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).
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 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 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.