Foreign investment in the US real property market is big business. US property sales to foreign buyers in 2019 totaled US$78 billion. A look at statistics from more recent years shows that the largest share of foreign residential investors are from China and Canada, followed by Mexico. The US tax laws apply to foreigners owning US real property in many respects in the same way that they apply to US persons. In a nutshell, rental income is taxable and so are the capital gains earned upon disposition of the US property. Foreign investors should note that rental income from real property located in the United States and the gain from its sale will always be US source income subject to US tax regardless of the foreign investor’s personal tax status and regardless whether an income treaty has been signed by the United States with the foreign investor’s home country. Given the significant degree of foreign investment in US real estate and the Treasury’s need for sources of tax dollars, it is not very surprising that the Internal Revenue Service (IRS) is now looking to target tax compliance in this area.
The Latest IRS Tax Compliance Initiatives
The IRS Large Business & International Division (LB&I) announced a campaign on October 5, 2020. This is the most recent IRS audit campaign targeting nonresident aliens (NRA) who do not properly report US real estate rental income. Just one month prior, an earlier audit campaign was announced focusing on tax noncompliance of NRAs with withholding of tax and reporting obligations on the disposition of so-called US real property interests under the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA). Both of these IRS audit campaigns are designed to increase NRA compliance with the myriad tax rules relating to foreign ownership of US real property.
These recent compliance initiatives were likely spurred on by a study conducted by the Treasury Inspector General for Tax Administration (“TIGTA Report”). The TIGTA Report showed that a significant percentage of foreign investors in the US real property market are not following the tax rules, and this noncompliance is costing the IRS tens of millions of dollars in tax revenue each year. The relevant TIGTA Report is available here (Treasury Inspector General for Tax Administration, “Additional Controls Are Needed to Help Ensure that Nonresident Alien Individual Property Owners Comply with Tax Laws.” Reference No. 2017-30-048 (8/23/17)).
The IRS campaigns delineate the two basic scenarios that will trigger US income taxation to the NRA owning US real estate (US estate taxation is a completely separate tax trap): earning rental income and “disposing” of the US real property. Today’s blog post will briefly examine the foreign investor’s tax duties when it comes to rental income.
Tax Responsibilities of the Foreign Investor During Ownership and Rental of US Real Property
The first consideration is whether the rental income will be taxed as investment income through withholding at source (generally at a 30% rate), or on a net income basis as “ effectively connected with a US trade or business,” (USTB) without withholding. The method by which rental income will be taxed depends on whether the foreign individual who owns the property is considered “engaged in a US trade or business”. Ownership of real property is not considered a USTB if it consists of merely passive activity (for example, a net lease in which the lessee pays rent, taxes, operating expenses, repairs, and interest in principal on existing mortgages and insurance in connection with the property). Such passive rental income is subject to a flat 30 percent withholding tax (unless reduced by an applicable income tax treaty) applied to the gross income rather than the “net rent” received. Thus, the real estate taxes, operating expenses, ground rent, repairs, interest and principal on any existing mortgages, and insurance premiums paid by the lessee on behalf of the foreign owner-lessor, must be included in gross income subject to the 30 percent withholding tax. In the typical case, the lessee is required to make all tax return filings when submitting the withholding tax to the IRS. (The gross income and withheld taxes must be reported by the lessee to the IRS on Form 1042-S, Foreign Persons U.S. Source Income Subject to Withholding and reported to the payee by March 15 of the following calendar year. Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons, must also be submitted by March 15.)
On the other hand, if the foreign investor is considered engaged in a USTB (for example, operating a shopping center or an apartment complex), the rental income will not be subject to withholding and will be taxed on a net basis at ordinary progressive rates. Expenses such as mortgage interest, real property taxes, maintenance, repairs and depreciation may be deducted in determining net taxable income. The NRA must make estimated tax payments for the tax due on the net rental income, if any. The only way these expenses can be deducted, however, is if an income tax return is timely filed by the foreign investor (Form 1040NR for nonresident alien individuals; Form 1120-F for foreign corporate owners).
Section 871(d) Election
Foreign investors can make a special US tax election to have their passive rental income taxed as if it were effectively connected with a USTB. For NRA individuals, this is commonly called a “Section 871(d) election” based on the relevant Internal Revenue Code section. While it may sound simple to make this election, as usual, the devil is in the details. This election is made by a simple declaration attached to a timely filed income tax return (more on this below). Once made, the election may not be revoked without the consent of the IRS.
While making the election sounds simple, there are traps for the unwary along the way. One such trap involves a failure to properly notify the property manager who is typically hired to collect rent on behalf of the foreign investor. The property manager is considered a “withholding agent” for US tax purposes. Unless the foreign investor has properly informed the property manager that the rental income is to be treated as “effectively connected income” by giving the property manager a completed IRS Form W-8ECI, Certificate of Foreign Person’s Claim for Exemption From Withholding on Income Effectively Connected With the Conduct of a Trade or Business in the United States, the well-informed property manager will withhold 30 percent of the gross rental receipts so as to avoid personal liability. A fully completed Form W-8ECI must include a valid US tax identification number for the foreign investor and withholding must take place until this requirement is satisfied.
Assuming the rental income will be treated as “effectively connected with a USTB” (either by making the special election or, because the rental activity constitutes an active business) a tax return must be filed by the foreign investor. A nonresident alien who fails to submit a timely filed income tax return loses the ability to claim deductions against the rental income, thus causing the gross rents to be subject to tax.
“Timely Filed” Tax Return
The tax law generally provides that an NRA is not permitted to claim deductions unless a true, accurate, and timely Form 1040NR is filed. This includes deductions related to rental real estate. The concept of “timely” filing is quite precise in this context. If an NRA filed a Form 1040NR for the previous year, or if the current year is the first year for which the NRA is required to file a Form 1040NR, then, to be considered “timely”, the NRA must file the Form 1040NR within 16 months of the due date. If the current year is not the first year for which the NRA is required to file a Form 1040NR and the NRA did not file the Form 1040NR for the previous year, then the deadline for filing the Form 1040NR for the current year is, the earlier of (1) 16 months from the due date or (2) the date on which the IRS mails a notice to the investor advising that Forms 1040NR have not been filed and that most deductions and/or credits cannot be claimed. If the NRA’s ability to elect to treat the rental income as effectively connected with a USTB is lost due to untimely filing, the rental income may be subject to tax under the gross income method (including back years)! NRAs who ignore the rules do so at their peril, just like Mr. Espinosa who got burned in the Tax Court for his folly, Espinosa v. Commissioner, 107 T.C. 146 (1996). For curious readers, the various rules are laid out in Treasury Regulation Section 1.874-1 here.
If you need assistance on US tax matters associated with your US real property investments, let me know. Don’t wait for the IRS to catch improper filings in the recent campaign because doing so may mean a loss of deductions associated with the rental real estate and 30% tax on a gross rental basis.
Posted November 5, 2020
All the US tax information you need, every week –
Just follow me on Twitter @VLJeker (listed in Forbes, Top 100 Must-Follow Tax Twitter Accounts 2017-2020).
Subscribe to Virginia – US Tax Talk to receive my weekly US tax blog posts in your inbox.
Visit my earlier US tax blog “Let’s Talk About US Tax” hosted by AngloInfo since 2011, it contains all my old posts. Some hyperlinks to my blog posts on AngloInfo may have expired. If you copy the expired URL, you can most likely retrieve the actual post by using the “Wayback Machine” which is an archiving service. Simply paste the URL into the Wayback Machine search box. It will show you the archived post was saved on a specific date. Click on that date to retrieve the post.
You can access my papers on the Social Science Research Network (SSRN) at https://ssrn.com/author=2779920