There are many income tax issues that must be considered when a foreign national invests in U.S. real estate.
The analysis begins with the foreign national’s tax status in the U.S. tax system:
1) Are they U.S. citizens (dual citizens)?
2) If not, do they hold a “Green Card” that allows permanent U.S. residency status?
3) If not, do they meet the “substantial presence” test?
4) If they do not satisfy these tests, they are treated as a U.S. non-resident.
The following comments summarize some of the most important items to consider before investing in U.S. real estate, including:
- U.S. citizens and U.S. residents – global taxation
- U.S. non-residents and foreign entities – U.S. source income taxation
- Foreign nationals – U.S. residents vs. U.S. non-residents
- Foreign Investors Real Property Tax Act (FIRPTA)
- Rental income from U.S. sources received by U.S. non-residents and foreign entities
- Rental activity U.S. trade or business election
- Personal use real estate
- Holding title to U.S. real estate
- International Income Tax Treaties
- State income taxes
U.S. Non-residents and Foreign Entities – U.S. Source Income Taxation
Foreign nationals who are not U.S. citizens or U.S. residents are treated as U.S. non-residents. U.S. non-residents and foreign entities are subject to U.S. income tax only on their U.S. source income.
“Fixed or Determinable Annual or Periodic Income” (FDAP) is income that is not effectively connected with a U.S. trade or business. FDAP includes income such as interest, dividends, rents, royalties, etc. FDAP is subject to U.S. income tax withholding at a 30% rate. FDAP income is taxed on a gross basis and is not reduced by any related expenses.
U.S. source capital gain income earned by U.S. non-residents generally is not subject to U.S. income tax, but FIRPTA has a critical difference, as discussed below.
Income earned by U.S. non-residents that are effectively connected with a U.S. trade or business is subject to the same tax rates imposed on U.S. citizens and U.S. residents. Effectively connected income is taxed on a net basis (gross income less allowable expenses).
Foreign Nationals – U.S. Residents vs. U.S. Non-residents
Foreign nationals who are not U.S. citizens can be taxed as U.S. residents on their worldwide income under two different tests.
A foreign national that has a “Green Card” that allows permanent U.S. residency status is taxed as a U.S. resident.
A foreign national is also taxed as a U.S. resident if they meet the “substantial presence” test. The substantial presence test is based on the number of days that the foreign person is present in the U.S. The substantial presence test is a formula that includes the sum of:
1) 100% of days present in the U.S. in the current tax year,
2) One-third of days present in the U.S. in the prior tax year, and
3) One-sixth of days present in the U.S. in the second preceding tax year.
If the sum is at least 183 days, then the foreign national is treated as a U.S. resident taxable on their worldwide income.
A foreign national that is not a U.S. citizen or a U.S. resident is treated as a U.S. non-resident.
It is important for U.S. non-residents to keep track of the number of days that they spend in the U.S. so that they do not inadvertently become a U.S. resident.
Foreign Investors Real Property Tax Act (FIRPTA)
FIRPTA imposes special income tax rules for foreign parties that invest in U.S. real estate, and it was enacted over 40 years ago.
As discussed above, U.S. source capital gain income earned by U.S. non-residents generally is not subject to U.S. income tax.
However, FIRPTA has a significantly different rule.
FIRPTA treats gains derived from the disposition of real property located in the U.S. as effectively connected trade or business income. This means that U.S. non-residents who recognize a gain on the sale of U.S. real property are treated as taxable U.S. source income.
Rental Income from U.S. Sources Received by U.S. Non-residents and Foreign Entities
There is some uncertainty about whether real property rentals qualify as a U.S. trade or business or as an investment activity.
The tax consequences of a U.S. trade or business compared to an investment activity are dramatically different, as illustrated in the example below.
Real property rentals may qualify as a U.S. trade or business based on the facts and circumstances, but only if there are substantial operating and management activities. A real property rental business is taxed on a net basis. Net taxable income is gross income less allocable operating expenses, including mortgage interest, property taxes, insurance, repairs, maintenance, etc.
Ownership of one rental property will almost always be treated as an investment activity. Investment activity character usually will apply unless several properties are owned and actively managed by the U.S. non-resident. The gross income from a real estate rental investment activity is subject to 30% income tax withholding.
For example, assume that a U.S. non-resident owns a U.S. rental property that has a rental income of $50,000, rental expenses of $50,000, and net taxable income is zero. A rental business would pay no income tax because it has zero net taxable income. A real estate rental investment activity would pay $15,000 U.S. income tax withholding on its $50,000 gross income (30% times $50,000 gross income).
Rental Activity U.S. Trade or Business Election
The U.S. non-resident owner can make an election to treat an investment rental activity as a U.S. trade or business (“net election”). The net election would mean that the investment rental activity would be taxed on a net basis as a U.S. trade or business. The result in the above example would be that the real estate rental investment activity would have no gross income tax withholding and zero net income tax.
Most U.S. non-residents that do not own multiple rental properties that have substantial management and operating activities make the net election in the year that they purchase the rental property.
Personal Use Real Estate
Personal use real estate owned by U.S. non-residents that do not produce rental income will not be subject to U.S. income tax. Likewise, the carrying costs will be personal, non-deductible expenses. This includes mortgage interest expenses, real estate taxes, insurance, repairs, etc.
Holding Title to U.S. Real Estate
A foreign national can hold the ownership title of U.S. real estate in their individual name.
Many owners choose to hold title to U.S. real estate through a legal entity, including U.S. citizens, U.S. residents, and U.S. non-residents. There can be several reasons to do so, including legal liability insulation and confidentiality. The most common structure is to form a limited liability company (LLC) and use the LLC to take title upon purchase.
An LLC that has only one owner is treated as a disregarded entity (DRE) for U.S. income tax purposes. A DRE’s activities are deemed to be conducted by the sole owner for U.S. income tax purposes, and the DRE is not required to file U.S. income tax returns.
Some states, such as California, require DRE LLCs to file simple information returns and impose a minimum tax and/or a gross receipts tax.
The sole owner can contribute U.S. real estate held in their individual name to a single-member LLC as a non-taxable transaction for U.S. income tax purposes.
International Income Tax Treaties
The U.S. has almost 70 Income Tax Treaties with foreign countries. Income Tax Treaties supersede the income tax rules of both countries. Each Treaty is separate and distinct, and the provisions and details in each Treaty may differ. Treaties can provide better tax results than the consequences under the host country’s income tax rules, and they rarely provide detrimental results.
A foreign national must be a citizen or resident of the Treaty partner country to claim the benefits of that Income Tax Treaty.
The 30% U.S. withholding FDAP tax rate is usually reduced or eliminated under most Treaties.
Most Treaties provide a “tie-breaker” rule when a foreign national is treated as a resident under the laws of both countries.
The tie-breaker will determine which country will treat the foreign national as a resident.
State Income Taxes
Most states have an income tax, which is separate from and in addition to U.S. income tax. Many states follow federal income tax rules and have stated differences, but some have their own system. States are not part of the U.S. government, so they are not subject to and do not follow U.S. international Income Tax Treaties.
Rental income usually is taxable in the states that have an income tax. Most states do not have an FDAP system. The specific rules in the state that you plan to invest in must be considered.
Most states also have various non-income tax fees and filing requirements.