I represent foreign nationals and non-resident aliens in Washington DC, and the greater DMV area who have IRS or State tax issues. In Part 1 of this article, I discussed how foreign nationals living abroad or in the U.S. can navigate the tax environment at the time of buying (or converting existing property into) U.S. rental real property.
I also mentioned that that there will be a 30% tax on foreign national and non-resident alien gross rental income without the benefit of deducting allowable expenses that U.S. citizens can normally use to lower their taxable income. However, I am going to summarize for you some broadly unknown provisions that can provide tax relief to foreign and non-resident rental property owners.
Depending on your personal situation, you can be taxed at a lower rate if you either (1) claim the benefits of a tax treaty between the U.S. and your country, (2) acquire U.S. tax residency, or (3) elect to have your rental income treated as business income (Effectively Connected Income) for tax purposes. You cannot take advantage of these options without acquiring an Individual Taxpayer Identification Number (ITIN), which I discussed in Part 1.
Of the three options, the election to classify your rental income as business income (Effectively Connected Income) is open to the broadest number of foreign and non-resident rental property owners. It should be done on your first tax return that includes each U.S. rental property you own. The election is done on a property-to-property basis, so making the election for your first property does not cover your future properties. You should seek a knowledgeable tax expert to walk you through this election, along with the attached statements it requires.
Once your real property income is deemed Effectively Connected, you can deduct operating expenses, property taxes, or depreciation from your gross income and you pay tax only on your Net Income. Depending on your other U.S. sourced income (e.g., wages, investments, crypto, etc.), you will generally end up paying tax below the default 30% rate. When you receive Form 1042-S (see Part 1) from your tenants, rental management company, Airbnb or any other rental income source, applying this election may result in a tax refund to you.
Acquiring U.S. tax residency can occur through becoming a U.S. citizen, Green Card holder, or satisfying the Substantial Presence Test (STP). Depending on the visa you hold and your days of presence in the U.S., you may never pass the STP. You could also fall out of tax residency status by failing the STP in future. Additionally, if you relinquish U.S. citizenship or Green Card status in future, your rental income tax would default up to the 30% rate.
It is very important to understand that taking up U.S. tax residency exposes you to taxation on your worldwide income, which has implications on wages, investments, businesses, real estate, and inheritances you own abroad. However, it would be a mistake to generalize that declaring foreign-based income and assets would increase your tax liability in the United States. With good advice, you may end up with tax savings.
The benefits of tax treaties vary from nation to nation. With certain exceptions, treaties do not reduce the tax of U.S. dual citizens or Green Card holders. Even if a tax treaty provision eliminates all your taxable rental income, you still need to file a tax return on time. Otherwise, you face a $1,000 penalty by the IRS. Again, you should seek a knowledgeable expert to review your treaty tax benefits and to apply them correctly.
Now, before things begin to appear too easy, foreign and non-resident rental real property owners need to be careful not to conclude that what applies to IRS will apply at the State tax level. Tax treaties, for instance, are treaties between nations and the U.S. federal government only. You could end up lowering your federal tax liability but paying more (or nothing at all) at the State level. In this case too, you should seek good advice to navigate the State tax context wherever your rental real property exists.
When a foreign national/non-resident sells U.S. real property, any capital gains are taxed in the same manner as if the property were sold by a U.S. citizen. Depending on how long you have held the property, you can pay tax at the lower long-term capital gains rate. However, if you have not made the business income (Effectively Connected Income) election discussed above, your selling closing agents must withhold 30% tax and pay it to the IRS and may withhold more to pay the State. Even with the business activity election, an additional 15% non-resident tax is levied on the gross sale proceeds unless you can claim a tax treaty exemption.
The 30% or 15% tax rate would not apply in cases where you have hold U.S. citizenship or tax residency at the time of selling. However, in Part 1 of this essay I mentioned that if you bought the property while you were a foreign national or non-resident, there are certain tax rate expectations that are recorded with the IRS on Form 1099-S. You may have to address these expectations if your citizenship or tax residency has changed.
Given the scarcity of tailored advice and services for foreign-based or non-resident U.S. real property buyers, there is a lot that could go wrong with these investments.
Should you (or someone you know) have any questions about foreign national or non-resident rental income, wish to rectify past-year rental income tax filings, or need to resolve foreign national or non-resident tax issues/liens with the IRS or a State, please feel free to contact me by phone (1-877-632-6829) or email at akyele@archersolutions.biz.
Abraham Kyele King’oo, EA, MBA
6400 Georgia Avenue NW, Suite 11
Tel. 1-877-632-6829
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