Rental income taxed at 30% of gross income

The default rule for nonresident owners of U.S. rental real estate is that rental income is taxed at 30% of gross rent collected. That’s the Federal income tax. State income tax varies from State to State and I will ignore it.

For Federal purposes you do not take a tax deduction for mortgage interest, property taxes, repairs, etc. You do not get a deduction for depreciation.

Sit with a piece of paper and a pencil and you will soon find that this can put you into negative cash flow.

Have rental income taxed on net income instead

It is much better to pay income tax on your net income — collect rent income, deduct your expenses, and pay tax on whatever is left.

The law

Nonresidents make a special election with the U.S. tax authorities to make the desirable “tax me on net income not gross income” result occur. Here’s the law, found at Section 871(d) of the Internal Revenue Code:

(d) Election to treat real property income as income connected with United States business

(1) In general

A nonresident alien individual who during the taxable year derives any income–

(A) from real property held for the production of income and located in the United States, or from any interest in such real property, including

(i) gains from the sale or exchange of such real property or an interest therein,

(ii) rents or royalties from mines, wells, or other natural deposits, and

(iii) gains described in section 631(b) or (c), and

(B) which, but for this subsection, would not be treated as income which is effectively connected with the conduct of a trade or business within the United States,

may elect for such taxable year to treat all such income as income which is effectively connected with the conduct of a trade or business within the United States. In such case, such income shall be taxable as provided in subsection (b)(1) whether or not such individual is engaged in trade or business within the United States during the taxable year. An election under this paragraph for any taxable year shall remain in effect for all subsequent taxable years, except that it may be revoked with the consent of the Secretary with respect to any taxable year.

(2) Election after revocation

If an election has been made under paragraph (1) and such election has been revoked, a new election may not be made under such paragraph for any taxable year before the 5th taxable year which begins after the first taxable year for which such revocation is effective, unless the Secretary consents to such new election.

(3) Form and time of election and revocation

An election under paragraph (1), and any revocation of such an election, may be made only in such manner and at such time as the Secretary may by regulations prescribe.

How to do it–the Regulations

The Treasury Regulations give guidance on how to make the net election:

Regulations Section 1.871-10(d)(1)(ii) — Statement To Be Filed With Return

An election made under this section without the consent of the Commissioner shall be made for a taxable year by filing with the income tax return required under section 6012 and the regulations thereunder for such taxable year a statement to the effect that the election is being made. This statement shall include (a) a complete schedule of all real property, or any interest in real property, of which the taxpayer is titular or beneficial owner, which is located in the United States, (b) an indication of the extent to which the taxpayer has direct or beneficial ownership in each such item of real property, or interest in real property, (c) the location of the real property or interest therein, (d) a description of any substantial improvements on any such property, and (e) an identification of any taxable year or years in respect of which a revocation or new election under this section has previously occurred. This statement may not be filed with any return under section 6851 and the regulations thereunder.

Sample language

Here is a sample you can follow. Just attach this on a statement attached to the Federal income tax return filed (Form 1040-NR or Form 1120-F).

(Taxpayer Name)
(Taxpayer Identification Number)
Attachment to Form (1040-NR or 1120-F)
Tax Year Ending December 31, 2008
This statement constitutes an election under Regs. §1.871-10(d)(1)(ii) to treat the income generated from the following properties in the United States owned by the taxpayer as income effectively connected with a U.S. business for taxable year ending December 31, 20__ and thereafter:

Property 1 -
Land and Improvements located at 123 Easy Street, Anytown, USA. The structure is a commercial office building. Taxpayer holds a fee interest in the land and all property improvements located thereon. No prior election has been made under Regs. §1.871-10(d)(1)(ii) with respect to the subject property.

Property 2 –
Identify other properties as appropriate.

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).