Question & Answer: Investing in U.S. Real Estate as a non-U.S. Resident

Ashley Erwin, CPA

Wilson LLP recently had an individual contact us regarding her father’s interest in purchasing a home in the United States for purposes of generating some rental income as well as capital appreciation. The following questions and answers are helpful to those interested in investing in U.S. real estate.

My father (who is a U.K. citizen and is not a U.S. green card holder) is currently exploring potential rental property investments in Arizona.  He has no plans to relocate to the U.S. in the future, and he would probably only visit the U.S. once every few years, so he plans to hire a property management company and does not intend to manage the property himself. If he goes through with this investment, it would be his very first real estate transaction here, and he has no other investments or income in the U.S. (he has no plans to have any other future investments or income in the U.S. aside from the real estate property). 

Over the past years my father has heard a lot of conflicting things from his friends about investing in the U.S. real estate market, and he's basically asked me to find a CPA to clarify those tax/legal concepts that his friends are talking about so he knows for sure what he's getting himself into. So it would be great if we could start with these questions:

Question:  According to his friends, the best way to purchase rental property in the U.S. is by setting up an LLC because it protects the individual owner from potential lawsuits brought on by tenants, etc.  My father personally prefers purchasing the property as an individual because he thinks it's less complicated, but he wants to know for sure what the tax and legal pros and cons of each option (individual vs. LLC) are. Based on your experience, what would you recommend to a first-time investor like my father, keeping in mind he'll only be visiting the U.S. once every few years and thus will likely not be able to personally take care of the paperwork usually involved in starting/maintaining a business entity like an LLC?

Answer:  If your father sets up an LLC where he is the sole owner, this entity will be considered a single member LLC.  A single member LLC is treated as a “disregarded entity” for U.S. tax purposes and thus the LLC is not required to file a separate tax return, so there will not be extra paperwork or cost associated with the various tax filings.   As a single member LLC, we will include the income/deductions from the rental directly on your father’s Form 1040NR.  If he later decides to have additional partners, it is no longer a single member LLC and the LLC will be required to file a separate tax return.  An attorney would probably be able to give him better advice as far as the legal concerns with owning the property personally vs. through an LLC, particularly as it relates to the state law where the property is located. Some investors prefer to keep the accounts related to the property separate from their personal assets, hence setting up the LLC.   Others believe it is simpler to own the property directly and purchase expanded insurance coverage to reduce the risks associated with rental real estate.

Question: What are the capital gains tax rules and rates for nonresident aliens? I understand that tax laws change every year, but according to today's laws, if a few years down the road my father decides to sell his property, can he bring his net after-tax profits back to his home country or is there a rule that requires you to keep/reinvest the money here in the U.S. for a specified period of time?

Answer:  Tax law with respect to capital gains has been in flux the past several years.  The capital gain tax rates are always subject to change, particularly in the current economic environment, but yes he may bring his after tax-profits back to his home country.  Currently, the capital gains rate is 0% for low income tax brackets (taxable income up to $35,350, married filing separately) and 15% for higher income brackets.  Typically, some of the gain will be classified as “unrecaptured Section 1250 gain”.  This means that a rate of 25% may be imposed on a portion of the capital gain attributed to prior depreciation expense taken on real property.   There are also some alternative minimum tax issues to be considered on gains on the sale of U.S. Real Property by nonresident aliens. 

Question: What are the rental income rules and rates for nonresident aliens? Are they allowed to deduct expenses and/or depreciation? If yes, what are the common deductible expenses?

Answer:  Nonresident aliens are able to deduct expenses and depreciation related to rental real estate.  Residential real estate will be depreciated over 27.5 years.  Other common expenses for real estate investments are taxes, insurance, interest, professional fees, management fees, repairs and maintenance.  Of course, sometimes repairs may be considered capital assets and required to be depreciated for tax purposes.  If considered a structural component, it should be depreciated over the same life as the property.  Other assets have shorter depreciable lives.  For example, carpet is depreciated over 7 years.  As your father’s tax accountant, we would determine the appropriate tax treatment. 

Also, please note, rental income and losses are typically considered passive.  Generally, passive losses cannot be used to offset other types of taxable income.  However, if he incurs a passive loss in one year, he may carry it forward to offset future passive income (such as capital gain associated with the disposition of the property) in later years. 

Question: I hear a lot about the “1031 exchange”.  Are individual nonresident aliens eligible for the “1031 exchange”? If yes, are single-family homes and single condominium units eligible? Again I know that tax laws change over the years, but according to the current rules, let's say my father keeps using the 1031 exchange to trade up to newer properties over the next 10 years. Then at the end of 10 years he decides to sell his last property. Will he be taxed only on the capital gains from that last transaction, or will he be required to pay back taxes on each gain from each transaction (assuming they're all gains and not losses)?

Answer: Yes, nonresident alien individuals are eligible for the 1031 exchange.  And, yes, single family homes and condominium units are eligible.  When the exchange is made, gain is only recognized to the extent money or other property is received, but if he puts all of the proceeds into the next property, no gain will be recognized.  However, we will need to calculate the basis for the new property each time an exchange occurs.  In the end, one gain calculation is computed.  Additionally, there are very strict guidelines to follow in order to qualify for the 1031 exchange.   It would just require that whenever your father is ready to sell and buy new, he would need to follow the guidelines very closely.   There are attorneys who specialize in coordinating these transactions.