Foreign investment in U.S. real estate continues at a high rate. Unfortunately, many foreign investors fail to consult a tax professional prior to any U.S. real estate investment. There is often confusion over tax rates along with uncertainty over tax filing requirements at both the state and federal level. To make matters worse, many foreign investors fail to make a specific tax election that can literally save them thousands of dollars. Let’s take a closer look.
How to Save Thousands of Dollars
Residents (including resident aliens) and nonresidents are taxed in different ways. Resident aliens are typically taxed just like U.S. citizens. Nonresidents are subject to taxation based on the source of their income and whether or not their income is effectively connected to a U.S. trade or business. A nonresident’s income that is subject to U.S. taxation is divided into two specific categories:
- Income that is effectively connected with a trade or business in the U.S.; and
- Income that is not effectively connected with a trade or business in the U.S.
The main difference between these two categories is that income that is effectively connected (after any allowable tax deductions) will be taxed at graduated rates. These would be the same tax rates that apply to U.S. citizens and resident aliens. However, income that is not effectively connected to a trade or business will be taxed at a flat 30% rate, unless reduced by a specific tax treaty. Also, income not effectively connected does not allow any tax deduction for expenses. This is important because rental real estate is defined as income that is not effectively connected and, accordingly, is subject to the 30% withholding.
However, this is where the tax tip can be a tremendous benefit to foreign investors. If individual investors have rental real estate, they may elect to have the property treated as a U.S. trade or business for tax purposes. If this choice is made with a filed tax return, they are allowed to deduct expenses attributable to the real property income and only the net income from the real estate is taxed. This choice applies to all income from real property located in the U.S. that is held for income production. In order to make this election, they must attach a statement to their return that considers the following:
- That the investor is making the election;
- Whether the election is under Internal Revenue Code section 871(d) (explained above) or a specific tax treaty;
- A list of all real property (or real property interests) located in the U.S.;
- The extent of the investor’s ownership in the real property;
- The location of the real property;
- A description of major improvements (if any) that were made to the property;
- The dates the investor owned the property;
- The income derived from the property; and
- Specific details of any previous choices and revocations of the real property income choice;
Let’s take a look at an example.
Example of Tax Tip
Let’s assume you are a nonresident alien, and you are not engaged in a U.S. trade or business. You own a single family home in the U.S. that is rented out. The annual rental income is $12,000 and this is your only U.S. source income. In addition, you have $10,000 in expenses, which includes repairs, property management fees, property taxes, insurance, depreciation and other miscellaneous expenses. Assuming there is not a lower treaty rate, the gross rental income would typically be subject to a tax rate of 30%, which would amount to $3,600.
But if you make the election discussed above, the gross rental income can be offset by all the rental expenses of $10,000. You would then be taxed on the net income of $2,000, which would then be reduced further by your exemption and any itemized deductions. The result is likely no tax liability and a savings of $3,600.
U.S. tax law can be complex. Before any foreign investor acquires real estate he or she must consult a tax professional who has extensive knowledge of foreign tax issues. Tax planning is crucial and foreign investors need to ensure they are educated prior to any acquisition.
About the Author
Paul B. Sundin is a CPA and tax strategist. He works with clients worldwide on real estate tax issues. You can find out more information on him by visiting www.sundincpa.com. Should you have any questions for Paul, you can reach him at 480-361-9400. Use of any information from this article is for general information only and does not represent personal tax advice — either express or implied. Readers are encouraged to seek professional tax advice for personal income tax questions and assistance.