When A Nonresident Alien Individual Wants to Buy A U.S. Rental Property
posted Jul 13, 2015 by Paul Oliveira, CPA
We regularly receive inquiries from nonresident aliens who are interested in investing in U.S. real property. As I have discussed in prior articles, U.S. real estate is considered by many to be a relatively safe place to put one’s investment.
The U.S. tax treatment of a nonresident alien can vary significantly and be quite onerous, depending on certain decisions that are made. Therefore, we usually begin discussions with a high level explanation of what may be expected if the nonresident alien simply owns the property in his or her name. For example, one might consider a three family rental property in the Greater Boston Area. What should be expected?
Income Tax: The 2 Methods
Using our example of the three family rental property, there are two ways the nonresident alien’s rental income may be taxed in the U.S.
- Taxation on a gross basis- This is generally the default method. The rental income received will be taxed on a gross basis (i.e., no deductions) at a rate of 30%. This can be a hefty tax, particularly if the tax cannot be fully credited in the home jurisdiction.
- Taxation on a net basis- This method is typically more favorable. The cost of being taxed on a net basis is that the rental income is subject to U.S. ordinary income tax rates that can be as high as 39.6%. However, - and this is critical – the nonresident is generally able to take deductions against gross rental income (e.g., depreciation, rental related expenses, etc.). Therefore, although the tax rate may be higher, the tax base is usually much smaller…as is the U.S. tax liability.
Income Tax: Selecting the Method
In an ideal world, assuming that the net basis method produces a better result, the nonresident alien would elect to have his or her rental income from the Boston three family rental property taxed on this basis. The world of U.S. taxation is generally far from ideal, but this is one instance in which it comes close.
If the nonresident alien can demonstrate that he or she is actively engaged in the rental business, then the position may be taken that he or she is entitled to be taxed on a net basis. This position can be challenged by the IRS, however, depending on the facts and circumstances.
Fortunately, there is an alternative that frequently makes sense and provides greater certainty. The nonresident alien can attach a specific election to his or her U.S. income tax return. This tax election informs the U.S. tax authorities that the nonresident alien elects to be taxed on all U.S. real estate investments on a net basis.
The selection of a method requires careful consideration and is unique to every taxpayer.
Capital Gains Tax
Direct ownership of U.S. real estate allows the nonresident alien to enjoy a relatively low long-term capital gains tax rate of 20% when he or she decides to sell the Boston three family rental property.
Estate tax is frequently overlooked by nonresident alien investors, which can be a costly oversight. A nonresident alien is subject to the estate tax on U.S. situs assets, including U.S. real property interests, such as our Boston three family rental property. There is a $13,000 credit against the tax that is available, but this is often far less than the total U.S. estate tax liability.
Under U.S. law, the maximum estate tax rate is 40%. The estate tax is levied on the value of the nonresident alien’s U.S. situs assets. Therefore, at the time of death, there is the chance that nearly 40% of the Boston three family rental property’s value may be subject to a tax of 40%. This could constitute a real economic hardship to the nonresident alien’s heirs, who may not have the liquidity to pay this unexpected tax from the assets of the estate.
Nonresident aliens interested in making a direct investment U.S. real estate need to give careful consideration to the U.S. tax considerations. Furthermore, they should consult with a competent attorney to understand non-tax, legal liability considerations.
Nonresident aliens should discuss the possibility of using tailored investment structures that can provide material tax and legal liability benefits. Placing our Boston three family rental property in a well-designed structure can help to mitigate many of the U.S. tax results described above. However, each circumstance is unique and requires evaluation and counsel by competent U.S. tax advisors and attorneys.
Questions? Contact any member of our Global Tax Services Team.