Last week, the IRS announced that it will increase audits and scrutiny on nonresidents with US rental properties. This move is part of the IRS’s campaign, launched on October 5, 2020, to improve the timeliness and accuracy of returns filed by nonresidents (including G-4 visa holders) to report US rental income.
Why is the IRS targeting nonresidents with US rental property?
The IRS focuses its limited resources on areas where it is most likely to find errors and abuse. According to IRS data analysis and feedback from IRS employees, nonresident reporting of US rental income is a significant problem area.
What is the IRS looking for?
Although the IRS doesn’t give specific detail on what it is looking for, we have a pretty good idea. Many nonresidents (and some tax professionals) assume that nonresidents who own US rental property are taxed the same way as US citizens and residents who own rental property. In fact, there are several major differences.
Below, we highlight some of the most common problems and errors we encounter with nonresidents who own US rental property.
Common Mistakes Nonresidents Make in Reporting Their Rental Income
Mistake 1: Assuming you don’t need to file a US tax return because your rental property had losses. If you received any income from your rental property, then you are required to file a US tax return (Form 1040NR) each year. If you failed to file a return, then the IRS can charge you a 30% tax on your gross income, without deductions. Plus, it can impose 25% “failure-to-file” penalties and interest for each year.
Mistake 2: Claiming tax deductions for your depreciation and rental expenses without a “net election.” Did you know that nonresidents are taxed on their gross rental income? Rental income is considered FDAP (Fixed, Determinable, Annual or Period) income. And FDAP income is generally taxed at a 30% rate, without deductions of any kind. This means that even if you have losses on your rental property, you may still owe 30% tax on the income you received.
Fortunately, you can make a special one-time “net election” to treat your rental income as “Effectively Connected Income to a US Trade or Business” (ECI). This allows you to claim deductions for your rental expenses. It also affects the tax rates that apply. Instead of a 30% flat rate on your gross rental income, you can use the graduated tax rates, which start at 10%, on your net rental income.
Mistake 3: Filing only one tax return to report a US rental property owned jointly with your spouse. Nonresidents must file Form 1040NR each year to report their US taxable income. Form 1040NR cannot be filed jointly with a spouse. So, if two nonresident spouses jointly own a US rental property, then both spouses must file a Form 1040NR. If each spouse owns 50%, then each spouse will report half the total income and half the allowable deductions.
The same is true if a nonresident is married to a US citizen or other tax resident. If the spouses own the rental property jointly, then each spouse must file a separate return to report his or her portion of the rental income and allowable deductions. There is one exception: a nonresident spouse who has made a special “6013(g) election” to be treated as a US tax resident can file jointly with a spouse. But be careful—it also means that the nonresident must now pay US tax on all worldwide income!
Mistake 4: Not filing the proper forms if your rental is held in a US LLC. If you hold your rental property in a US LLC, then you must file additional required forms each year. The important thing to know about these forms is that failure to file one of them (Form 5472) results in a $25,000 penalty per year! Some tax professionals believe that the IRS will focus on this issue because it will provide the IRS with a quick return on its investment of audit resources.
What happens if the IRS finds one of these common mistakes on your return?
Typically, if you are audited and the IRS finds that you made one of the common mistakes above, then the IRS will:
- Deny any losses or deductions claimed for your rental expenses
- Calculate the 30% tax on your gross rental income for all open years
- Impose accuracy penalties, failure-to-file penalties, and failure to pay penalties, along with interest charges
- Ignore a return filed jointly with a spouse and calculate tax and penalties on the income the nonresident should have reported
If you hold your rental in an LLC, then the $25,000 per-year penalty would generally apply.
Should I fix the mistake now or wait for an audit?
The IRS warns taxpayers before launching targeted audit campaigns because it wants taxpayers to fix their mistakes on their own. Ultimately, it’s up to you whether you fix the mistake or wait to see if you will be audited.
Generally, you will obtain a better result if you correct your situation before the IRS audits you. Once you have been contacted for an audit, you may not be able to make the elections to obtain better tax treatments. Often, fixing any issues on your own will allow you to make the “net election” to deduct rental expenses and benefit from lower tax rates.
For rentals held in LLCs, it is especially important to correct the situation before the IRS audits you. Correcting the situation in advance can help you avoid the $25,000 per-year penalties. Once you are under audit, the IRS no longer allows you to use the amnesty programs that waive the penalties.
What do I need to do to fix the mistake?
Usually, fixing the problem involves filing original or amended returns with the proper reporting. If you are not under audit, then the following options are available:
- If returns (Form 1040NR) weren’t filed, then you generally fix the issue by filing a certain number of late returns, making the “net election” for the first year, and paying any tax and interest owed. The number of returns to file will vary. Technically, the IRS can audit any tax years for which a return has NOT been filed, so it’s important to explore how far back it makes sense to go.
- If deductions were claimed without a net election, then you usually only need to amend the earliest open return to add the net election to it.
- If returns were improperly filed, either jointly or with some other problem, then you typically need to file amended returns and, if appropriate, unfiled original returns to correct the issue. Depending on the case, the IRS may agree to waive the penalties.
- If proper forms weren’t filed for your rental held in a US LLC, then you will likely need to use one of the IRS’s current amnesty programs to avoid large penalties.
In all of these cases, the number of returns to file or amend will depend on your specific situation. We regularly assist new clients in determining the best way forward. We can also support you by preparing original returns, amended returns, and necessary elections.
Do you have further questions or need tax help? Contact us.
If you have questions or would like a complementary discovery call to discuss your situation, please contact us.
Also, you can find further information on related topics on our website:
- US taxation of nonresidents
- Tax treatment of US real estate owned by nonresidents
- Amending tax returns
- Sale of US real estate by a nonresident (FIRPTA Tax Help)
- OVDP, Streamlined and Amnesty programs (for rentals held in a US LLC)
The Wolf Group has 37 years of International Tax experience, including audit defense and penalty abatement representation. Our firm has represented taxpayers in a wide variety of international tax-based audits including but not limited to audits of G-4 visa holders, FBAR examinations, Streamlined Filing audits, foreign tax credit redeterminations, and IRS “wealth squad” audits/examinations. We are well versed in the fundamental rules and regulations related to nonresident taxation, asset reporting, and FIRPTA.