The taxation of U.S. rental income of a nonresident of the United States depends on whether the foreign national owner of the property is considered engaged in a “U.S. trade or business.”
The passive ownership of residential real property generally does not rise to a sufficient level of activity to meet the “U.S. trade or business” standard. Passive rental income earned by a U.S. nonresident is subject to a flat 30 percent tax on gross rental income rather than being taxed on a property’s net income (after deducting appropriate expenses).
However, nonresident individuals may make an election to have their passive rental income treated as if it were a “U.S. trade or business.” If this election is made, all expenses related to the production of the rental income – such as mortgage interest, real property taxes, maintenance and depreciation – may then be deducted in determining net taxable income. The net taxable income from the property is then subject to U.S. taxation at progressive tax rates ranging from 10% to 39.6%. It is almost always beneficial for a nonresident who owns U.S. rental properties to make this so-called “Net Election.”
The Net Election
In order to make the Net Election, the income tax regulations provide that a statement should be attached to the nonresident individual’s tax return (Form 1040NR). The statement should include the following:
• A schedule of all U.S. real property in which the taxpayer owns a beneficial interest;
• The extent of the taxpayer’s direct and beneficial interest in each item of U.S. real property;
• The location of each item of U.S. real property;
• A description of any substantial improvements on each item of U.S. real property; and
The election should be made on the first U.S. tax return for which the net election is to apply. The election need only be made once, and it remains in effect until it is revoked.
As previously discussed, if the Net Election is made with respect to a U.S. rental property, all expenses incurred related to income generated by the property may be deductible. We will now discuss some of those items.
One of the most important tax deductions allowable to a nonresident subject to U.S. progressive tax rates on their net rental income is depreciation. The portion of the rental property that pertains to the building is depreciable on a straight-line basis over 27.5 years. The land on which the building sits is not depreciable.
The acquisition of real property is often financed by debt. Home mortgage interest is not deductible by a nonresident; however, interest related to debt to finance a U.S. rental property is generally fully deductible. The foreign investor, however, should bear in mind that the interest deduction may be subject to some limitations the discussion of which is beyond the scope of this article.
Passive Loss Limitations
The impact of the passive loss limitation rules on a nonresident U.S. real estate investor can be significant. Net rental losses generated by the holding of U.S. rental properties are generally considered “passive losses.” Taxpayers, whether they are residents or nonresidents, may not be permitted to utilize certain losses in the current taxable year under the passive loss limitation rules. Any passive activity loss, however, may be carried forward and offset against the net rental income of the property in subsequent years. When the nonresident disposes of his U.S. real estate, the entire amount of suspended passive loss may be utilized in full without limitations.
Tax on the Gain from the Sale of Real Property
When the real property is sold, the foreign national will be taxable on both the appreciation of the property as well as recapture of the depreciation previous taken.
Each year the property is rented, a depreciation deduction is taken that reduces the current year net taxable income from the property, and the depreciation also reduces the tax basis of the property. When the property is sold, the “recaptured” depreciation is taxed at a 25% rate and the remaining gain is taxed at capital gains rates of 15% or 20% depending on the income level of the taxpayer.
As an example, say a nonresident purchased a residential rental property 14 years ago for $500,000 and sold it in 2014 for $600,000. Assume that $300,000 or 60% of the total purchase price is related to the building and $200,000 or 40% of the price is related to the non-depreciable land. At the time of sale, the property has a tax basis of $347,200 (Land = $200,000; Building = $300,000 – $152,800 depreciation taken = $147,200). The nonresident has a capital gain of $252,800 ($600,000 – $347,200), $100,000 is taxed at a capital gains tax rate of 15%-20% and the amount relating to depreciation of $152,800 is taxed at a 25% rate.
Taxpayers cannot avoid depreciation recapture by not claiming depreciation since the law provides that depreciation recapture is calculated based on the actual depreciation taken or the amount of legally allowable depreciation whether or not it was actually claimed.
The Foreign Investment in Real Property Tax Act (FIRPTA) requires a FIRPTA withholding tax of 10% of the sales proceeds realized on the disposition of U.S. real property by nonresidents.
A buyer of U.S. real property from a nonresident is the withholding agent and responsible party to perform the 10% withholding. If the buyer fails to withhold, the buyer may be held liable for the tax. The nonresident seller must report the sale of real property by filing a U.S. tax return, Form 1040NR. If the FIRPTA withholding tax is more than the actual tax due on the sale, then the nonresident will receive a refund of the difference; if the withholding tax is less than the amount due, the nonresident must pay the amount due with the tax return. For more information on FIRPTA, please see here.
Tax Return Filing Requirements
A nonresident engaged in a U.S. trade or business at any time during the taxable year, or who derives income that is subject to U.S. income tax under subtitle A of the Internal Revenue Code (“Code”) is required to file a U.S. income tax return. The return is filed on Form 1040NR by a nonresident individual. Thus, for example, a nonresident engaged in a U.S. trade or business is required to file a U.S. income tax return even if:
• He has no income that is effectively connected with a U.S. trade or business;
• He has no U.S.-source income; or
• His income is exempt from U.S. tax either under an income tax treaty or under a Code provision.
Therefore, a nonresident who has made a net election is required to file a U.S. income tax return.
A nonresident who fails to submit a timely filed U.S. income tax return loses the ability to claim deductions against the rental income, causing the gross rents to be subject to the 30 percent flat tax. Generally, if a nonresident has failed to file U.S. tax returns, he or she will need to retroactively file at least six years of delinquent income tax returns (if applicable). Also, the ability to make the net election to treat the rental income as a U.S. trade or business will be lost after 16 months from the original due date of the return.