U.S. Income Tax Concerns for Nonresident Aliens Directly Owning and Renting U.S. Real Estate

Ashley Erwin, CPA

With interest rates and U.S. property values at all time lows, it is a great time to invest in U.S. real estate.  For individuals who are foreign to the United States (nonresident aliens for U.S. tax purposes), purchasing and renting U.S. residential and commercial real estate can be simpler than one might expect.   A nonresident alien should consider the following issues before, during and after purchasing rental real estate directly in the United States.

This article focuses specifically on foreign individuals who own real estate directly as opposed to investing in U.S. real estate funds.   Investors in these funds should refer to our three-part series on Foreign Investors in U.S. Real Estate Funds.  You may also be interested in the article, Question & Answer: Investing in U.S. Real Estate as a non-U.S. Resident.

Property Management & Maintenance: There are several real estate management companies in the United States who manage rental properties on behalf of owners who live overseas.   The management companies’ duties include, but are not limited to, finding desirable properties, assisting in purchases, finding tenants, collecting rent from tenants, disbursing rent to the nonresident alien owner and paying the property expenses on behalf of the nonresident alien owner.  These management companies are required to report to the IRS any rents which are paid to nonresident aliens owners.  This typically places a tax burden on the nonresident alien investor.

Owning the Property as an Individual or Single Member LLC (SMLLC): An SMLLC is a limited liability company with only one member, the nonresident alien for purposes of this article.   The SMLLC is beneficial because it provides a layer of liability protection for the nonresident alien from lawsuits from tenants.  Additionally, we generally believe it is good practice to keep the bank account and assets related to the investment property separate from personal bank accounts and assets.  The single member LLC approach allows for a clean and clear separation.  This approach may require a little more upfront documentation, but does not complicate tax matters, because the owner may elect to complete his income tax return in the same manner as if the LLC did not exist.  Although the SMLLC keeps the individual separate from the entity for legal purposes, the SMLLC is a 'disregarded entity' for tax purposes, unless the owners elects to be treated as a corporation.  As a disregarded entity, the IRS looks through to the owner of the LLC to determine tax treatment of payments of income, withholding, etc. Any income received by the LLC will be reported by the owner, on his annual individual income tax return.  

It is important to note that only the Single Member LLC is disregarded for federal income tax purposes.  An LLC with more than one member (including a husband and wife who are each nonresident aliens) would be required to file a separate informational tax return in addition to each member being required to file individual income tax returns.

Real Property Income Background: Rental income is FDAP (Fixed, Determinable, Annual, Periodic) income, which the nonresident alien recipient can choose to treat as EC (effectively connected to a U.S. trade or business) or NEC (non-effectively connected to a U.S. trade or business).  If treated as EC, one can take deductions (depreciation, management fees, interest expense, taxes etc...) and the net income is reported on page 1 of Form 1040NR via schedule E and subject to the graduated tax rates.  If treated as NEC, gross rents are reported on Page 5 of Form 1040NR, no deductions are allowed and this income is taxed at a flat 30% rate (unless a different treaty rate applies).  Additionally, if treated as EC, there is no withholding requirement, but if treated as NEC, 30% withholding applies (also subject to treaty differences).  We believe treating the rental income as EC is generally better from a tax standpoint because the nonresident alien is taxed at graduated rates and deductions are allowed to offset the gross rents received.  This is important because it affects whether the nonresident should file form W-8BEN or W-8ECI with the management company. 

Completion of Form W-8ECI (Certificate of Foreign Person’s Claim That Income Is Effectively Connected with the Conduct of a Trade or Business in the United States) and/or W-8BEN (Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding): A nonresident alien should complete Form W-8ECI if treating the rents received as EC and Form W-8BEN if treating the rents received as NEC.   If the property is owned as an SMLLC, the nonresident alien should complete Form W-8 using his name and ITIN, not the name and EIN of the SMLLC.  Basically, in the case of a single Member LLC, the IRS sees the recipient of the income as the foreign individual, not the LLC.  The management company must follow this treatment when filing information returns which report to the IRS payments the management company has made and the identity of the recipients of these payments.  When filling out Form W-8, it is important to indicate to the management company that the actual rental payments are made to the SMLLC.  There should also be a place for this on Form W-8.  As for the ITIN on Form W-8, it will take 4-6 weeks to receive an ITIN (see below for how to apply for an ITIN).  It is important to discuss with the management company when they would like the ITIN to be obtained. 

W-7 (Application for IRS Individual Taxpayer Identification Number): Generally the application must be filed with the filing of the first annual tax return, Form 1040NR.  But nonresident aliens may be able to file early under Exception 1(d).  If applying under Exception 1(d), Form W-7 is accompanied by a signed letter on official letterhead from the management company verifying that an ITIN is required to make distributions that are subject to IRS information reporting or federal tax withholding. If this letter cannot be provided, then the nonresident alien needs to wait to apply for the ITIN with the filing of initial Form 1040NR.  

Form 1040NR (U.S. Nonresident Alien Income Tax Return):  Form 1040NR will be filed for each year the nonresident alien owns the property.  The management companies provide basic statements of income and deductions which are used in the preparation of Form 1040NR.   The due date of Form 1040NR is six months after the close of the tax year an automatic extension of six months can be granted by filing Form 4868.  However, the nonresident alien is required to pay any tax by the original due date.  Most nonresident aliens hire a tax professional in the United States, such as Wilson LLP, to handle the annual filing of Form 1040NR.  

This article is meant to give U.S. nonresident aliens an overview of certain issues involved with purchasing and renting U.S. Real Estate.   After the initial purchase and set up for the first year’s tax returns, the annual tax return process is relatively simple.  If you have additional questions or concerns more specific to your own situation please contact any of the Wilson partners.