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For nonresidents who buy U.S. real estate and rent it, there is an essential income tax election to make. It is called the “net election” and you’d be fool to miss this.
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.
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