Tax Planning for Nonresident US Real Estate Investments
Tax Planning for Nonresident US Real Estate Investments: Each year, foreign investor nonresident aliens from across the globe invest into US real estate and other USRPI. The US real estate rental income market can be a very lucrative investment for foreign residents. Unlike other types of US capital gains, the sale of US real estate property by a nonresident alien is taxable and falls into the FIRPTA territory by the IRS. Likewise, income generated from rent is also taxable, and the default category is FDAP — which comes with certain tax consequences such as 30% withholding.
In order to avoid the harsh FDAP treatment, a foreign national/nonresident alien can also make certain elections and apply for withholding certificates to have the rental income treated as ECI.
Let’s review the tax planning basics for nonresident and foreign investment in US real estate, with an example.
David NRA Purchases a US Real Estate Investment
The first aspect of David’s tax planning for US real estate investment and acquisition is the purchase of his US real estate property for rental income.
David is a nonresident alien (NRA) with no US person tax status. He has a significant amount of cash burning his wallet and sees the US real estate market as a lucrative investment and he wants in. Therefore, David individually purchases a real estate property in San Jose, CA — all-cash and generates significant rental income from the get-go.
Rental Income (FDAP & Withholding)
Even without mortgage interest deductions, David still has a significant amount of deductions due to property tax and depreciation. The problem from a tax perspective is that rental income is deemed FDAP, unless he elects to be treated as ECI. If David does not make any election to treat the income as ECI, his US tenant is supposed to withhold 30% of the rent and submit it to the IRS.
Nonresident Tax Planning Solution: ECI Tax Election
Once deductions and expenses are factored in, David will have a significantly reduced net income tax liability. Therefore, David makes the election to have the rental income taxed as ECI — which means the income is “Effectively Connected Income” to a US trade or business instead of FDAP. As a result of the election, instead of having 30% withheld from the rental payments, David can apply rental deductions and expenses — and will be taxed at graduated rates similar to a US person. This results in a much better tax position, as long as David is okay with filing an annual tax return.
Sale of Real Estate (FIRPTA)
Unfortunately, as a result of the down market, David’s tenant stopped paying rent. In addition, there were several other external factors that David did not consider before purchasing the property, and he is tired of playing landlord. Also, David does not want to pay a Property Manager to handle the investment.
Therefore, the next step on David’s tax planning journey is the sale of the home.
FIRPTA Tax Problem for Nonresident Investors
Since David is a foreign seller of US property, he is subject to FIRPTA – Foreign Investment in Real Property Tax Act. As a result of FIRPTA, 15% of the sale price (not the gain) has to be remitted to the IRS.
The reason for the withholding is because the Internal Revenue Service wants to make sure foreigners who are required to pay tax on US real estate & property sales actually pay the taxes due. In fact, many foreigners would not even know they had to file a US tax return — never mind pay tax on it. For David, based on the value of the property value and FMV, 15% would be a hefty withholding to have to submit the IRS — and would far exceed the tax consequences based on the gain.
Real Estate Tax Investment Solution to FIRPTA
David can apply for a Form 8228-B withholding certificate to significantly reduce or avoid any withholding on the sale. It is important for David to properly time the application for the withholding certificate to coincide with the closing dates for the transaction for the sale of the property — to avoid any unnecessary delay and/or impact on the sale.
Tax Planning and Structuring Before Investing in US Real Estate
What are some other options? David might have formed a foreign company instead to hold the property (although the benefits may be limited under TCJA). Alternatively, David could have transferred the money for purchase to his permanent resident children under their own names — who would not be subject to FIRTPA or rental income withholding.
*If David purchased the property outright and then transferred it to his children — it could result in an immediate gift tax consequence for a NRA transferrring USRPI.
While US real estate can be a great investment in both the rental and sales market, it is important to note that a little bit of planning can go a long way.
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