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.
Branch profits tax for nonresident investors in U.S. real estate
This little FAQ is a simple (for certain values of $SIMPLE) explanation of the branch profits tax for nonresident investors in U.S. real estate.
As a general principle it is a Very Bad Idea for nonresidents to own income-generating U.S. real estate through foreign corporations. If you live in a country that has an income tax treaty with the United States, there may be a solution to the branch profits tax via the treaty.
What is the branch profits tax?
The branch profits tax is an extra income tax imposed by the United States on foreign corporations which earn profit from their U.S. investments or U.S. business operations.
How much will the branch profits tax cost?
The branch profits tax is imposed on a non-U.S. corporation’s after-tax net profit. Simply put, the branch profits tax works like this:
- Calculate the non-U.S. corporation’s profits derived from U.S. investments or business operations.
- Pay regular corporation income tax on that profit.
- Whatever is left over is your after-tax net income. Pay 30% of that after-tax net income as the branch profits tax.
Example of calculating branch profits tax
Let’s assume that a non-U.S. corporation owns U.S. real estate that is rented. At the end of the year, after paying all business expenses, the corporation has a profit of $100.
First, the corporation will pay income tax. The tax rate is on a sliding scale (higher income means higher tax rate). But let’s use 34%, the rate that applies for income of about $350,000 and up. After paying the regular income tax, the corporation has $66 remaining.
Then the corporation pays the branch profits tax, which is 30% of the $66 remaining after payment of the regular income tax. The branch profits tax is $19.80.
The total tax paid is $34.00 + $19.80 = $53.80, or 53.8% of net profit.
Only foreign corporations pay the branch profits tax
The branch profits tax is only imposed on foreign corporations. This means two things:
- The entity must be viewed as a corporation from the perspective of the U.S. tax authorities; and
- The entity must be formed under the laws of a country other than the United States.
People, then, do not pay the branch profits tax, even if they are nonresidents of the United States. Nor do partnerships or trusts.
What is a foreign corporation?
Be careful. Sometimes you may have an entity that is called a corporation but is treated in the United States for tax purposes as something else. Similarly, you may have an entity that is not called a corporation, but is treated as a corporation in the United States for tax purposes.
Many countries attribute residence of a corporation to its place of management. This does not matter for U.S. tax purposes. A corporation is foreign if the organizing documents (Articles of Incorporation or similar) say something to the effect of “This corporation is formed under the laws of ________” and the place named is not a place in the United States.
Why the branch profits tax exists
The branch profits tax is intended to cause non-U.S. corporations (and their shareholders) to be taxed identically to U.S. corporations (and their shareholders). The idea is that a nonresident investor should be indifferent–from a U.S. tax perspective–between investing in the United States through a non-U.S. corporation or through a U.S. corporation.
If a non-U.S. person owned a U.S. corporation which made the equivalent investment, the net profit would be taxed at 34%. Under the example I gave, this means that the corporation would contain $66.00 after paying its income tax. If the shareholder wanted that cash, the corporation would pay a dividend to the non-U.S. shareholder. As the dividend money leaves the United States there is a withholding tax imposed, at a default rate of 30% of the amount of the dividend. (It can be less if the recipient lives in a country that has an income tax treaty with the United States.)
Thus, a non-U.S. investor who used a U.S. corporation would pay two levels of tax: the regular corporate tax calculated at 34% of income, and the 30% withholding tax on the dividend paid by the corporation to the shareholder.
Compare that to the same investment made by a non-U.S. investor through a non-U.S. corporation. The non-U.S. corporation earns $100. It pays the regular income tax at 34%.
It has $66.00 remaining in its bank account. Now the shareholder wants a dividend. The United States cannot tax that dividend because it is paid from a non-U.S. corporation to a non-U.S. shareholder. The second level of tax–the 30% tax on dividends–will not be paid.
The branch profits tax plugs that hole.
The branch profits tax applies automatically
The branch profits tax automatically applies if there is a profit generated in a fiscal year for the non-U.S. corporation. Compare that to the tax on a dividend: here the corporation controls if and when the withholding tax on the dividend will be paid, by deciding to pay (or not) a dividend.
How a non-U.S. corporation avoids the branch profits tax
The branch profits tax is imposed in an automatic and mechanical way. There are only a few ways to eliminate it:
- Reinvest your profits in the United States;
- Find an exemption in the income tax treaty between the United States and the country in which the corporation was formed (the United Kingdom, for instance, has an exemption); or
- Completely terminate all business and investment operations in the United States (also know as “sell your assets and take your money home”).
When the branch profits tax is harmless to real estate investors
The branch profits tax is harmless to nonresident real estate investors if the non-U.S. corporation owns one piece of U.S. real estate, and that property is not producing income. Direct ownership of land is fine. So is direct ownership by a non-U.S. corporation of a house which is used for personal purposes.
The branch profits tax does not matter in these situations because there is no annual rental income collected. No income means nothing to tax.
In the year of sale there will be profit and the branch profits tax will apply. But there is a simple exception which can be used to eliminate the branch profits tax in the year of sale–the branch profits tax will not apply if the non-U.S. corporation ceases all U.S. business and investment operations in the year of sale.
When the branch profits tax applied to rental property
The branch profits tax will apply to nonresident investors in U.S. real estate who have rental income held directly by a non U.S. corporation. The income collected (after expenses) will be subjected to the branch profits tax.
When the branch profits tax applies to multiple properties
A non-U.S. corporation which owns many pieces of U.S. real estate will have a branch profits tax problem.
If any of the properties are rented, the rental income will be subjected to the branch profits tax.
If one of the pieces of real estate is sold, the profit on sale will be subjected to branch profits tax, and the exception traditionally used to eliminate the branch profits tax (the non-U.S. corporation ceases all U.S. investment and business operations in the year of sale) cannot be used, because the corporation continues to hold other pieces of real estate.
What to do if branch profits tax is a problem
If you have an existing situation which triggers branch profits tax, consider adding a U.S. corporation to the holding structure. Instead of the non-U.S. corporation owning U.S. real estate directly, the non-U.S. corporation will own all of the shares of a U.S. subsidiary corporation, which in turn owns the U.S. real estate.
This type of restructuring will not trigger any tax if done correctly. It is purely a paperwork exercise.
Since the owner of the real estate is now a U.S. corporation, the branch profits tax will no longer apply. (Branch profits tax only applies to non-U.S. corporations).
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. :-)
Nonresidents, withholding on real estate sales, and time for claiming tax refunds
Here’s a problem that comes up again and again, so I am going to solve it for the interwebs once and for all.
Let’s take a common situation. A nonresident of the United States creates a Bahamas corporation to buy U.S. real estate. The Bahamas corporation is the owner of the real estate.
Later, the nonresident decides to sell the U.S. real estate. Technically, the seller is the Bahamas corporation, since the Bahamas corporation is the true owner of the real estate. As is normal, 10% of the sales prices is withheld for Federal income tax.
No income tax returns is filed in the United States for the year in which the real estate is sold. This may happen because the person did not know of the requirement, or because the person had a busy life full of other things that had to be done.
Then, a few years later the person remembers the amount of tax withheld and wonders if some or all of it can be claimed as a refund.
Why there is tax withholding for nonresidents
U.S. tax law is designed to treat nonresident owners of real estate exactly the same as residents. In theory, two identical real estate investors (one a resident, one a nonresident) should pay exactly the same tax on the capital gain made when real estate is sold.
In the case of a U.S. resident who sells a piece of real estate, there is no requirement of tax withholding. The U.S. government is confident of its ability to collect tax on the sale. Why is the government so confident? Simple. The U.S. resident faces a very real threat of imprisonment if taxes aren’t paid. :-) And if not imprisonment, then forcible collection of the tax by assorted means.
With nonresidents, the U.S. government is quite certain of its inability to collect tax on sale of the U.S. real estate. A nonresident can sell U.S. real estate, wire the money to his/her/its home country, and never set foot in the United States again. Avoiding the tax is trivially easy, and the U.S. threat of imprisonment or forcible collection is laughable to someone who will never set foot in the United States again.
That’s why withholding exists for nonresidents.
Withholding is not the final tax
The “10% of gross sale price” withholding is not the nonresident’s final tax liability. It is a credit against the actual tax liability that is computed for the sale.
The nonresident is required to file an income tax return (Form 1040-NR for humans, Form 1120-F for foreign corporations) in the year of sale. On this tax return the nonresident calculates the actual capital gain and the tax due on that gain.
- If the tax withheld is more than the actual tax due on the gain, the nonresident is entitled to a refund.
- If the tax withheld is less than the actual tax due, the nonresident faces the prospect of making an additional payment to satisfy the tax liability.
Claiming the refund if you never filed a tax return
The rules for claiming a tax refund apply to nonresident investors in U.S. real estate in exactly the same manner as they apply to U.S. residents.
If you believe you are entitled to a tax refund, there are time limits for claiming that money. If you never filed a tax return, the time limit is two years from the date that the tax was paid.
You sold U.S. real estate in October, 2001. That means you paid the 10% withholding tax in October, 2001. You have until October, 2003 to claim a refund of the tax.
You sold U.S. real estate in October, 2008. That means you have until October, 2010 to claim a refund of the tax.
File your tax return promptly and claim the refund if you are entitled to it.
Related recommendation: if you are in the middle of a sale transaction now, consider using the procedures of Form 8288-B for reducing withholding tax in the first place.