Foreign Property Ownerâ€™s Tax Return Responsibility During Ownership and Rental of Real Property Interest
Before agreeing to manage U.S. real property for a foreign taxpayer, a real estate professional or rental agent should discuss with the foreign client whether the rental income will be taxed as investment income through withholding, or on a net income basis as â€œ effectively connected with a U.S. trade or business,â€ without withholding (although the owner may have to file estimated tax returns). Rental income from real property located in the United States and the gain from its sale will always be U.S. source income subject to tax in the United States regardless of the foreign investor's personal tax status and regardless of whether the United States has an income treaty with the foreign investor's home country.
The method by which rental income will be taxed depends on whether or not the foreign person who owns the property is considered "engaged in a U.S. trade or business." Ownership of real property is not considered a U.S. trade or business if it consists of merely passive activity such as a net lease in which the lessee pays rent, as well as all taxes, operating expenses, repairs, and interest in principal on existing mortgages and insurance in connection with the property. Such passive rental income is subject to a flat 30 percent withholding tax (unless reduced by an applicable income tax treaty) applied to the gross income rather than the "net rent" received. Thus, the real estate taxes, operating expenses, ground rent, repairs, interest and principal on any existing mortgages, and insurance premiums paid by the lessee on behalf of the foreign owner-lessor, must be included in gross income subject to the 30 percent withholding tax. The gross income and withheld taxes must be reported on Form 1042-S, Foreign Persons U.S. Source Income Subject to Withholding (PDF) to the IRS and the payee by March 15 of the following calendar year. The payor must also submit Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons (PDF), by March 15.
If, on the other hand, the foreign investor is engaged in a U.S. trade or business such as the developing, managing and operating a major shopping center, the rental income will not be subject to withholding and will be taxed at ordinary progressive rates. Expenses such as mortgage interest, real property taxes, maintenance, repairs and depreciation (accelerated cost recovery) may then be deducted in determining net taxable income. The nonresident must make estimated tax payments for the tax due on the net rental income, if any. The only way these expenses can be deducted, however, is if an income tax return Form 1040NR for nonresident alien individuals and Form 1120-F for foreign corporations is timely filed by the foreign investor.
Foreign individuals and foreign corporations may elect to have their passive rental income taxed as if it were effectively connected with the U.S. trade or business. Once such an election is made by attaching a declaration to a timely filed income tax return, there is no obligation to withhold even in a net-lease situation. Once made, the election may not be revoked without the consent of the IRS. Unless the foreign investor has properly informed the property manager that the rental income is to be treated as "effectively connected income" by submitting to the property manager with a fully completed Internal Revenue Service Forms W-8ECI, Certificate of Foreign Personâ€™s Claim for Exemption From Withholding on Income Effectively Connected With the Conduct of a Trade or Business in the United States (PDF), the property manager should withhold thirty percent (30 percent) of the gross rental receipts so as to avoid personal liability. A fully completed Form W-8ECI must include a valid U.S. tax identification number for the foreign landlord (in other words, the rental agent must withhold and remit the 30 percent tax to the IRS until this requirement is satisfied). A real property manager who collects rent on behalf of a foreign owner of real property is considered a withholding agent and is personally and primarily liable for any tax that must be withheld. The liability of the withholding agent includes amounts that should have been paid plus interest, penalties, and where applicable, criminal sanctions. Property managers who do not comply with these rules will be held liable (either individually or through their company) for 30 percent of gross rents, plus penalties and interest. Also, property managers need to report annual rents collected on behalf of foreign landlords on Forms 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons, and 1042-S, Foreign Personâ€™s U.S. Source Income Subject to Withholding. These are the equivalent of Forms 1096 and 1099-MISC but are for foreign owners.