All foreign investors owning U.S real property are responsible for paying taxes on any and all rental income they earn in the United States from that property. As a general rule, a non-US person who rents out his or her U.S. property is subject to a 30% withholding tax imposed on the gross amount of each rental payment. However, the method by which rental income will be taxed depends on whether or not the foreign person who owns the property is considered to be engaged in a “U.S. trade or business.” If so, the income is considered effectively connected income (“ECI”).
Under the U.S. tax code, a foreign investor who buys a U.S. property and simply rents it out is considered a passive investor. However, foreign investors have the option to elect to have their passive rental income taxed as if it were effectively connected to a U.S. trade or business. This election removes any obligation to withhold taxes from the gross rental income.
Do I have to Report Foreign Property to IRS?
The tax on U.S. source income that is not effectively connected income is generally subject to a withholding requirement, meaning the tax is withheld when the income is paid to the foreign person. The foreign owner, the U.S. property manager, and even the tenant may be responsible for sending in the 30% withholding to the IRS. The IRS can go after any of the parties who fail to send in the 30% withholding from the gross rental payment. A property manager should withhold 30% of the gross rental receipts to avoid personal liability.
The Internal Revenue Code defines a “withholding agent” to be “any person in whatever capacity, having the control, receipt, custody, disposal or payment of income that is subject to withholding.” Thus, a real property manager who collects rent on behalf of a foreign owner of real property is clearly considered a withholding agent. Withholding agents must report annual rents collected on behalf of foreign landlords on Forms 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons, and 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding.
If the foreign investor makes the election, they must properly inform the property manager that the rental income is to be treated as ECI by submitting to the property manager Forms W-8ECI, Certificate of Foreign Person’s Claim for Exemption from Withholding on Income Effectively Connected with the Conduct of a Trade or Business in the United States. A fully completed Form W-8ECI must include a valid U.S. tax identification number for the foreign landlord, meaning the rental agent must withhold and send the 30% tax to the IRS until this requirement is satisfied.
Accountants and CPA’s should advise their foreign clients on the difference between “passive rental income” and “effectively connected income.” The difference entails different tax consequences. Ownership of real property is not considered to be engaged in a U.S. trade or business if it consists of merely passive activity and is therefore not effectively connected income. Such passive rental income is subject to a flat 30% withholding tax applied to the gross income rather than on the “net basis.” However, the Internal Revenue Code §871(d) and §882(d) allows a foreign investor or foreign corporation that derives income from real property, but that is not engaged in a US trade or business, to elect to be taxed on a “net basis” at graduated progressive rates as if the income were ECI.
This election is beneficial because real estate income can often be offset by the substantial expenses associated, such as depreciation, mortgage interest, real property taxes, maintenance, repairs, and interest expenses. Upon making the election the investor is relieved of the 30% tax withholding on the gross rental income and can deduct all real estate expenses. Often these expenses exceed income and therefore no U.S. tax is due. The foreigner must make estimated tax payments for the tax due on the net rental income if any. However, the only way these real estate expenses can be deducted is if an income tax return Form 1040NR for nonresident alien individuals and Form 1120-F for foreign corporations is filed by the foreign investor.
If the election is not made, and withholding is required, then the gross income and taxes withheld must be reported on the tax Form 1042-S, Foreign Persons U.S. Source Income Subject to Withholding to the IRS, and the Form 1042, Annual withholding Tax Return for U.S. Source Income of Foreign Persons, by March 15 of the following calendar year.