Rental income from real property located in the United States will always be U.S. source income subject to tax in the United States regardless of the foreign investor’s status and regardless of whether the United States has an income treaty with the foreign investor’s home country. The US tax rules that apply to ownership and dispositions of US real estate by foreign persons are different in some important respects from the rules that apply to US persons.

Who is a foreign person?

A “foreign person” includes:

• A nonresident lien individual;
• A partnership created or organized in a foreign country or under the laws of a foreign country;
• A corporation created or organized in a foreign country or under the laws of a foreign country;
• A foreign trust;
• A foreign estate, or
• Any other person that is not a U.S. person.

How is rental income taxed?

How rental income will be taxed depends on whether or not the foreign person who owns the property is considered “engaged in the 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% 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.

If, on the other hand, the foreigner is engaged in a U.S. trade or business such as the developing, managing and operating a major shopping center, the rental income  will be taxed at ordinary progressive rates and will not be subject to withholding. Expenses such as mortgage interest, real property taxes, maintenance, repairs and depreciation (accelerated cost recovery) may then be deducted in determining net taxable income.

Foreign individuals and foreign corporations may elect to have their passive rental income taxed as if it were effectively connected with the US 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.

What is the responsibility of the rental agent?

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 Person’s Claim for Exemption From Withholding on Income Effectively Connected With the Conduct of a Trade or Business in the United States, the property manager should withhold thirty percent (30 percent) of the gross rental receipts so as to avoid personal liability. 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. 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 Person’s U.S. Source Income Subject to Withholding.  These are the equivalent of Forms 1096 and 1099-MISC but are for foreign owners.

What is the responsibility of the foreign investor?

Foreign investors must obtain aU.S.tax identification number from the IRS for theUSincome tax purpose. The foreign investor must inform the property agent that the rental income is to be treated as “effectively connected income” by submitting to the property manager a fully completed IRS form W-8ECI. A fully completed form W-8ECI must include a validUStax identification number for the foreign investor. The foreign investor may have to file estimated tax returns based on the net rental income. 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 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% 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.