International Tax Lunch Session: Portfolio Interest Exception
What: Portfolio Interest Exception
When: Friday, March 14, 2014 at Noon (Pacific Time)
Where: HodgenLaw, 80 S. Lake Avenue, Suite 680, Pasadena, CA 91101
Who: Rufus v. Rhoades, International Tax Attorney
For this month’s international tax lunch session, Rufus will be speaking about the portfolio interest exception, which is very useful information for nonresidents investing in U.S. real estate.
Rufus provides tax consulting to law firms, accounting firms, and international trust companies. He specializes in international tax, foreign tax issues, non-resident issues, and provides expert testimony for international taxation matters.
To register for conference-call participation:
*Call-in participation is listen-in only, but you can email your questions to us here.
The international tax lunch sessions are held every month on the second Friday of the month. Past topics include expatriation, PFICs, and nonresident investment in U.S. real estate.
To be notified of upcoming sesions, sign up for the lunch list here:
Presentation and Q&A: Global Real Estate Transactions
What: Global Real Estate Transactions — Presentation followed by Q&A
Time: Tuesday, January 14, 2014 from 1:00 PM to 2:00 PM
Where: Malibu Public Library — 23519 Civic Center Way, Malibu, CA 90265
Host: Malibu Association of Realtors – Global Committee
Phil will be part of a presentation and Q&A session along with Mitch Creekmore, SVP with the Stewart Title Guaranty Company.
If you are interested in joining the event, please contact Olivia at olivia.park (at) hodgen.com.
Make the net election once
Nonresidents who have U.S. rental real estate will usually make an election to have their rental income taxed as if they were residents of the United States.
They do this because it results in lower income tax. It results in lower income tax for a simple reason: if they don’t make the election their rental income is taxed at 30% of gross rental income received, and no deduction is allowed for business expenses. By making the election, they are taxed instead on their rental income AFTER deduction of business expenses.
This election is called the “net election” because it is an election to be taxed on net income (income minus expenses) rather than gross income (income without deduction of expenses).
Making the net election
You, the taxpayer, can unilaterally make this election and you do not need consent from the Federal tax authorities to do so. Treasury Regulations Section 1.871-10(d)(1)(i) says:
A nonresident alien individual or foreign corporation may, for the first taxable year for which the election under this section is to apply, make the initial election at any time before the expiration of the period prescribed by section 6511(a), or by section 6511(c) if the period for assessment is extended by agreement, for filing a claim for credit or refund of the tax imposed by Chapter 1 of the Code for such taxable year. This election may be made without the consent of the Commissioner. Having made the initial election, the taxpayer may, within the time prescribed for making the election for such taxable year, revoke the election without the consent of the Commissioner. If the revocation is timely and properly made, the taxpayer may make his initial election under this section for a later taxable year without the consent of the Commissioner. If the taxpayer revokes the initial election without the consent of the Commissioner he must file amended income tax returns, or claims for credit or refund, where applicable, for the taxable years to which the revocation applies.
The method for making the election is described in Treasury Regulations Section 1.871-10(d)(1)(ii), which says:
An election made under this section without the consent of the Commissioner shall be made for a taxable year by filing with the income tax return required under section 6012 and the regulations thereunder for such taxable year a statement to the effect that the election is being made. This statement shall include (a) a complete schedule of all real property, or any interest in real property, of which the taxpayer is titular or beneficial owner, which is located in the United States, (b) an indication of the extent to which the taxpayer has direct or beneficial ownership in each such item of real property, or interest in real property, (c) the location of the real property or interest therein, (d) a description of any substantial improvements on any such property, and (e) an identification of any taxable year or years in respect of which a revocation or new election under this section has previously occurred. This statement may not be filed with any return under section 6851 and the regulations thereunder.
In practice this means that you attach the required statement to your tax return. That is the first year that you get the desired tax treatment on your rental income.
You’re only required to do it once
You only need to make the election once. From then on it is effective until you revoke it. The authority for this is found in Treasury Regulations 1.871-10(d)(2)(i):
If the nonresident alien individual or foreign corporation makes the initial election under this section for any taxable year and the period prescribed by subparagraph (1)(i) of this paragraph for making the election for such taxable year has expired, the election shall remain in effect for all subsequent taxable years, including taxable years for which the taxpayer realizes no income from real property, or from any interest therein, or for which he is not required under section 6012 and the regulations thereunder to file an income tax return. However, the election may be revoked in accordance with subdivision (iii) of this subparagraph for any subsequent taxable year with the consent of the Commissioner. If the election for any such taxable year is revoked with the consent of the Commissioner, the taxpayer may not make a new election before his fifth taxable year which begins after the first taxable year for which the revocation is effective unless consent is given to such new election by the Commissioner in accordance with subdivision (iii) of this subparagraph.
Emphasis added by me.
We do it annually
We just completed an estate tax return for a nonresident individual who had several rental properties in the United States. He did not have a proper holding structure and as a result his heirs paid about $750,000 of estate tax on about $4,000,000 of real estate. And the probate and administration costs were gigantic. The moral of THAT story? Don’t assume that because you’re young and healthy you can get away with sloppy tax planning.
But I digress.
One of the collateral problems we faced was attempting to determine whether the deceased person had made the net election in a proper fashion. (In order to do an estate tax return, you have to make sure that all of the income taxes are paid up, which means you need to figure out if the tax returns were done correctly). For a couple of the properties, he had held them so long that we could not find the tax returns for the years in which he acquired the properties. So we did not know whether the net election had actually been made. (We were told that it had been made, and everything looked consistent with that treatment, but we couldn’t be sure).
The simple solution for this is to attach a statement to every U.S. income tax return that is filed. Every year. Attach the net election statement again but rewrite it in the past tense to say “The taxpayer made the net election for the following properties on his/her/its <year> income tax return . . . . ” and continue with the required information.
This can be set to automatically print as an attached statement for every year in the future in your software (we use Lacerte) and you just might save some work for someone in the future.
Milestones for the nonresident investor in U.S. real estate
If you are a nonresident of the United States and are considering real estate investments in the U.S., the first thought is “Where do I start?” It is a big job to buy real estate in your home country. Investing in a faraway land adds to the complexity.
Here is a quick set of milestones to help you think through the process. This comes from an email I just sent to someone who is thinking about starting the investment process, and I edited it a bit for clarity. I hope it helps.
Your project, I think, has the following milestones:
- Investment objectives. Tentative decision on type/location/size of investments. (You’ve done this already).
- Management requirements. Determination of amount of management required. (Can you outsource 100% or will there be a lot of work from you or from people you trust?) Example: a major retail shopping center has scads of maintenance people, janitors, leasing agents, etc. and it is an all-the-time job to keep the place rented and maintained. Yes, you can job out the janitorial work etc. to outside firms, but you need to monitor the jobbed-out work to make sure it’s done right, so that means you have a manager or two on staff on your own payroll.)
- Analysis and selection on holding structure. Given the type of property you want to buy, and the practical needs for hands-on management, choose how to own and operate the real estate investments. Factors involved:
- Type/location/size of investments (from above). This helps you make the cost/benefit analysis necessary for the holding structure. Bigger investments mean more complexity expense will pay off with tax savings. Smaller investments mean “keep it simple.”
- Management structure you need to carry (from above). (Translation: do you need a dedicated property management company or not?)
- U.S. and [home country] income tax considerations on rental income
- U.S. and [home country] tax consequences on sale of the property
- U.S. and [home country] tax considerations for tax if you have the bad judgment to die
- Business considerations, such as lenders — will your structure be something that a bank will lend to?
Create holding structure taking into consideration the factors above and a rigorous eye on cost/benefit considerations Buy property. This is the fun part, right? People and operations. Find key people to help you with owning/operating the real estate and holding structure — property management, bookkeeping, legal, tax returns, etc.
Speech to South Bay Association of Realtors
I just got back from a lunchtime speech to the South Bay Association of Realtors (that’s Torrance, Hermosa Beach, Manhattan Beach, Redondo Beach, etc. for those of you outside Southern California. They’re having a week-long Certified International Property Specialist certification course. I was part of the entertainment today. Good time.
I did the “FIRPTA in One Hour. Backwards” talk. In 30 minutes. :-)