In many countries, real estate is commonly owned through entities with limited liability, such as corporations and limited companies.  If a U.S. person inherits the stock of a foreign corporation from a non-U.S. person, or from another U.S. person, the U.S. tax costs related to the disposition of the underlying real estate can be much greater than most taxpayers and tax professionals would expect.

As a preliminary matter, it is important to file the appropriate U.S. tax forms to disclose the receipt of an inheritance from a non-U.S. person.  Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, must be filed by U.S. persons that receive foreign inheritances of $100,000 or more.  Failure to file Form 3520 to report the inheritance can result in a penalty of 5% of the amount of the inheritance for each month that the failure to report continues (not to exceed a total of 25%).  See Code § 6039F(c).

The following example demonstrates the U.S. tax ramifications of a U.S. person inheriting stock in a foreign corporation that owns foreign real estate.  Assume the following facts:

Individual A is a U.S. resident or U.S. citizen.  Individual A’s father (“Father”) is not, and has never been, a U.S. resident or U.S. citizen.  Prior to his demise, Father’s only asset is stock in a foreign corporation (“FC”).  FC was formed years ago when Father had contributed $100,000 into FC in exchange for FC stock.  FC used the cash to purchase undeveloped real estate in a foreign country.

Father dies and leaves his sole asset (stock in FC) to his only child, Individual A.  The real estate owned by FC has substantially appreciated since FC purchased it years before.  The fair market value of the real estate held by FC at the time of Father’s death is $1,000,000 and the fair market value of the stock of FC is also $1,000,000.

Three months after Individual A inherits the stock of FC, FC sells the foreign real estate for $1,000,000 and distributes the cash of $1,000,000 to Individual A in liquidation of FC.  For simplicity, this example assumes that there are no transaction-related costs on the sale and that there are no foreign income taxes imposed on the sale.

For U.S. tax purposes, Individual A will receive a tax basis in the stock of FC equal to the fair market value of the stock at the date of Father’s death ($1,000,000).  Code § 1014(a).  This is often referred to as a “stepped up” tax basis.  FC’s tax basis in the foreign real estate, however, remains equal to FC’s original cost of the real estate ($100,000).  When FC sells the foreign real estate, for U.S. tax purposes, a gain of $900,000 will be recognized by FC.

When Individual A inherits 100% of the stock of FC, FC will become a controlled foreign corporation (“CFC”).  Code § 957(a).  As a U.S. shareholder of a CFC, Individual A will be required to file Form 5471, Information Return of U.S. Person With Respect to Certain Foreign Corporations, for FC.  See Code §§ 6038 and 6046.

Certain income of CFCs is treated as an inclusion in income of the CFC’s U.S. shareholders (similar to a “deemed” dividend), even if no cash or other property is actually distributed out of the CFC.  Such income is known as “subpart F income.”  The $900,000 gain recognized by FC on its sale of the undeveloped foreign real estate would be considered subpart F income.  Code § 954(c)(1)(B)(iii).  Thus, Individual A will have an inclusion in income of $900,000.  This inclusion will be treated as ordinary income and will not qualify for the maximum 15% rate on dividend income, even if FC is located in a country that has a comprehensive income tax treaty with the U.S.  See Notice 2004-70.

Thus, even though the fair market value of the FC stock was $1,000,000 and Individual A’s tax basis in the stock of FC was $1,000,000, Individual A will recognize ordinary income of $900,000.  Under Code § 961(a), Individual A will receive an increase in his/her tax basis in the stock of FC as a result of the recognition of the subpart F income.  This increase in basis is generally intended to prevent double taxation of the same income.  Thus, Individual A will increase his/her tax basis in the stock of FC from $1,000,000 to $1,900,000.

The liquidation of FC will be treated as a sale or exchange of the stock of FC by Individual A in exchange for the $1,000,000 received.  Code § 331(a).  Individual A’s proceeds will equal $1,000,000 and his/her basis in the stock will be $1,900,000.  Thus, Individual A will recognize a loss on the liquidation equal to $900,000.  Although Individual A and FC are treated as related parties, and losses on sales or exchanges between related parties are generally disallowed, an exception applies for distributions in corporate liquidations.  Treas. Reg. § 1.267(a)-1.

If the subpart F income and the loss on the liquidation were both treated as ordinary income/loss, or both treated as capital gain/loss, then the income of $900,000 would be offset by the loss of $900,000.  However, because the subpart F income is ordinary income and the loss on the liquidation is a capital loss, the two cannot be directly offset.  Instead, the subpart F income will be included in income in its entirety but, the capital loss will be subject to restrictions on the amount that can be deducted.  If Individual A has no capital gains during the year, then he/she will only be able to deduct $3,000 of the $900,000 capital loss.

The net result of these transactions is that Individual A will recognize ordinary taxable income during the year of $897,000 and will have a capital loss carryforward of $897,000 that can be used in future years (subject to the annual limitation of $3,000, plus capital gains).  This result typically comes as a huge surprise to taxpayers and tax practitioners alike.

There are certain tax planning strategies that can be implemented to avoid this unexpected and uneconomic result.  However, some strategies require that steps be taken soon after the stock is inherited.  Other strategies can be implemented at a later date, but almost certainly require that steps be taken before the property is sold.  Thus, if a U.S. person inherits foreign real estate in a foreign corporation, it is important to contact an international tax advisor as soon as possible.