. Australian-resident US taxpayers can be caught out by the differences. The US mortgage interest deduction is unlikely to reduce US taxes, as most expats will have sufficient FTC to reduce US tax to zero. Claiming the deduction, however, could help increase FTC carryovers, which could help reduce the US tax bill when the home is sold. Of course, for that to work, the house must be sold before the FTC carryover expires (carryovers last 10 years).Residential Property Index

Over the last decade, house prices in Sydney and Melbourne have more than doubled, and the average price of residential real estate in the capital cities has grown at an average rate of 5.8% per year. In Sydney and Melbourne, in particular, it is important to consider the US tax consequences of any capital gain realised. If a principal residence is owned jointly with a non-US partner, then only half of the total gain will show up on the US tax return. When computing the gain, you can add the cost of renovations (not repairs) to the original cost of the house, so be sure to keep records of the cost of renovations. Also, remember that all US tax computations are done in US dollars, so buying a home is a foreign exchange transaction. When computing the gain on the sale of any asset, the cost base and sales proceeds are converted to USD at the exchange rate from the date of each transaction. This can lead to phantom gains if the AUD appreciates over the period the house is owned. As stated above, the first US$250,000 per owner is excluded from US taxable income. If the gain is more than this threshold, then it is taxed as a capital gain and any US tax can be offset by FTC.

The sale of any real estate may also involve the repayment of an outstanding mortgage. This is another danger area for US taxpayers, because US tax is computed using the fiction that all transactions are in US dollars. If the Australian dollar depreciates between the time the mortgage loan is initiated (when the home is purchased), and the time the loan is extinguished (when the home is sold), the US tax code will treat this as a gain. In effect, the IRS thinks you’ve borrowed US$100,000 (when the exchange rate was USD1=AUD1) and paid back US$75,000 (when the exchange rate was USD1=AUD0.75) for a gain of US$25,000. Of course, since the loan is in AUD, you’ve really borrowed A$100,000 and repaid A$100,000 – no real gain or loss. And, since a principal residence is a personal use asset, the US tax code will only recognise gains on mortgage discharge; losses will be disallowed. For more background on this topic (and how Congress could have fixed the problem in 1986) see this post on The Isaac Brock Society.

3. Real Estate

Buying investment property is very popular in Australia. One of the big attractions is “negative gearing”. Essentially, this means that the Australian tax rules allow interest deductions on loans to purchase an investment property, even if the property is not making a profit. With depreciation deductions, it is possible for a rental property to have a positive cash flow, but generate a taxable loss that will offset other taxable income, including salary.

The rules are different on the US side. Unless substantial time is spent managing a rental real estate portfolio, rental real estate is considered a “passive activity”.  Under US tax rules, passive activity losses can only be deducted to the extent of passive activity income; that is, losses from rental real estate cannot be used to offset salary and other active income. Any losses that are disallowed are carried forward and used to offset future passive activity income. There is a special exception from the passive activity loss rules for rental real estate when you actively participate – this is defined as owning more than 10% of the property and making management decisions or arranging for others to provide services such as repairs. Under this exception, you can deduct as much as US$25,000 of rental losses against ordinary income UNLESS your filing status is Married Filing Separate. For those US taxpayers married to non-resident aliens, this exception is not available.

For US tax purposes, all transactions are converted to US dollars. This can generate phantom currency gains and losses when the property is sold and the mortgage is repaid. Since an investment property is not a personal use asset, unlike a personal residence, currency losses on a mortgage should be available to offset gains on the sale of the property.

 

These are just the broad outlines of US tax treatment of real estate owned either personally or for investment. As always, you should consult a professional advisor before entering into any significant transaction. Next week we will continue this series with an article on investing in shares, either directly or indirectly, and the consequences of the dreaded PFIC rules.

How do US Tax Rules Constrain the Investment Choices of US Taxpayers Living in Australia?

In the Facebook group last week, someone claimed that only the very wealthy are disadvantaged by the dual tax obligations imposed on US citizens and green card holders living in Australia. Certainly, for an Australian resident with only salary income, it is likely that foreign tax credits (FTC) or the Foreign Earned Income Exclusion (FEIE) will completely eliminate any US tax liability. However, for anyone who is considering investing for the future or running their own business, there are many pitfalls and traps in US tax law that need to be carefully considered. It seems like almost anything “foreign” is treated punitively by US tax law, and these xenophobic rules make it difficult for middle class US taxpayers to save effectively while living outside the US.

Over the next few weeks, I will be covering the following areas where US taxpayers living in Australia need to be particularly careful:

  1. Superannuation
  2. Homeownership
  3. Real Estate
  4. Australian Managed Funds
  5. Australian Shares
  6. Business Ownership Structures
  7. Investing in the US
  8. Record keeping

This series (and everything on this website) is general information only. I am not a lawyer, tax professional, or financial planner, just someone who has learned about US tax and wants to pass on general knowledge. Many areas of tax law are interdependent, so changes in one area may have unintended consequences in another. You should consult a professional who can consider your own personal circumstances before taking any action. Continue reading “How do US Tax Rules Constrain the Investment Choices of US Taxpayers Living in Australia?”

CRS – Coming soon to a bank near you…

From 1 July 2017, Australian financial institutions will be required to report account information of anyone with a tax residence outside of Australia to the ATO under the OECD’s Common Reporting Standard (CRS). Once the United States rolled out FATCA, countries in the OECD decided that cross-border reporting of financial accounts might be a good way to rein in use of tax havens for tax evasion. However, while the two are similar, there are some differences.  The key features of CRS are a common standard for: the scope of reporting (type of information, which account holders and which institutions), the due diligence required, format of the data to be exchanged.

With the current push for FATCA repeal, and the recent Hearing on The Unintended Consequences of FATCA, CRS is mentioned by some as a possible substitute for FATCA. Unfortunately, there seem to be a few misconceptions about the differences between the two Automated Exchange of Information (AEOI) schemes. As implemented in Australia, CRS is perfectly compatible with Citizenship Based Taxation.

While it is exceedingly unlikely that the U.S. Congress will ever sign on to CRS, it is important for those who advocate CRS as a more “benign” alternative to be clear on exactly what CRS entails.

This article covers:

  1. How is CRS being implemented in Australia?
  2. Who must report?
  3. Who and what must be reported?
  4. Reciprocity – FATCA vs CRS
  5. Penalties – FATCA vs CRS
  6. Implications for US Persons

Continue reading “CRS – Coming soon to a bank near you…”

Explaining the Saving Clause III

This is Part 3 of our series explaining the Saving Clause in the Australia / US tax treaty. In Part 1 we saw how international tax works for 90% of the world’s population: income sourced in the country where you live is taxed only by that country. Income from elsewhere is governed by the treaty and generally taxed by the source country – with a tax credit in the resident country if it is also taxed there. In Part 2 we saw how the Saving Clause works in US tax treaties[1]: US citizens are subject to US tax wherever they live due to the unique practice of Citizenship Based Taxation; the Saving Clause allows the US tax its citizens as if most of the treaty did not exist, allowing the US to tax foreign-source income of foreign residents.   Continue reading “Explaining the Saving Clause III”

Explaining the Saving Clause II

This is part 2 of a three part series explaining how the Saving Clause works in international tax treaties. In part 1, we saw how international transactions are taxed for almost 90% of the world’s population under Residence Based Taxation (RBT). We looked at the example of Maria, an Australian resident with rental income in Santiago Chile. Maria pays tax to Chile on the rental income, but is not required to report or pay tax in Chile on any of her Australian income. On her Australian tax return, Maria reports the Chilean rental income and is able to deduct the tax paid in Chile from her Australian tax. Essentially, Chile has the first right to tax Chilean source income.  Continue reading “Explaining the Saving Clause II”

Strategy Document Feedback

Just before Christmas, Karen released our initial Steering Committee work on the group strategy for your feedback through the blog comments, our Facebook Group or Private Message.   Perhaps the timing was not the best given how frenetic things get for most of us over the holiday season? Continue reading “Strategy Document Feedback”

Explaining the Saving Clause I

When it comes to fixing the tax treaty, the “Saving Clause” is a key piece of the puzzle. From the discussion that followed the Strategy Roadmap, it is clear that many find the saving clause very confusing. So, in a series of three posts, I’m going to attempt to explain how the saving clause works and why it is important. In this first post we’ll look at how international tax works under the Residence Based Taxation model used by three quarters of the taxing jurisdictions in the world and covering almost 90% of world population, without the saving clause. The second post will look at how the saving clause, coupled with Citizenship Based Taxation changes the result. In a nutshell, we’ll see that the saving clause allows the US to tax US citizens living in Australia on their Australian source income. The final post will explore ways to fix the problem. Continue reading “Explaining the Saving Clause I”