Any purchase of real estate is an important decision; but the investment of real estate in the United States can result in taxing problems for foreigners. Depending on the type of the real estate investment and the investment entity, there are special rules for purchase, operation and the eventual sale of US real property interests. Let’s take a closer look at the tax implications for foreigners investing in US property.
Purchasing Vacant Land
The purchase of vacant land may appear to be the easiest investment in US real estate as it does not usually result in monthly income and expenses. However, the payment of any interest expense, real estate taxes, and other carrying costs will not result in any yearly US tax benefit to the foreign investor. If the investor buys the vacant land for growth, he may have to file a tax return to claim an annual election to capitalize his carrying costs (IRC Regulations 1.266-1) of the property thereby adding to his basis in order to use it against an eventual capital gain. Otherwise, these costs will go unused for any tax benefit.
Vacant land can be used for constructing rental property or a personal residence. In the event the vacant land is to be subdivided, it is possible that the owner may be considered a dealer and may not qualify for capital gain treatment (lower tax rates) on sale.
It is extremely important to know your use for vacant land so that you may plan the tax consequences of your actions.
If you use the real property as a rental, you may be required to have tax withheld on the rental income at 30% unless you have a lower treaty rate. A special election must be made to treat all real estate property as ‘effectively connected income engaged as a US trade or business’ so you can report the income and expenses on a US tax return and avoid the withholding on the rental income. However, any cash or property distributions may be subject to withholding. If the real property is in an LLC or partnership, any foreign partners will be subject to this withholding (IRC Section 1446).
In the event the vacant land is to be used for constructing a personal residence or vacation home, there are restrictions about how you treat the property. Building a personal residence will not require filing a tax return; however, any carrying costs will be lost such as mortgage interest and real estate taxes assuming there is no US source income to apply against these expenses. A vacation rental will require special annual operating rules that could affect the gain on sale as well as require special withholding tax on the rental income and/or distributions to the owners.
Personal Residence vs. Vacation Home
A personal residence is considered where you live on a permanent basis. In the case of a nonresident alien, they may not qualify for the special tax treatment as a permanent residence if the property is not considered their primary residence. In the case of a vacation rental, you may use a dwelling unit as a home during the tax year if you use it for personal purposes more than the greater of:
14 days, or 10% of the total days it is rented to others at a fair rental price.
One of the main reasons to have the real property considered a residence or vacation home is to have the first $300,000 of the selling price excluded from the 10% withholding tax when the real estate property is sold (IRC Section 1445). The gain on sale is computed by taking the sales price, less the cost of purchase, capital improvements, and sales expenses. A nonresident alien may exclude up to $250,000 of gain on the sale of their personal residence or $500,000 if married. Depending on the sales price of the property, the nonresident alien may be required to file a tax return.
Rental real estate has may have many facets in the business of rentals. Rental real estate can include the commercial rental of buildings, such as a strip mall. Or rental real estate can include the rental of single family residents or multi-unit apartments. They both use different depreciation periods.
- The commercial properties must use a 39 year life for depreciation.
- Residential rentals use a 27.5 year depreciable life.
- Net income or loss from rental real estate is classified as “passive” income or loss.
- In order to take losses, you must actively participate in the management of the rental. Otherwise, the losses will be suspended until you sell the property or have other passive income to offset the losses.
- Depending on your marital status and your gross income, losses may be fully suspended each year and you will not be able to take any losses until you sell the real property.
Taking Losses on Real Estate Sales
In order to take any losses on rental real estate, there is a two fold test. First, you must determine if the real estate is “actively managed”. This is defined by the IRS as “participating in making management decisions or arranging for others to provide services in a significant and bona fide sense”. Otherwise, unless you must have rental income in order to offset losses.
Foreigners investing in US property often do not like to have to manage their rental properties so they engage the services of a management company. In this event, the rental property will truly be a “passive investment” which limits the deductions on any rental losses.
These passive losses generated by the rental will continue to accumulate over time if there is no passive income to offset the losses. In the event there is other passive income generated, the suspended losses will be used against any other passive income. Passive income is defined as “any rental activity and any business activity in which you did not materially participate”.
Proper Reporting and Taxation of Gains
In the event the owner of a foreign investor has any funds distributed to him/her, there must be taxes withheld. In the event the activity generating cash distributions is not considered “effectively connected with a trade or business”, withholding will be required. Each country of residence has different withholding rates depending on tax treaties with the US. You can find the applicable withholding rate for your country on rents in IRS Publication 515. The funds are reported on Form 1042 to the US government and the foreign investor is given a Form 1042-S indicating the amount of funds distributed to them, along with the appropriate tax withheld.
In order to do the proper withholding, a foreign investor must apply for a taxpayer identification number (TIN) on Form W-7. It can take several months to get a TIN, so it is important to file this form as soon as possible.
An attempt to avoid withholding on income generated by US real estate property interests are tried by creating domestic entities such as a LLC. If a foreign person has an ownership interest in a domestic entity that distributes cash or property, that foreign person is subject to withholding on their distributions. As discussed previously, passive losses can be used when the real estate is sold. However, the sale of the property could generate a capital gain or loss. The gain or loss is calculated depending on the sales price, less costs of sale and the basis of the property. Internal Revenue Code Section 1445 requires the withholding of tax on the disposition of real estate. The transferee/buyer may be considered the withholding agent and they must withhold 10% of the amount realized on the disposition of US real property interests. In the event of a loss on sale, a special withholding certificate may be obtained to exempt the transaction from the withholding tax. It is extremely important that any sales be analyzed for gains or losses prior to sale to determine if a withholding certificate for a reduced tax or no tax be requested.
The US estate of a nonresident alien is only allowed an exemption of $60,000 (prior to 2014) before US estate tax is calculated. This could include any assets considered US assets such as bank accounts, vehicles, and real estate property. Proper estate tax planning should be considered before buying or investing in US real property.
Proceed with Caution
Purchase of any real estate in the United States by a non-resident or non-citizen should be carefully planned. Care must be taken in the income generation process of any US real property interests in order to not run afoul of any withholding requirements, as well as the sale of those investments. As tax laws may change, it is important to remain informed about any changes that can occur year to year.
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