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June 8, 2015 - Phil Hodgen

Resident is not resident, ergo tax-free interest

Hi, it’s Phil Hodgen again. Welcome to the Friday Edition.

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Tax-free interest on U.S. real estate loans

Today’s topic is a real estate finance question that came from a friend:

A nonresident alien borrows funds from a fellow countryman. The nonresident alien uses those funds to purchase California real estate. The NRA pays interest on the loan.

Two questions:

  • is the interest subject to withholding (should not be because the NRA is not a U.S. resident) and
  • is the interest deductible from the income generated by the California property? If so, why? If not, why not?

Let’s assume the following as well:

  • The fellow countryman is also a nonresident alien from the perspective of the Internal Revenue Code.
  • The borrower secured the loan with a lien against the California real property.

To save time and electrons…

In the interests of saving time and space:

  • we will only deal with normal withholding rules, leaving FATCA withholding rules for another day; and
  • we will postpone the question of deducting interest.

I am only solving the first of many questions.

If all of them are successfully solved, a foreign lender can make real estate loans on U.S. real estate investments by nonresidents . . . and collect the interest expense tax-free. The borrower can get a tax deduction for the interest paid on that loan.

Withholding — U.S. source income only

A person who pays money to a nonresident alien individual must withhold 30% of the payment:

“to the extent that any of such items constitutes gross income from sources within the United States”. I.R.C. § 1441(a).

If the source of the income is not from “within the United States”, then there is no withholding requirement.

This means that we must figure out whether interest paid by a foreign borrower to a foreign lender on a mortgage on U.S. real estate is “U.S. source” interest income for the lender, or whether it is “foreign source” interest income to the foreign lender.

Source for interest income = debtor’s residence

Interest will be U.S. source income when it is:

Interest from the United States or the District of Columbia, and interest on bonds, notes, or other interest-bearing obligations of noncorporate residents or domestic corporations[.]

I.R.C. §861(a)(1). Emphasis added.

The borrower in our example is an individual, so whether the interest is U.S. source income depends on whether he is a “noncorporate resident””. Noncorporate is easy. Our borrower is a human. But is our borrower a “resident”?

Resident defined

A resident of the United States is defined as follows by the Regulations:

The term “Resident of the United States”, as used in this paragraph, includes (i) an individual who at the time of payment of the interest is a resident of the United States, (ii) a domestic corporation, (iii) a partnership which at any time during its taxable year is engaged in a trade or business in the United States, or (iv) a foreign corporation or a foreign partnership, which at any time during its taxable year is engaged in a trade or business in the United States.

Regs. §1.861-2(a)(2). Emphasis added.

When is an individual a “resident”?

The source rule definition of a “resident” is circular — “‘Resident of the United States’ . . . includes (i) an individual who . . . us a resident of the United States”.

The only thing we know for sure is that an individual borrower’s business activities in the United States do not matter for determining whether the borrower is a resident (or not) of the United States.

  • Foreign partnerships and corporations are resident or not based on whether they are engaged in business in the United States (or not). Regs. §1.861-2(a)(2)(iii) and (iv).
  • A human’s status as a “resident” for the source rules, however, is not affected by whether the individual is engaged in business in the United States. Regs. §1.861-2(a)(2)(i).

“Resident” defined generally

We now need to look elsewhere in the Code to understand what the source rules mean for deciding that a borrower is a resident of the United States in deciding whether interest income is U.S. source or not.

When in doubt, we look to I.R.C. § 7701 for definitions of terms used in the Code. There, we find that a “resident alien” is someone who is not a U.S. citizen (hence, an alien) and who becomes a resident under one of three methods:

  • by getting a permanent resident visa;
  • by spending lots of time in the United States (the “substantial presence” test); or
  • by electing to be treated as a resident of the United States for income tax purposes.

I.R.C. § 7701(b).

“Resident” defined for source of income

But when we talk about an individual’s “resident” status for determining the source of interest income (U.S. residents paying interest create U.S. source income for the lender), the definition of a “resident” in I.R.C. §7701(b) is not the (fully) correct definition.

For the purpose of defining “resident” for the source rules, a borrower is a “resident” of the United States (and the interest paid by that person is U.S. source income to the lender) if and only if that person is a resident of the United States using the substantial presence test.

Specifically, the following conclusions were reached by the IRS in CCA 201205007 in analyzing the source rules for interest:

  • A U.S. citizen must be a U.S. resident using the substantial presence test in order for interest paid by that citizen to be considered U.S. source income for the lender.
  • A non-citizen of the United States who has a green card but is living outside the United States (by the substantial presence test) would be considered to pay foreign source income to the lender.
  • A non-citizen of the United States who has a green card but is living outside the United States (by the substantial presence test) and who makes a treaty election to be treated as a nonresident of the United States for income tax purposes would be considered to pay foreign source income to the lender.

If we follow the logic from CCA 201205007, a non-citizen of the United States who does not hold a green card will be judged as resident of the United States only if the substantial presence test makes him/her so.

Please read CCA 201205007 to follow Chief Counsel’s reasoning.

Conclusion: no withholding, no tax

This leads us to a very interesting conclusion: the interest income received by the foreign lender from a mortgage on U.S. real estate is tax-free to that foreign lender.

Withholding is only required on U.S. source interest income paid to a foreign lender [I.R.C. § 1441(a)] and the foreign lender is only taxed in the United States on U.S. source interest income [I.R.C. § 871(a) and (b)].

This is a foundational conclusion in setting up financing structures for foreign investors in U.S. real estate:

  • Foreign investors buy U.S. rental real estate. They pay interest to a foreign lender from the rental income stream they generate from the U.S. property they own.
  • The foreign lender is not taxed on that interest income, and has a competitive advantage compared to domestic lenders.

If we can figure out how to give our foreign investor in U.S. real estate a tax deduction for mortgage interest paid, things are even better:

  • We have created a tax deduction on one side of the transaction (for the borrower) and
  • tax-free income on the other side (for the lender).

This is the best of all possible worlds. Tax free income, well-secured by U.S. real estate. More on this sometime soon.

Disclaimer

This blog post is not tax advice.

It is designed to demonstrate an idea in tax law (the definition of “resident” varies from place to place in the Internal Revenue Code) and show one interesting implication of this (the ability to make money in the United States as a real estate lender and pay no income tax).

Hire someone to give you good advice on what to do.

See you next week.

Phil.

Friday Edition