Rental of U.S. Real Estate by a Nonresident

I was speaking with someone from overseas about buying real estate around here and renting it out. This person is a green card holder, so their tax considerations in owing rental real estate would be the same as yours or mine.

But what if they were not a green card holder?

Different set of rules. We are talking about the U.S. taxation of a nonresident alien. A nonresident alien does not have a green card or spend enough time in the U.S. to be considered a resident.

There are two ways to handle a nonresident alien’s reporting of U.S. rental real estate.

Let’s call the first one the “default” rule. This type of income is referred to as “fixed, determinable, annual or periodic” (FDAP) and carries a 30% tax rate on the gross amount of income. Examples of FDAP are interest, dividends, annuities, royalties and rents. 

Let’s use some numbers to make this concrete:

                        Rent received                                                24,000

                        Property management                                    2,400

                        Real estate taxes                                            6,000

                        Insurance                                                        1,600

                        Depreciation                                                   9,000

                        Net profit                                                        5,000

Oh, the property manager will have to withhold the 30% upfront. The manager has to, as the tax code requires the manager to pay the 30% from his/her own funds if he/she does not withhold it from you.

Under the default rule the property manager will withhold 30% of your rental income, or $7,200, and forward it to Treasury. At the end of the year the manager will send you a Form 1042-S reporting the withholding. The good news is that you do not have to file further taxes. The bad news is that it cost you 30%.

NOTE:  The 30% is not cast in stone. It can be overridden by treaty.

The second way is to make an election, so let’s call it the “election” rule. The idea here is that you have a trade or business in the United States (you do, sort of, as a landlord), and you are going to elect to have the rental property “effectively connected” to your business. The principal tax difference is that you will owe tax using graduated tax rates on your net rental income. To phrase it another way, “effectively connected income” (ECI) of a foreign person is taxed like the income of a U.S. person.

The first thing you do is file a form (Form W-8ECI) with the property manager so the manager does not have to withhold 30% from you.

The second thing you have to do is file a tax return (Form 1040NR) at the end of the year. You have to include an election in the return alerting the IRS what you are up to. You will pay tax on $5,000, which is big improvement over paying tax on $24,000. Technically, you would be paying tax on less than $5,000, as you also get a personal exemption, but you get the idea. You also have graduated tax rates – not a flat 30% like under the default rule.

By the way, if you came into our offices using the default rule, we would likely encourage you to file a return anyway under the election rule. Why? To get back some of your 30% withholding, that’s why. The government would have gotten $7,200 from you. That was more than your profit before giving the government anything! Then we would have you fill out the paperwork to have the property manager stop withholding on your rent checks.

A Surprise for US Persons With Undeclared Canadian Retirement Plans

We have a few clients who are Canadian or lived in Canada. We have two who lived in Toronto through last year before moving to Wisconsin. Nothing like that warmer weather!

Anyway…

There is a very specific tax issue if you are Canadian and emigrating to the U.S. It has to do with Canada’s version of IRAs and 401(k)s. Canada calls them Registered Retirement Savings Plans (RSSP) or Registered Retirement Income Funds (RRIF).

In Canada these accounts are tax deferred (just like IRAs and 401(k)s in the US). In the US they are not UNLESS you make certain tax elections. The IRS otherwise considers these accounts to be just another broker’s account and will tax you annually on the interest, dividends and capital gains.

Rev Proc 2002-23 states the procedures to make an election on your US tax return. You have to make a separate election for each plan. The form you use is Form 8833 Treaty Based Return Position Disclosure. You state that you are claiming the benefit of Article XVIII(7) of the US-Canada Income Tax Convention. You’ll have to include the name of the financial institution where the account is kept, the account number of the plan, and the account balance at the beginning of the year.

If somewhere down the road you finally draw on the Canadian plan, you will owe Canadian tax. If you truly have emigrated, then Canada will consider you a nonresident and withhold – at 25%, I believe.

If you paid tax annually to the US, the US tax calculation at that moment could be hair-pulling. You would have “basis” in some of the account – to the extent you paid tax – and not have “basis” in the rest.

If this is you, please get professional advice.