Why you can't take a tax deduction for that (FIRPTA edition)

We (the team here at HodgenLaw PC) will be presenting a series of four webcasts for the California Society of Certified Public Accountants. I am preparing the first set of webcasts on a topic I really like – U.S. real estate investments by nonresidents. Shameless sales promotion: you should sign up for the CalCPA webcast.This week's Friday Edition is spawned by me being hip-deep in that topic.

TL;DR

Nonresidents who own vacation homes in the United States cannot take tax deductions for any of the costs of ownership.

House in the USA For You and Your Family

Here is the situation I will look at in this week's Friday Edition.Let's say you are a nonresident/noncitizen of the United States and you buy a house that you use now and then for vacation. Perhaps your family members use the house–maybe you have a child who lives in the house while going to school in the United States. You never rent the house to anyone. It is only for personal use by you and your family.Ordinarily a nonresident should own real estate indirectly -- through a trust or corporate structure -- to eliminate the risk of estate tax being imposed. However, I know many nonresidents who simply purchased a U.S. house in their own names, and are betting that they will sell the house and take the money home before they die. And most people are right about this.This example (direct ownership of a house used exclusively for personal purposes) is thus an oversimplified example, intended to show you the limitations in the U.S. tax system that apply to nonresident owners of U.S. real estate on the deduction of expenses for tax purposes.

Tax Benefits?

Owning real estate is expensive – there are all kinds of expenses, such as gardeners, utilities, repairs, property taxes, and mortgage interest (if you have a mortgage loan on the property). Is there some way to get a tax benefit from these expenses?U.S. residents have some tax benefits for home ownership. They can take a tax deduction for property taxes and for mortgage interest paid.Nonresidents do not have the ability to take tax deductions for these (or any other) expenses of owning a home for personal use.

When Nonresidents Can Take Tax Deductions

U.S. income tax rules for nonresidents have a specific limit on taking tax deductions for expenses: you can only use expenses to reduce your taxable income (and by doing so you reduce your tax) if the expense is associated with generating business income in the United States. The tax jargon is “effectively connected income.”

In the case of a nonresident alien individual, the deductions allowed shall be allowed only for the purpose of section 871(b) and (except as provided by subsection (b)), only if and to the extent that they are connected with income which is effectively connected with the conduct of a trade or business within the United States[.]¹

This means that you can only take a tax deduction:

• “For the purpose of section 871(b)”; and
• If there is income you are collecting; and
• If the deduction is related to the business activity that generated the income.

Don't worry about that insider talk about “for the purpose of section 871(b)”. That is the government being doubly-sure that you only take deductions for tax purposes if you are being taxed on active business income.(Quick aside. If nerding out on tax stuff bothers you, skip over this next part.)

For the tax nerds amongst you, nonresidents are taxed in two ways on income that they earn from the United States. One way is “you pay 30% of the income you received, and take no deductions.” That is Section 871(a). The other way – the one we are talking about – is “you pay income tax on the income you receive minus the business expenses associated with making that income, at the regular tax rates applicable to U.S. residents”. That is Section 871(b).

No Income? No Deductions

This rule simply means that for a nonresident person, if you are not doing some kind of business activity that is generating income, you cannot take a tax deduction for the expenses you incurred.Owning and using a house does not generate any income. Even if the house expenses were business related (and they are not; see the next section) you would not have the ability to take a tax deduction for the expenses because there is no income.

Personal (Not Business) Expenses, so No Deductions

There is a second reason why you cannot take a tax deduction. Taxpayers may take a tax deduction for “ordinary and necessary” expenses from a business activity.² When you use a house for personal reasons, you are not engaged in a business activity.Because this is not a business expense, you cannot take a tax deduction for the expenses of owning the house that you and your family use.

No Deduction Under the “Investment Expense” Theory

There is a way to take a tax deduction for expenses that are not related to the activity of being in business to generate a profit. You can take a tax deduction for for expenses associated with holding an asset for investment purposes.³When you use the real estate for personal purposes, you are not holding it for investment. It is a personal use asset. Therefore there is no tax deduction allowed for expenses associated with owning the house. This general rule applies to all taxpayers – resident and nonresident.Additionally, nonresidents (as noted above) are limited to deductions for expenses associated with generating income from the running a business in the United States. This is a second reason why the expense of owning a house for personal use cannot generate tax deductions for a nonresident owner.

Special Property Tax Deduction: Not Allowed

Individuals are permitted to take a tax deduction for real property taxes, even if these expenses are not associated with operating a business, or with holding the real estate for investment purposes.⁴This will not work for a nonresident owner of a vacation home in the United States.The property tax deduction is claimed on Schedule A (attached to Form 1040) as an itemized deduction. (If the property tax expense related to the operation of a business – such as the business of renting real estate to tenants – it would go on Schedule E. Since it is unrelated to this business activity, it must go on Schedule A, which is the place for tax deductions allowed to individuals, where the expenses are not business-related.Nonresidents are not permitted to reduce their taxable income by claiming expenses like this. Remember that nonresidents can only take a deduction for expenses attached to income generated by business activities in the United States. See Section 873(b). So this back-door method of taking a tax deduction for property tax only will not work.The property tax deduction would only work for a nonresident individual if he filed a resident's income tax return (Form 1040) to take the itemized deduction for property taxes. And this creates more problems than it solves. You are self-declaring that you think you owe income tax on your worldwide income, as a U.S. resident. You probably do not want to do that. :-) Yes, that helps you escape from the limits of Section 873(b) [“tax deductions only for business activity-related expenses”], but it does so at a terrible cost.

Mortgage Interest Deduction: Not Allowed

The other specific tax deduction that is allowed for real estate owners is for mortgage interest. If you borrowed money to buy the real estate, you are allowed to take a tax deduction for the interest on the loan, in one of two ways:

• The loan was used to buy rental or investment property; or
• The loan was used to buy a “qualified” residence–either your primary home or a second home.⁵

This sounds promising. The house in the United States is a “qualified residence”⁶ so initially it would seem that even if all of the other expenses are denied, at least a deduction can be taken for mortgage interest.Alas, no. We again run afoul of the Section 873(b) rule that issues a flat denial of all tax deductions except for those related to the generating of income from a business activity in the United States.No deduction for mortgage interest is allowed.

One Way Out

There is only one way out that I know about – one way to take a tax deduction for the expenses of owning a house. Instead of owning the house in your own name, you put it into a holding structure: a trust, corporation, etc. owns the house. Then you pay rent every time you live in the house.The reason this works is that the owner is not you – it is, for instance, a corporation. The corporation owns the house as a business asset. The corporation holds the real estate for the purpose of generating rental income. Now it is acceptable for the corporation to take a tax deduction for all of the expenses incurred, as an ordinary and necessary business expense.The real question is whether the economics work. Looking at the whole lifespan of the investment – from purchase to sale – will this strategy save you money? This is ultimately a question that a spreadsheet can answer, based on your property, the rental value, the operating costs, and other factors. I will be covering this topic in the CalCPA webcast. Hint, hint. Maybe you should sign up. :-)

Disclaimer

You know the routine by now: don't be dumb, this isn't legal advice, hire someone competent.See you next week. Email me and say hi.Phil.