Withholding when Nonresidents Own U.S. Rental Real Estate

Proving the Obvious

In a quick email exchange I had with Susan Brown Otto (hi Susan) we touched on a topic that deserves attention. The topic is not terribly difficult, but its existence points to a meta problem.

Susan’s question/comment was about the non-requirement of withholding that is required when nonresidents own U.S. rental real estate . . . sometimes. It’s counterintuitive, because the IRS loves withholding.

So often in tax law there is an answer that you know, intuitively, but you can’t put your finger on exactly why the answer is true. This is dangerous territory for tax advisors. I have done this: blurt out an answer only to find out my memory was faulty. Ooops.

There is great value in systematically proving the obvious.

Let’s do that right now.

Withholding Requirements on Rent

A nonresident alien owns U.S. real estate. Tenants pay rent. How is that rent taxed? Do the tenants have a requirement to withhold tax on rental payments made?

Your brain leaps to the immediate answers:

• Default: the nonresident alien landlord pays 30% tax on gross rent received (no deductions for expenses), and the tenant must withhold 30% of rent payments and remit the withheld amount to the IRS. Give the tenant Form W-8BEN.
• Smarter: the nonresident alien landlord pays tax on net rental income (rent collected minus deductible expenses) at graduated tax rates, with no tax withholding required. Give the tenant Form W-8ECI.

Default: 30% Tax on Gross Rental Income; Withholding Required

The default treatment of that rental income is straightforward (if unpleasant): the nonresident alien landlord pays a tax of 30% of gross rent received.¹

The Internal Revenue Code makes sure that the nonresident alien pays that tax by adding a withholding requirement:

• the tenant² paying rent must withhold 30% of the rent payment for taxes, and
• send the withheld tax to the IRS.³

A practical caution: sometimes tenants have “net” leases, where they pay property tax and other costs for the property. The tenant’s payment of these expenses is rental income received by the nonresident alien landlord, and withholding should be done on those payments as well.

The tenant (as a withholding agent) has personal liability for any withholding screwups.

So the intelligent tenant will demand a Form W-9 from the landlord. A Form W-9 will show that the landlord is a domestic taxpayer; no withholding is required.

If the landlord does not deliver Form W-9 (because he is a nonresident alien), then the intelligent tenant will ask for Form W-8BEN. This will prove that the landlord is a nonresident alien and the 30% tax will be withheld.

The withholding rules are vastly more fiddlier⁴ than my description. If you want to see anal-retentive thinking in action, read Section 1441 and the accompanying Regulations. Someone with a very systematic brain wrote that stuff.

Smarter: Graduated Tax Rates on Net Income

If the nonresident alien owner of U.S. real estate is “engaged in business” in the United States, then the rental income is taxed differently. Net income is taxed (rental income minus deductible expenses) at the normal graduated rates that apply to U.S. residents and citizens.⁵

Interesting point: no withholding is required.⁶

A nonresident alien owner of U.S. rental real estate is treated as “engaged in business” by the IRS in one of two ways:

• Prove it. The nonresident proves to the satisfaction of the IRS that the real estate activities look like a business, not like a passive investment.
• Paper it. The nonresident files a piece of paper (the “net election)⁷ on a tax return filed with the IRS. Just do it.⁸

On the tenant’s side, again, the paperwork received from the nonresident landlord is critical.

Tax withholding is not required if the nonresident landlord gives the tenant Form W-8ECI.

This is a superior solution for both sides: the nonresident alien owner of U.S. rental real estate pays less tax on rental income, and the tenant avoids the complexity and brain damage that comes with tax withholding.

Summary

My email from Susan centered mostly on the paperwork side of things: what to do after the nonresident alien real estate owner made the net election. So here’s the basic set of rules:

• Form W-8BEN = 30% tax withheld by the tenant.
• Form W-8ECI = no tax withheld by the tenant.

One final warning. The withholding rules are riddled with lacunae and treachery, so be wary. Get someone to help you (if you are the tenant). The “right” paperwork in your files will eliminate your risk of making a costly withholding mistake.

See you in a couple of weeks.

Phil.