Foreign Nationals in the U.S. Real Estate Market - Know Your Ground - Part 3
Clearly, investors purchasing U.S. real estate with a view to generating rental income need to understand the income tax landscape also.
If such an asset generates income, it is considered U.S. source under U.S. tax principles based upon the location of the asset. If the owner-recipient is non-resident for income tax purposes (i.e. a non-immigrant visa holder spending less time in the U.S. than required to be considered income tax resident), such U.S. source rental income is subject to U.S. income tax.
The question as to how this income is taxed, however, is dependent upon whether the income is to be considered generated in a U.S. trade or business.
Net lease arrangements wherein a tenant pays rent plus handles all expenses on the property and mortgage interest and real estate expenses is not trade or business income. As such, the taxpayer is taxed at a flat rate of 30% on gross income (i.e. with no deduction for expenses) unless the amount considered taxable, or the rate of tax, are eligible for reduction by any applicable Income Tax Treaty.
If the taxpayer is significantly more actively involved in managing the property as a business concern, possibly with multiple properties, such income may be properly regarded as trade or business income not subject to this flat rate of withholding and also eligible for offset of expenses associated with the production of this income.
However, provided a timely election is made on a U.S. income tax return filing, the Internal Revenue Code permits nonresidents for income taxpayers to elect to treat rental income as derived from a U.S. trade or business and, therefore, not subject to flat rate withholding. This applies even in a net lease situation.
The two key points to understand in this context are that, firstly, particular procedures need to be followed in order to avoid the tax withholding, and secondly, - although no less importantly - that only by filing a U.S. tax return may the nonresident taxpayer make the appropriate tax election to be taxed on a net basis.
So, what else do we need to know?
As is true for many things in life, getting in seems much more straightforward than getting out!
And so it is true for U.S. real estate being sold by foreign nationals who are subject to an automatic withholding of 10% federal tax on gross proceeds at closing.**
Such sellers must complete certain IRS Forms at the time of the sale and also require a Taxpayer Identification Number in order to file the Forms. An application may be made for the tax to be reduced or eliminated, but often this can present a timing issue and, on occasion, even a cash-flow problem. Specialist guidance should be sought well in advance of a contemplated sale in order to avoid, or at least alleviate these issues.
The life cycle of real estate for the foreign investor is fraught with potential traps that need to be carefully navigated. Proper advance planning from a qualified professional familiar with these issues could be the best investment you make to avoid a series of problems down the line.
** Refer to my article "Foreign Investment in Real Property Tax Act 1980 - Buyer AND Seller Beware" at www.goldsteinjones.com
* R. Scott Jones, Esq. is a partner with New York law firm Goldstein Jones LLP. Copyright ©, GOLDSTEIN JONES LLP - February, 2009
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The information contained herein is general in nature and is not intended as a substitute for specific legal advice nor is it to be relied upon for individual circumstances.