One, two or three income taxes

Income tax is imposed by the Federal government.

In addition, most States have an income tax. (Some states do not have an income tax. Examples: Nevada, Texas, Florida, Washington, and some others).

Finally, a few cities impose an income tax. New York City, for instance, has one. Los Angeles does not.

Income taxes are calculated on a calendar year basis.

The default Federal income tax rule: 30 percent of gross income

For nonresident real estate investors, the income tax on rental income is simple and harsh: your tax is 30 percent of the gross rent collected. You are not entitled to a deduction for any of your business expenses.

Example

You own an apartment that you rent for US$2,000 per month for the entire calendar year. You collected $24,000 of rent. Your Federal tax — under the default rule — is 30 percent of that, or $8,000.

That is harsh because most real estate investors incur high out-of-pocket expenses to purchase their real estate. They borrow money for a mortgage and must make payments to the bank. They pay property taxes, management fees, maintenance and repair costs.

Often, the default rule for Federal income taxation would mean that the investor would be paying out more money for expenses and taxes than he or she would collect in rent. Negative cash flow is highly undesirable.

A better Federal tax solution

A nonresident real estate investor can elect to NOT pay Federal tax at 30 percent of gross income. Instead, he or she can elect to be taxed just like a U.S. resident.

You accomplish this by making a special election — using the required magic words — on a U.S. income tax return that you file in a timely manner. (The tax return you need to file is Form 1040-NR for humans. I’ll write about investing through partnerships, corporations, limited liability companies, and trusts another time).

Truth serum

You must file income tax returns and file your tax returns on time in order to do this. It is essential that you get an experienced income tax return preparer — lawyer or accountant — who knows how to prepare nonresident tax returns and make this election.

When you’re talking to a prospective lawyer or accountant about this, ask them whether you need to make the “net election.” That’s the jargon we use in the trade.

If they know what they’re doing, you’ll know it by their response. If they bumble and huff and don’t seem to recognize what this is, don’t work with them.

If you make this election, you are entitled to deduct all of your business expenses from your rental income. The NET income (all the rental income collected minus your business expenses) is then taxed at the same tax rates that apply to U.S. residents. This rate is likely to be lower than 30 percent.

In addition, by making this election, you will be able to take a tax deduction for depreciation of your property. In many real estate investments, the total of cash expenses for owning and operating the property PLUS depreciation will be more than your rental income. Thus, you will have zero taxable income, and therefore zero Federal income tax.

TINLAB (This is not legal advice, but…) I can’t think of any situation where you WOULDN’T want to make this election for Federal income tax purposes.

Warnings:

Warning for procrastinators: if you are “too” late in filing your Federal income tax returns, you will lose the ability to make this election.

Warning for the “How will the U.S. tax authorities ever find me?” brigade: You’re right. You might be able to avoid filing tax returns and paying tax while you own the property — at least for a while. But when you sell, all of the chickens come home to roost.

There is a large Federal withholding tax imposed on sale of U.S. real estate by nonresidents (10 percent of the sale price). Frequently the withholding tax is far more than the actual tax liability you owe. In that case, you won’t be able to get a refund of part of the withholding tax unless you’re up to date on all of your tax filings for all of the years you owned the property.

State income tax

Every State reserves the right to tax rental income derived from real estate located within the State.

You are going to pay income tax on the NET income from your property (total rent collected minus expenses, including depreciation deductions). Rates vary from State to State. California’s top rate is 9.3 percent, for instance.

City income tax

A few cities impose an income tax on rental real estate located within the city. New York City is the one with which I have the most experience, since it is a city where nonresidents are likely to buy a property. Again, the tax will be on NET rental income.

Best practices recommendations

Best tax practices for a nonresident investor in U.S. real estate, then, are:

• The overall tax burden will be higher in some States and cities than in other. While tax is not the only consideration, you should think about it when deciding where to purchase real estate.
• Hire an experienced U.S. tax advisor — someone who knows specifically about nonresident investors and how they are taxed — to advise your and prepare your U.S. income tax returns.
• Make the Federal “net election” on your very first U.S. tax return filed.
• File all income tax returns on time. (Typically, for a nonresident, the deadline will be the following June 15. Thus, income tax returns for 2004 are due on June 15, 2005).