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.
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:
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:
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.
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:
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.
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:
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.