A home in the south of France, a seaside condo in Cabo San Lucas, or a ranch in Argentina-this is typical fare for the wealthy client, and it adds complexity to tax, estate, protection and cash management planning. As an advisor, it's hard enough to keep up with U.S. tax and legal developments, without adding international issues to the mix. But your client will need experts on both sides of the border who are willing to communicate and coordinate with each other.
Tax and legal regimes vary widely among countries, but for U.S. citizens, there are certain regulations to keep in mind.
There's No Escaping The IRS
First, you can't escape income tax simply by moving permanently outside of the United States. Unlike most countries, U.S. citizens are subject to U.S. taxes, regardless of where their primary residence is or where their investments are held. U.S. citizens also cannot relinquish their citizenship to avoid U.S. taxes. The expatriate could be subject to U.S. taxes for a 10-year period after expatriation, even if he or she has no U.S. source of income. Fortunately, some relief is available through the foreign tax credit on the IRS Form 1040.
Second, it is getting harder to leverage tax treaties. Various tax treaties between the U.S. and other countries provide relief from some types of taxes imposed by other countries. Tax treaties rarely help you decrease U.S. income taxes, however, due to certain tax savings clauses, which will not override U.S. tax liabilities for its citizens. So, while your client may hear about income tax avoidance strategies from his or her international neighbors-such as owning real estate in one country within a business entity established in another-these strategies will rarely work for U.S. citizens living abroad.
Third, offshore trusts and corporations do not offer the tax havens they once did. In an effort to control money laundering, treaties between the U.S. and former tax haven jurisdictions now extend to an agreement to exchange information. The U.S. can identify the offshore entity's beneficial owners and tax any income, even if it is not distributed to the U.S. citizen, under complex anti-deferral regimes.
The good news is that while the U.S. taxes worldwide income, most other countries only tax income generated within their borders. Many countries are aware of the boost that wealthy expatriates bring to their economy, and they have adjusted their laws accordingly. Spain, Panama and Costa Rica, in particular, offer reduced income tax rates for residents whose main source of income is from investment.
In addition, some U.S. tax laws will work to your client's benefit. When considering buying and selling foreign properties, recognize that you may be able to defer capital gains. IRC Section 1031 can shelter the gain on investment or rental property when it is exchanged for another like-kind property. Foreign real estate will not qualify as like-kind property when exchanged with U.S. based property, but these tax deferral rules can apply to exchanges of solely foreign property. So while you cannot avoid taxation by exchanging your vacation property in Vail, Colo., for a villa in Tuscany, you may be able to exchange investment property in Germany for investment property in Italy.
Given the popularity of retiring in Mexico, it's important to note that this country will tax its permanent residents' worldwide income. If you plan to live in a country for an indefinite period of time, the local government will require you to apply for residency. Applying for a "retirement visa" in Mexico will establish domicile and expose you to Mexican income taxes on U.S. income. Mexico, like the U.S., allows a credit for taxes paid to other countries, but the best practice is to avoid filing unnecessary tax returns in other countries. When working with clients with worldwide property, find out what actions or how many days spent in a country will establish residency for tax purposes.
Estate Planning For Worldwide Properties
Not all tax treaties are created equally. The U.S. may or may not have a tax treaty that extends to gift, estate and other inheritance taxes. Real estate and personal property located outside the U.S. may be exposed to death taxes by both the U.S. and the other country. In fact, some countries extend their inheritance taxes to U.S.-owned property when a U.S. citizen dies in their country as a permanent resident. Because the foreign death tax credit does not cover taxes imposed by a foreign country on U.S. property, the client can be stuck in a tax trap. In some countries, foreign estate taxes may be avoided by holding real estate in a trust or U.S. business entity, such as a limited liability company.
It is important to understand whose laws will govern the transfer of the property owned outside the U.S. Real estate and personal property located in another country are subject to the inheritance laws of the local government. For instance, in France, the property owner's children must inherit a portion of the property. This can unexpectedly disrupt estate planning that was designed to make maximum use of credit shelter and QTIP trusts.
A U.S. citizen planning to retire permanently in another country should consider how property can be owned in order to manage the transfer of the property to the next generation. Can the property be owned with rights of survivorship? Will the use of a trust or other entity avoid local succession laws? Outside the United Kingdom and its former British colonies, most countries do not recognize trusts, and, if they do, they don't recognize trusts created under the laws of another country.
Recently, more countries in Europe, including Italy, are changing their laws to accept trusts, while other countries, such as Mexico, are using trusts to attract American investors. Before 1994, Mexico restricted foreign ownership of real estate in Mexico to 99-year leases. Now Americans can outright own property within 50 kilometers of Mexico's coast through a bank trust called a fideicomisio. This trust allows the beneficial owner to easily transfer Mexican
property to heirs at death.
Clients should establish a will under the laws of each country where they own a residence. Advisors on both sides of the ocean should be aware of the terms of both the U.S. and the foreign wills to ensure a cohesive estate plan that minimizes taxes. A good place to find professional advisors familiar with international issues is to contact the European American Tax Institute, www.e-ati.com.
Life insurance is a useful tax-planning tool for U.S. citizens living outside this country. Life insurance cash values grow tax-deferred in most countries, and the death benefit is generally received tax-free or taxed at very low rates. Life insurance provides liquidity to pay the income and inheritance tax imposed by other countries where a U.S. tax treaty does not protect inheritances. Most U.S. life insurance companies will insure U.S. citizens living abroad, as long as they maintain U.S. banking relationships and declare their intention to travel or live outside of the U.S. on the application.
Charitably Speaking
Living outside the U.S. will expose your clients to the charitable needs of their adopted country. While tax considerations are usually secondary in philanthropic planning, it is worth noting that there is no U.S. charitable income tax deduction for gifts to foreign charities, nor can a client's charitable remainder trust have a foreign charitable beneficiary.
If taxes are an issue, consider leaving a bequest to a foreign charity to take advantage of a federal estate tax deduction. Otherwise, create a charitable lead trust. The creator of the trust donates income-generating property to the trust. Income is paid to a charitable beneficiary over a period of years. At the end of the term, the property passes to the donor's heirs. While there is no current charitable income tax deduction available, there is an opportunity to provide a gift and estate tax haven for assets expected to appreciate in value.
Protection Planning
Even outside of Third World countries, kidnapping can be a major security issue. With ransom demands passing $10 million, wealthy clients living abroad should seriously consider purchasing kidnap insurance. Kidnap insurance will not only cover the ransom, but will also provide expertise for negotiating hostage retrieval. Anyone who saw the Russell Crowe movie, Proof of Life, about the kidnapping of a corporate executive by rebels in a fictional Latin American country can appreciate the importance of a timely response by professional negotiators. Policies and premiums can vary widely, so it is important to carefully scrutinize terms before purchase.
It is also a good practice to review the client's property and casualty insurance to see if liability coverage is extended outside the U.S.
Establishing Banking Relationships
Currency exchange-rate fluctuation will impact where investable assets should be held. The value of the U.S. dollar can fluctuate from day to day in relationship to other countries' currencies. Know the history of exchange rates over several years, and determine if it makes sense to keep several years of living expenses in local banks. If your client expects relocation to be temporary, such as in the early years of retirement, keep long-term investments in U.S. dollars.
The wealthy have been relying on the services of the offshore banking industry for many years. These services can include currency exchange management, tax advice and asset protection, as well as safe custody outside the country. Establishing banking relationships outside of the U.S. is a lot like asking for your future spouse's hand in marriage: Expect to provide extensive personal, credit, financial and even medical information when establishing bank relationships outside the U.S. In fact, the client may have to pay for an investigation of his or her financial and personal background before being accepted as a customer.
U.S. banks may offer an offshore alternative to their banking customers, making it easier to maintain financial affairs outside of the U.S. Even banks with a U.S. parent can be subject to local restrictions on withdrawals or bank transfers in and out of the country. Determine banking limitations that may have an impact on cash flow for the client retiring abroad and plan accordingly.
The word "retirement" generates visions of a leisurely life of travel and foreign adventure, but the complexities involved with living abroad make a coordinated wealth management plan challenging. With tax and legal developments changing daily around the world, no one can be an expert on all aspects of the global economy and legal systems. The successful advisor taps into experts on both shores to create a flexible plan for migrating clients.
Tere D'Amato is the director of advanced planning at Commonwealth Financial Network in Waltham, Mass. She can be reached at tdamato@commonwealth.com.
