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.
If, on the other hand, the foreign investor is engaged in a U.S. trade or business, the rental income will not be subject to withholding and will be taxed at ordinary progressive rates. Expenses such as mortgage interest on the net income, real property taxes, maintenance, repairs and depreciation 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.

A nonresident who fails to submit a timely filed income tax return loses the ability to claim deductions against the rental income, causing the gross rents to be subject to the 30 percent tax. Generally, the nonresident will need to retroactively file at least six years of delinquent income tax returns, or all prior year tax returns, if they have held the rental property for less than six years. However, the ability to elect to treat the rental income as effectively connected with a U.S. trade or business will be lost after 16 months from the original due date of the return, and the remaining back years may be subject to tax under the gross income method.