For nonresidents who buy U.S. real estate and rent it, there is an essential income tax election to make. It is called the “net election” and you’d be fool to miss this.

Rental income taxed at 30% of gross income

The default rule for nonresident owners of U.S. rental real estate is that rental income is taxed at 30% of gross rent collected. That’s the Federal income tax. State income tax varies from State to State and I will ignore it.

For Federal purposes you do not take a tax deduction for mortgage interest, property taxes, repairs, etc. You do not get a deduction for depreciation.

Sit with a piece of paper and a pencil and you will soon find that this can put you into negative cash flow.

Have rental income taxed on net income instead

It is much better to pay income tax on your net income — collect rent income, deduct your expenses, and pay tax on whatever is left.

The law

Nonresidents make a special election with the U.S. tax authorities to make the desirable “tax me on net income not gross income” result occur. Here’s the law, found at Section 871(d) of the Internal Revenue Code:

(d) Election to treat real property income as income connected with United States business

(1) In general

A nonresident alien individual who during the taxable year derives any income–

(A) from real property held for the production of income and located in the United States, or from any interest in such real property, including

(i) gains from the sale or exchange of such real property or an interest therein,

(ii) rents or royalties from mines, wells, or other natural deposits, and

(iii) gains described in section 631(b) or (c), and

(B) which, but for this subsection, would not be treated as income which is effectively connected with the conduct of a trade or business within the United States,

may elect for such taxable year to treat all such income as income which is effectively connected with the conduct of a trade or business within the United States. In such case, such income shall be taxable as provided in subsection (b)(1) whether or not such individual is engaged in trade or business within the United States during the taxable year. An election under this paragraph for any taxable year shall remain in effect for all subsequent taxable years, except that it may be revoked with the consent of the Secretary with respect to any taxable year.

(2) Election after revocation

If an election has been made under paragraph (1) and such election has been revoked, a new election may not be made under such paragraph for any taxable year before the 5th taxable year which begins after the first taxable year for which such revocation is effective, unless the Secretary consents to such new election.

(3) Form and time of election and revocation

An election under paragraph (1), and any revocation of such an election, may be made only in such manner and at such time as the Secretary may by regulations prescribe.

How to do it–the Regulations

The Treasury Regulations give guidance on how to make the net election:

Regulations Section 1.871-10(d)(1)(ii) — Statement To Be Filed With Return

An election made under this section without the consent of the Commissioner shall be made for a taxable year by filing with the income tax return required under section 6012 and the regulations thereunder for such taxable year a statement to the effect that the election is being made. This statement shall include (a) a complete schedule of all real property, or any interest in real property, of which the taxpayer is titular or beneficial owner, which is located in the United States, (b) an indication of the extent to which the taxpayer has direct or beneficial ownership in each such item of real property, or interest in real property, (c) the location of the real property or interest therein, (d) a description of any substantial improvements on any such property, and (e) an identification of any taxable year or years in respect of which a revocation or new election under this section has previously occurred. This statement may not be filed with any return under section 6851 and the regulations thereunder.

Sample language

Here is a sample you can follow. Just attach this on a statement attached to the Federal income tax return filed (Form 1040-NR or Form 1120-F).

(Taxpayer Name)
(Taxpayer Identification Number)
Attachment to Form (1040-NR or 1120-F)
Tax Year Ending December 31, 2008
This statement constitutes an election under Regs. §1.871-10(d)(1)(ii) to treat the income generated from the following properties in the United States owned by the taxpayer as income effectively connected with a U.S. business for taxable year ending December 31, 20__ and thereafter:

Property 1 -
Land and Improvements located at 123 Easy Street, Anytown, USA. The structure is a commercial office building. Taxpayer holds a fee interest in the land and all property improvements located thereon. No prior election has been made under Regs. §1.871-10(d)(1)(ii) with respect to the subject property.

Property 2 –
Identify other properties as appropriate.

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I got an inquiry today from a reader of FIRPTA.com that I figured would be worth answering here, because it is a topic of general application. The question is whether using a foreign corporation works to protect against U.S. estate tax.

Foreign corporations to hold U.S. real estate

Nonresident investors frequently hold U.S. real estate using foreign corporation structures. (A “foreign corporation” for our purposes is a corporation formed in a country other than the United States.) There are two common variations of this theme:

• Nonresident owns all the shares of stock of a foreign corporation. The foreign corporation owns the U.S. real estate.
• Nonresident owns all of the shares of stock of a foreign corporation. The foreign corporation owns all of the shares of stock of a U.S. corporation. The U.S. corporation owns the U.S. real estate.

This is done primarily for estate tax protection.

Why it works

The United States will impose an estate tax (for our purposes let’s say it is 45% of the fair market value of the property) on U.S. real estate owned directly by a nonresident. That is because estate tax is imposed only on a nonresident’s property that is “located” in the United States. And nothing screams “I am located in the United States” quite as much as real estate within the national boundaries of the USA.

The United States will NOT impose an estate tax on shares of stock of a foreign corporation which are owned by a nonresident deceased individual.

That is because a foreign corporation is treated as being “located” in the country under whose laws the corporation was formed. Thus, because the corporation is “located” outside the United States under the estate tax definitions, there is nothing to be taxed because if you look at what the nonresident individual actually owns, which is stock, not real estate.

“But . . . .”

“Well,” you say. “The foreign corporation owns U.S. real estate. Shouldn’t you look through the foreign corporation at the assets owned by the corporation?” And the answer is . . . no, we don’t do that.

Yes, we (meaning the U.S. tax authorities) could do that. And maybe they will some day. But at the moment it doesn’t work that way.

Summary of where we are now

For now the conventional wisdom is that indirect ownership of U.S. real estate by a nonresident — using the foreign corporation as described — will isolate the nonresident individual from U.S. estate taxation when he or she dies. Well, it won’t isolate that individual, because after death he/she doesn’t really care all that much, right? It’s the heirs that care.

Storm clouds over the horizon–family limited partnership analogy

The Internal Revenue Service has been attacking family limited partnerships — as an estate tax planning device — for several years. I won’t go into the details of the technical and metaphysical arguments on this.

But many people feel that the same theories used by the IRS to attack family limited partnerships could be used to attack the foreign corporation ownership structures used by nonresidents to hold U.S. real estate.

Storm clouds over the horizon–personal use of corporate asset

There’s a second thing. Let’s say you are a U.S. resident and you own a business. The business buys a yacht as a corporate asset and you happily sail it up and down the coast and have fun on it. Will the Internal Revenue Service have a cow? You bet. Individual use of corporate assets by shareholders and officers triggers all sorts of imputed income attacks by the government.

So now take a look at this holding structure used by nonresidents. They buy a house or a ski condominium or a beach house, and hold title in the name of a foreign corporation. Then they proceed to use the house. Personal use. And they are the shareholders of the foreign corporation.

I can see this as a potential reason to either disregard the foreign corporation or to cause the shareholders to have some kind of imputed income from the trust. U.S. source imputed income. Probably FDAP. On which 30% withholding should be imposed, ‘n other bad stuff.

Fashion-forward Canada

A few years ago the Canadian tax authorities changed the tax rules for Canadian resident taxpayers, essentially saying that if a Canadian had a personal use residence inside a corporation like this, there would be an imputed dividend to the shareholder based on the fair market rental value of the house. So imagine having taxable income and paying tax just for the privilege of living in your own house.

<understatement> Suddenly, corporate structures became much less appealing to Canadian residents. </understatement>

I take that as an early warning sign. The Canadians had an exit tax far before we in the United States acquired the entirely execrable, useless, and utterly counter-productive Section 877A. (Ah, but I am a fairminded man. I do not judge.)

So I think it reasonable to assume that at some point the Internal Revenue Service will wake up and announce that they have an entirely original idea and while it won’t be an exact copy of the Canadian method, at least it will rhyme with what the Canadians suffer under.

Bottom line

Foreign corporations probably work for estate tax protection. For now. Might not later. Your mileage may vary, all bets are off, this is not legal advice to you, and you’d be a damned fool to believe anything you read on the internets unless of course it is posted on Slashdot.

(This is cross-posted to my main blog at hodgen.com/phil and thanks Brian for the question.)

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