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February 17, 2010 - Phil Hodgen

How and when a nonresident investor in U.S. real estate makes a “Net Election”

By default a nonresident investor is taxed harshly on rental income from U.S. real estate holdings: 30% of gross rent is the Federal income tax, with no offset for operating expenses.

If you are collecting $1,000 per month in rent, this means your monthly income tax is $300, leaving $700 to pay the mortgage, property taxes, and other operating expenses. My experience is that this is a sure way to run a monthly cash flow loss.

You’d rather pay income taxes only on your net income: the rent you collect minus your tax-deductible operating expenses. These expenses include property taxes, mortgage interest, cost of repairs, depreciation, and other normal expenses associated with owning and operating real estate. Frequently these tax-deductible costs exceed the rent you collect, meaning that your taxable income is zero. Which of course means you pay no tax.

In order to get to this point, you need to make a special election on a U.S. income tax return. Use Form 1040-NR if you are a person, and Form 1120-F if the real estate is owned by a non-U.S. corporation. Write up a statement on a piece of paper and attach it to the back of the tax return. Your statement should consist of the following information:

  • a schedule of all U.S. real property (or an interest therein) in which the taxpayer owns a beneficial interest;
  • the extent of the taxpayer’s direct and beneficial interest in each item of U.S. real property;
  • the location of each item of U.S. real property;
  • a description of any substantial improvements on each item of U.S. real property; and
  • an identification of the taxable year(s) in which a revocation or new net election has previously occurred.

For your reading pleasure, here are the Treasury Regulations:

1.871-10(d)(1) Election, Or Revocation, Without Consent Of Commissioner–

1.871-10(d)(1)(i) In General.

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.

1.871-10(d)(1)(ii) Statement To Be Filed With Return.

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.

1.871-10(d)(1)(iii) Exemption From Withholding Of Tax.

For statement to be filed with a withholding agent at the beginning of a taxable year in respect of which an election under this section is to be made, see paragraph (a) of § 1.1441-4.

US Real Estate Investments