This discussion is inspired by an email I received from A.A., a CPA living and working outside the United States.1
When are nonresidents required to file U.S. income tax returns? Let’s ignore the obvious situation–when they earn income in the United States.
Let’s look instead at a vastly more interesting question. When must a nonresident individual file a U.S. income tax return (Form 1040NR) even when there is zero income earned in the United States?
Because yes, nonresidents with zero income must sometimes file U.S. income tax returns.
We start, as always, by seeking guidance from the Holy Writ. Please open your Internal Revenue Code to Section 6012.
Individuals whose gross income exceeds the standard deduction plus personal exemption amounts must file income tax returns.2 For your amusement and to help you with light cocktail party banter, the personal exemption amount in 2017 is $4,0503 and the standard deduction amount for a single person is $6,350.4
This means that an individual filing using “Single” status, with gross income of less than $10,400 in 2017, would not be required to file a 2017 income tax return.5
As usual, exceptions exist. Some of them are not relevant to our discussion,6 but one of them is. Congress gave the Treasury Department a license to write special rules for nonresident aliens:
. . . [S]ubject to such conditions, limitations, and exceptions and under such regulations as may be prescribed by the Secretary, nonresident alien individuals subject to the tax imposed by section 871 and foreign corporations subject to the tax imposed by section 881 may be exempted from the requirement of making returns under this section.7
If the nonresident is “engaged in trade or business within the United States” at any time during the year, Form 1040NR must be filed. This is true even if the nonresident:
In short, being engaged in trade or business within the United States means you must file an income tax return. End of story.
Here is what the Treasury Regulations say:
Except as otherwise provided in subparagraph (2) of this paragraph, every nonresident alien individual (other than one treated as a resident under section 6013 (g) or (h)) who is engaged in trade or business in the United States at any time during the taxable year or who has income which is subject to taxation under Subtitle A of the Code shall make a return on Form 1040NR. For this purpose it is immaterial that the gross income for the taxable year is less than the minimum amount specified in section 6012(a) for making a return. Thus, a nonresident alien individual who is engaged in a trade or business in the United States at any time during the taxable year is required to file a return on Form 1040 NR even though (a) he has no income which is effectively connected with the conduct of a trade or business in the United States, (b) he has no income from sources within the United States, or (c) his income is exempt from income tax by reason of an income tax convention or any section of the Code. However, if the nonresident alien individual has no gross income for the taxable year, he is not required to complete the return schedules but must attach a statement to the return indicating the nature of any exclusions claimed and the amount of such exclusions to the extent such amounts are readily determinable.8
The Internal Revenue Code tells us that “engaged in business” is really, really important. But the Internal Revenue Code does not really define what “engaged in business” means. Like pornography, I guess, you are supposed know it when you see it.9 Oh, yes, we are told that providing personal services in the United States can make you be “engaged in business”10 but beyond that, you’re on your own. It is a “facts and circumstances”, “case by case” analysis.11
Turning specifically to real estate investors, there are no hard and fast rules, but there are many Tax Court cases. The basic question is whether the taxpayer’s activities in the United States are “considerable, continuous, and regular”.12
The basic question is whether this is merely the investment of money for profit or the active management of real estate owned. Buying raw land and waiting for appreciation is passive investment. Owning and managing an apartment building or shopping center is obviously active management. But there is a vast middle ground, of course.
The investor can be personally engaged in the management activities. Or, the investor can hire people who do the management work, and the agents’ management activities will be attributed to the nonresident investor.
If a nonresident is a partner in a partnership, and the partnership is engaged in business in the United States, then the nonresident partner will be treated as engaged in business in the United States:
[A] nonresident alien individual or foreign corporation shall be considered as being engaged in a trade or business within the United States if the partnership of which such individual or corporation is a member is so engaged[.]13
Even limited partners–who under a partnership agreement typically have no management powers at all–are treated as engaged in business in the United States if the partnership itself is engaged in business in the United States.14
Fortunately, for nonresident investors in U.S. real estate the desired treatment is usually obvious: they want to be treated as if they are engaged in a U.S. trade or business for their real estate investment, because the income tax treatment for rental income is vastly better.15 And capital gain from the sale of U.S. real estate is by definition treated as if it is derived from a U.S. trade or business of the nonresident investor.16
Nonresident investors in U.S. real estate will typically make a special tax election to ensure the “trade or business” treatment,17 rather than rely on “facts and circumstances” to persuade a Revenue Agent if there is an audit.
As a result, when we see foreign investors in U.S. real estate (either direct or as partners in a partnership) we expect them to be engaged in a trade or business in the United States.
There are a few situations where this might not be true: purchasers of land held for appreciation, for instance. But these exceptions are the exception, not the rule.
As a result, when looking at foreign investment in U.S. real estate (directly or as a partner in a partnership), we expect the foreign investor to be engaged in business and therefore be required to file a U.S. income tax return every year–even if there is zero income.
In a close call (where you are relying on facts and circumstances to give you the “engaged in business” treatment because it is better for tax purposes), it is prudent to file U.S. income tax returns asserting that status. A long string of tax returns asserting you are engaged in trade or business will establish your position when income is finally generated.
For foreign investors who are partners in partnerships that own real estate, if the partnership is engaged in business in the United States (rental property will clearly qualify), then the nonresident partner is engaged in business and must file a tax return.