U.S. Tax Libility when purchasing property in Los Cabos, Mexico.
OWNING REAL PROPERTY IN MEXICO REQUIRES SPECIAL IRS FORMS 3520 AND 3520A IF YOUR
REAL PROPERTY IS LOCATED IN THE FEDERAL RESTRICTED ZONE
(This is also true if you are beneficiary or creator of any foreign trust including a fideicomiso)
By Don D. Nelson, CPA, Attorney, CPA – US International & Expatriate Tax Expert
If you, as an American who does not have Mexican citizenship, own a home or other residential real property located in the “restricted zone” close to the coast in Mexico, the Mexican constitution has been construed to require that you own it in a bank trust called a “fideicomiso.” The Mexican bank acts as trustee and you as the equitable owner of the real property are the beneficiary. The trust has a term of 50 years and can be renewed thereafter.
Under US tax law the fideicomiso meets the definition of a “foreign trust.” That means you are required to file Form 3520 when you initially establish the fideicomiso or foreign trust and for each year thereafter. The Trustee is suppose to file form 3520A for each year of the fideicomiso’s existence but in Mexico does not. Therefore under US tax law you as the beneficiary must file that form to avoid penalties being assessed against you personally. The Form 3520 must be filed by the extended due date of your personal tax return. Form 3520A is due on March 15 of each year for the previous calendar year. You can apply for an extension of time using Form 7004. These forms must be filed for any foreign trust controlled by a US citizen or those of which a US citizen is the beneficiary. This rule includes “asset protection trusts” created in other foreign countries also.
Some international tax professionals have argued that the fideicomiso is not really a trust but is an agent for holding title to real property in Mexico. Recent discussions with an IRS International Division Counsel has reaffirmed that the IRS considers Section 6048(a) to apply to fideicomisos as used in Mexico and Form 3520 and 3520A should be filed. They have indicated they have no current plans to issue any future rulings on this subject. This means regardless of the recent articles written by some attorneys stating that in their opinion a Fideicomiso does not have to file these tax forms, the IRS DOES NOT AGREE with those opinions. If you ignore the IRS position that the Forms 3520 and 3520A must be filed, you at risk of being assessed very high penalties for failing to file these forms.
Items that are required to be included in the 6 page Form 3520 include:
The name and address of the trustee and all beneficiaries
The value of the property and money transferred to the trust
Distributions from the trust
Copies of Trust documents
The name of any US agent appointed for the trust, etc.
If you fail to file Form 3520, there is a penalty charged equal to 35% of the value of the property transferred to the trust, or of any unreported distribution. This penalty can be waived by the IRS for reasonable cause (which has not been clearly defined). The IRS has issued no guidance with respect to what is considered reasonable cause for failure to file Form 3520 and 3520A for a Mexican fideicomiso. We have helped many taxpayers who have filed this form late or are many years in arrears, and to date have successfully had penalties assessed for late filing abated. There is no guarantee the IRS will continue to be so generous in the future.
The Form 3520A reports each year’s income and expenses for the trust. It includes a year end balance sheet for the trust and information on distributions made to beneficiaries. The US owners or beneficiaries of the trust are subject to a penalty of 5% of the trust’s gross asset value for failing to file this form. Penalties can be waived for “reasonable cause” but as stated above, what that reasonable cause is has not been defined by the IRS. You must file this form if the Trustee Bank does not. To date, to our knowledge, no Trustee bank in Mexico has agreed to file this form for the US Fideicomiso beneficiary. Therefore, you must file it because you as an American will be the taxpayer who will be penalized if it is not filed, or if later the IRS discovers it should have been filed but you do not cause it to be filed.
Many clients have asked us if it is possible for the IRS to discover if they own property through a Fideicomiso in Mexico. The answer is YES! When you purchase the property the Mexican registry of foreign property ownerships gets a copy of your passport. Your US passport is tied to your social security number. This information is regularly sent to the IRS. The US and Mexico have a tax treaty which allows them to conduct tax investigations and receive information on each other citizens in the other country. Therefore, should the IRS wish to discover which Americans have Fideicomisos in Mexico, it would be easy.
When you purchase property in Mexico outside of the “restricted zone” you can have title in your name and is no requirement to file these forms. The same non fiing requirement holds true if you purchased commercial property using a Mexican or foreign corporation. However, you should be aware that as a US Citizen, you are required to file Form 5471 each year with your tax return if you hold a 10% or more interest in a foreign corporation any where in the world. There is a $10,000 penalty for failing to file this form.
If you have rental property in Mexico owned by a Fideicomiso, you must report all income and expenses of the property on your US tax return each year. You can however, claim a foreign tax credit for any income taxes you pay in Mexico on that rental income against any US tax due allocable to the net rental income on your US tax return. Because the rental property is located outside of the US, it can only be depreciated using the 40 year straight line method of depreciation.
Which Type of Mexican Corporation is best for you?
There are two types of Mexican corporations as listed below. When, as a US Taxpayer, you chose a type for your Mexican business or real estate, the US Tax Consequences can differ and have significant affect on your US taxes. Below we discuss the US income tax consequences of each type of corporation.
1. Sociedad Anonima (S. A.) and Sociedad Anonima De Capital Variable (S. A. De C. v.) are
negotiable stock corporations of two or more persons whose liabilities for acts of the corporation
are limited to their capital contribution.
If the corporation sells its business or assets, it will pay tax on that gain on its Mexican corporate tax return and when those funds are distributed to you, you will have to report that distribution as income on your US return and cannot claim any tax credits for taxes paid against that income in Mexico unless you make a Section 962 election which will allow you to claim the foreign tax credit, but will subject that income to taxes at the US corporation tax rates (which can be higher than your individual US income tax rate). Form 5471 may have to be filed for this entity depending your ownership percentage.
This type of corporation will always be taxed as a foreign corporation. The corporation will pay taxes in Mexico on its income and if it pays out dividends to you the owner, you will have to pay taxes again on those dividends on your US tax return. Therefore its income is subject to double taxation. You as shareholder do not get to deduct is losses on your US income tax return or claim any foreign tax credits the taxes the corporation pays in Mexico to offset any of its income distributed to you.
2. Sociedad De Responsabilidad Limitada (S. De R. L.) and the Sociedad De Responsabilidad Limitada De Capital Variable (S. De R.L. De C.V.) are nonnegotiable stock limited liability corporations of two or more persons whose liabilities for acts of the corporation are limited to their capital contribution.
The tax consequences of this type of Mexican corporation are the same as stated above unless you make an election (which is only permitted for this type of corporation) to treat it for US tax purposes as a a disregarded entity(if you are the only shareholder) or a flow through partnership. This election must be timely made with the IRS. Only a S. De. R. L. can make this election. Mexican attorneys have stated that it is possible to convert to this type of corporation if you erroneously incorporated as a S.A. de C.V.
After the election is filed this type of Mexican corporation is treated for US tax purposes very similar to a US partnership or LLC. All income or losses of the Mexican corporation flow through to your US income tax return and are taxed on it. Any Mexican income taxes paid by the entity can be claimed as foreign tax credits against the US tax on the income that you are taxed on. If it has capital gains, those capital gains will be taxed on your US return the same as US capital gains. The clear possibility of double taxation is avoided when this election is made.
The S. De R.L. often works out best if the corporation owns Mexican real estate that will generate losses while rented out and capital gains when sold. It also works out well when an Mexican operating business will generate losses its early years and later when profits are made the owner expects to pull them all out from the corporation for his personal use.
The income or loss after the election is filed is included on your personal return if you are the sole shareholder or if there are several US shareholders, the income is reported by filing form 8865. We know Mexican tax law and how to best structure your Mexican business or real estate ownership to achieve he optimum US income tax benefits.