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May 26, 2017 - Phil Hodgen

Nonresident Real Estate Investors, Rental Income, and No Tax Returns Filed

What happens to a nonresident who owns U.S. real estate and — gasp — does not report the rental income on a U.S. tax return? What is the tax risk to that nonresident investor? And how can that investor fix the problem?

In this article I will discuss the following topics:

  • How does the United States tax rental income received by a nonresident owner of U.S. real estate?
  • What are the tax return requirements for that nonresident investor in U.S. real estate?
  • What can a nonresident do if he has not filed U.S. tax returns and reported (and paid tax on) the rental income collected?

This article covers Federal income tax. Most States have an additional income tax that is imposed, and a few cities as well. I will ignore State and city income taxes.

How Rental Income is Taxed

Nonresident investors in real estate pay U.S. income tax on their rental income in one of two ways:

  • Net Income. Total rent collected minus operating expenses = net income. Multiply net income by the same tax rates that apply to U.S. resident taxpayers: from 0% to 39.6%. That is your tax.1
  • Gross Income. Total rent collected multiplied by 30% tax rate.2 Note that the total rent collected is not reduced by operating expenses.

Example: Net Income

You are a nonresident investor in U.S. real estate. You own a small commercial property that is rented for $3,000 per month. You collect $36,000 in rent during the year. You have only one operating expense: property tax of $8,000.

If you calculate your U.S. income tax using the net income method, here is the result:

Description Amount
Rental income 36,000
– Property tax expense -8,000
= Taxable income 28,000

Your marginal tax rate for income as a single person (using the 2017 tax rates) is 15%. Your income tax will be approximately $3,434.

You have cash in hand (after payment of all expenses and income tax) of $24,566.

The same example, with the “gross income” method of taxation, yields a gruesome result.

Example: Gross Income

You are a nonresident investor in U.S. real estate. You own a small commercial property that is rented for $3,000 per month. You collect $36,000 in rent during the year. You have only one operating expense: property tax of $8,000.

If you calculate your U.S. income tax using the gross income method, you are taxed on the total rent collected, without any deduction for operating expenses.

Description Amount
Rental income 36,000
– Property tax expense disallowed
= Taxable income 36,000

Your tax rate is 30% of the rental income collected. Your income tax will be $12,000.

You have cash in hand (after payment of all expenses and income tax) of $16,000.

It could be worse. Let’s assume you have a mortgage payment on the property of $2,000 per month.

  • If you pay income tax using the “net income” method, you have $24,000 of mortgage payments and $24,566 of cash flow to pay the mortgage. This is extremely tight, but cash-flow positive.
  • If you pay income tax using the “gross income” method, you have $24,000 of mortgage payments annually, but the property is only producing $16,000 of cash flow after income tax ($12,000) and property tax ($8,000). Your property is cash-flow negative. You must dip into your own pocket every year to pay the mortgage on the property.

The conclusion is obvious: you want to pay income tax using the “net income” method.

Tax Returns

There are tax returns, of course. Here is what the nonresident investor is asked to file:

Tax Method Full Tax Withholding? Tax Return Rent Reported On
Net income Not applicable Form 1040NR Schedule E
Gross income No Form 1040NR Schedule NEC
Gross income Yes No tax return N/A

Net Income Method

If you are using the “net income” method to report your rental income and compute U.S. income tax, you will file Form 1040NR (the nonresident’s income tax return).

All of the rental income and expenses for the property is reported on Schedule E, to compute net rental income. The bottom line number from Schedule E is reported on page 1 of Form 1040NR, on Line 18.

Gross Income Method

The discerning reader will have noted that a nonresident investor using the “gross income” method may need to file a tax return, or may not be required to file a tax return at all. This curious result depends on what the tenant does, not what the property owner does.

As a general principle, any income that is taxed using the “gross income” method will have a companion tax withholding requirement. A U.S. person paying income to a nonresident must withhold tax at 30%, and give the money to the IRS.3 In our example, this means the tenant must withhold 30% of the rent payment for taxes.

Example

The tenant owes the nonresident landlord $3,000 per month of rent. The tenant’s obligation–under U.S. tax law–is to pay $2,100 to the nonresident landlord, and hold back $900 for the tax withholding. Then, the tenant sends the $900 to the Internal Revenue Service.

The discerning reader will note a strange synchronicity between the tax rate applied to the rental income (30%) and the rate of tax withholding that is required (also 30%).

The nonresident investor’s requirement to file a U.S. tax return–using the “gross income” method–is waived if the nonresident investor’s tax obligation is fully paid up by way of the tax withholding. No income tax return is required to be filed.4

If, however, there is a failure on the tenant’s part for withholding tax from the rent payments, then the nonresident investor’s taxes are not fully paid up. A tax return is required (Form 1040NR again). The rental income is reported on Schedule NEC, which, you will note upon careful examination of the form, has no place for deducting expenses.

Simply put:

  • If your tax is paid in full with tax withheld from the rent paid to you, then you are freed from the paperwork burden of a U.S. income tax return.
  • If your tax is not fully paid up from tax withholdings, you will file Form 1040NR and pay the additional tax you owe.

The Tenant’s Risk

One more thing. The tenant has personal liability for any tax collection shortfall if the tax withholding is screwed up and insufficient tax is withheld from the rental income paid to the nonresident landlord.

How Do You Achieve “Taxed Using the ‘Net Income'” Method?

The “net income” method is good. When is the nonresident investor entitled to use this method to calculate income tax liability?

When Engaged in a U.S. Trade or Business

Jargon time, people. Use the “net income” method if the rental income is “effectively connected with the conduct of a U.S. trade or business”. Use the “gross income” method if the rental income is NOT “effectively connected with the conduct of a U.S. trade or business”.

Rent received from a tenant is “effectively connected” to the underlying real estate asset. Just trust me on this, or we will be here for another 2,500 words.

How does a nonresident investor in U.S. real estate know that he is “engaged in the conduct of a U.S. trade or business?” Haha good question. Like many pivotal question in U.S. tax law, there is no definition in the Internal Revenue Code. It’s a touchy-feely, fuzzy-wuzzy, mamby-pamby, mumbo-jumbo “well it depends on the facts, doesn’t it?” question that depends heavily on the person providing the answer. As Dirty Harry would say, “Do you feel lucky? Well, do ya, punk?” (YouTube).

Prove It With Facts

When it comes to nonresident real estate investors, there are dozens of Tax Court cases, none of which give you confidence in deciding how your situation would be judged. I exaggerate only slightly.

The criterion that the Tax Court judges use is this: were the nonresident investor’s real estate management activities “considerable, continuous, and regular”? If yes, then the investor is engaged in a U.S. trade or business. To follow this method, file your income tax return (Form 1040NR) with Schedule E attached. Compute your taxable income, pay your tax. Hope you do not get audited, and if you get audited, prove to the satisfaction of the friendly Revenue Agent that you are engaged in business in the USA.

Guarantee It With Paperwork

Getting this wrong means drastically higher tax liability. You do not want to risk paying 30% of your total rent received. You want certainty.

The certainty can be achieved by filing a piece of paper with a U.S. tax return. On it, you say that you want to be taxed on your U.S. real estate only as if you are a U.S. resident taxpayer.

This is called the “net election“, if you are dying to fling tax jargon around at your next cocktail party.

What If You Never Filed Income Tax Returns?

Now we come to the fun part. A nonresident investor has owned U.S. rental real estate for several years, and has never filed U.S. income tax returns to report the rental income and pay U.S. income tax. How will this investor fix the problem, and what does the tax risk look like?

Default Position: All Years Are Taxed at 30% of Gross Income

Start with the default position: the nonresident investor will pay tax using the “gross income” method. Thirty percent of the gross rental collected will be the tax. Since the nonresident investor never filed a tax return, all of the years of ownership are open for attack by the IRS.

The solution is to file late income tax returns for all of those years, pay the 30% tax, plus interest, plus whatever penalties are imposed.

Pain factory.

Let’s see if we can find a less bad way to go.

Better: Recent Years Get “Net Income” Treatment

Remember the “net election” that I talked about? This is the piece of paper that you file with a U.S. income tax return. It guarantees that you will be taxed on “net income” and not “gross income” for your real estate rental activities.

You can use this method for the current year. You can also go back in time a little bit and use it as well. Some is better than none, right?

Here is the rule for nonresidents who never filed an income tax return: no income tax deductions are allowed unless they are claimed on a tax return that is not “too” late being filed.5 You have until 16 months after the original filing date for the tax return.6

Example

The filing deadline for your 2015 Form 1040NR is 15 June 2016. You have sixteen months from that date to file a tax return for 2015 and claim income tax deductions. That means you have until 15 October 2017 to file your Form 1040NR for 2015, claim that you were engaged in business in the United States, and take tax deductions for your expenses of owning and operating the U.S. rental real estate.

If your tax bill is punitive for previous years (because you are denied the ability to take income tax deductions), at least for 2015 and later years you can get the tax treatment that you want. You will either make a “net election” for those years, or you will take the position that you were actually engaged in a U.S. trade or business for those years. Something is better than nothing.

The solution here is to file all of the tax returns, be taxed on gross income for the earlier years, and on net income for the years that you can squeeze in under the deadline. Suck, but sucks slightly less than the default choice.

Worth a Shot: Beg for Mercy

Late tax returns mean no tax deductions for nonresidents. But there is an inkling of a hint of a possibility of a reprieve. The IRS can permit you to take tax deductions going way, way back in time, even if you are late with your tax returns. Here is the open door:

The filing deadlines set forth in [Regs. § 1.874-1(b)(1)] may be waived if the nonresident alien individual establishes to the satisfaction of the Commissioner or his or her delegate that the individual, based on the facts and circumstances, acted reasonably and in good faith in failing to file a U.S. income tax return. . . .7

There is no guarantee of a satisfactory outcome. Go read the Regulations to see some examples of what the IRS thinks “reasonable” and “good faith” look like.

The solution here is to file late tax returns, claim taxation under the net income method, and Pray to the Almighty Tax Gods that you are not audited. If you are audited, you will have to prove that you acted reasonably and in good faith.

Conclusion

Clean up your messes. That’s always my advice. Find someone to help you. That someone will help you understand which years you need take care of and file a tax return for. You will find out your estimated financial risk. Then just get it done. Otherwise you are leaving a latent tax problem that will haunt you when you eventually sell.

Standard Disclaimer

Cleaning up the past is fraught with risk. Get some advice from a professional before you take action, please.


  1. IRC § 871(b). For the jargon fans, this is income that is effectively connected with the conduct of a U.S. trade or business. 
  2. IRC § 871(a). For the jargon fans, this is fixed, determinable, annual, or periodic income. 
  3. IRC § 1441(a). 
  4. Regs. § 1.6012-1(b)(2)(i). 
  5. IRC § 874(a). 
  6. Regs. § 1.874-1(b)(1). 
  7. Regs. § 1.874-1(b)(2). 
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