Note: this is another answer for the accountants who took my all-day courses in Pleasanton in January.
The “Net Election” is an election by a nonresident of the United States who owns U.S. real estate. This is an almost mandatory election for a nonresident investor. The default U.S. income tax paid by a nonresident on rental income is 30% of the total rent received, without any allowance for operating expenses. The “Net Election” changes a nonresident’s U.S. income tax treatment so that the nonresident is taxed exactly as a U.S. resident is taxed — on the net income (rent collected minus operating expenses) from the property.
The “Net Election” takes its name from the fact that it changes the income tax payable by the nonresident investor to a method by which that investor is tax on net income.
Sometimes partnerships are used to hold U.S. real estate. A nonresident individual or a non-U.S. corporation will be the partner. In that case, who makes the Net Election — the partnership or the foreign partner?
Answer: the election is made by the foreign partner. The nonresident individual makes this election on Form 1040-NR, while a foreign corporation makes the election on Form 1120-F.
If a non-resident alien individual or foreign corporation is a member of a partnership which has income described in paragraph (b)(1) of this section from real property, any election to be made under this section in respect of such income shall be made by the partners and not by the partnership. [Emphasis added.] A nonresident alien or foreign corporation that makes an election generally must provide the partnership a Form W-8ECI, “Certificate of Foreign Person’s Claim for Exemption from Withholding on Income Effectively Connected with the Conduct of a Trade or Business in the United States,” and attach to such form a copy of the election (or a statement that indicates that the nonresident alien or foreign corporation will make the election). However, if the nonresident alien or foreign corporation has already submitted a valid form to the partnership that establishes such partner’s foreign status, the partner shall furnish the partnership a copy of the election (or a statement that indicates that the nonresident alien or foreign corporation will make the election). To the extent the partnership has income to which the election pertains, the partnership shall treat such income as effectively connected income subject to withholding under section 1446. See also section 1.1446-2.
Citation: Treasury Regulations Section 1.871-10(d)(3).
Action step: if you are a nonresident investor in a partnership that holds U.S. real property, check to see that you have taken the necessary action steps to be taxed on net income rather than gross income.