The United States has always been a desirable location for foreigners to invest their wealth, particularly in real estate.
Tax for foreign individuals and entities
Foreign corporations and trusts, as well as individuals who are neither US citizens or US residents, are usually subject to US income tax only on income that is either effectively connected with a US trade or business (“effectively connected income,” or “ECI”), regardless of source. , Or, if not ECI, the income is US sourced that is classified as fixed, determinable, annual, or periodic (“FDAP”) income. FDAP income includes US-source wages, interest, dividends, rents, and royalties, but generally it does not include capital gains.
The primary taxation difference between these two categories is that ECI is taxed at graduated rates on a net basis (gross income reduced by allowable deductions) while FDAP is taxed at a fixed rate on a gross basis (before allowable deductions).
Determining whether income is subject to the ECI or FDAP regime is important due to the differences in the tax withholding rates, the application of treaty benefits, and the difference between the taxes calculated on a net basis or gross basis.
Typically, US source income is ECI if one of two tests are met, the business-activities test or the asset-use test. The business-activities test looks to whether the activities of the US business are a material factor in generating the income. The asset-use test looks to whether the income comes from assets used or held for use in the conduct of a US business.
Both tests are relevant to income from real estate. For example, rental income earned on a building used in a US trade or business is ECI under these tests.
The tax consequences for foreign investors depend on if they are classified as a resident alien or nonresident alien (NRA) by the U.S. government.
Tax for US residents
US residents are taxed in the US on their worldwide income. If you are a US citizen or green card holder, even if living abroad, you pay the identical tax rates as any other US tax resident.
Even if you are not a citizen or green card holder, you may get taxed as a US tax resident if you qualify under the Substantial Presence Test.
The Substantial Presence Test consist of being in the US both 31 days in the current year and 183 days total in the current year and preceding two years counted according to formula:
- The days in the US of the current year are counted at full value,
- The days in the US in the first preceding year are weighted by 1/3 (every 3 days stayed in the US will count as just 1 day towards the 183). T
- he days in the US in the second preceding year is weighted by 1/6.
Your visa status in the US and if you are from a treaty country can also affect whether you are a tax resident.
Tax for non-US residents (NRA)
A nonresident alien (NRA) is a non-US citizen who does not hold a green card or meet the Substantial Presence Test. NRAs don’t have to pay tax in the US on their worldwide income. Only income from US sources is subject to US tax.
Real Estate and Taxes
Gains from real property can be both from rental income and the eventual sale of the property after it appreciates. Both are taxable income in the US.
For rental income, there are two options:
(1) pay 30% tax of the gross rental income, with a withholding agent collecting the 30% tax, or
(2) make an election called a net basis election (“net election”) to treat income from the property as being effectively connected with a trade or business of the United States. Here you must make quarterly estimated tax payments.
The net election is generally more beneficial. It enables you to pay taxes on the net profit, rather than the gross rental revenue.
Once you sell the real estate, a 15% tax must be withheld on the gain.
The effect of tax treaties on US income of foreign investors
Many countries have a tax treaty with the United States. You can find a full list of such treaties here. Since all treaties are not the same, it is important to review any applicable ones with your CPA.
Estate planning considerations for NRAs
In addition to real estate tax on foreign investments in the US, it is imperative for NRAs to understand US estate and gift tax rules.
For estates, US Citizens and tax residents currently receive a tax exemption of $11.58 million in 2020 ($11.7 million in 2021). Unfortunately, the estate tax exemption for NRAs is a mere $60,000.
However, if an NRA is married to a US citizen, they will still get an unlimited marital deduction.
Assets known as US situs assets are subject to this $60,000 estate tax threshold. US situs assets include US real estate, US stocks, cash accounts with US brokerage firms, and certain debts to US debtors.
Estate tax rates are the same for both US tax residents and for NRA.
To avoid this estate tax, one can own these US situs assets in a foreign trust or company rather than in their personal name. By doing so, the shares of the company or trust rather than the actual asset automatically pass to the beneficiaries, meaning there is no estate tax.
For help with your specific situation, talk to an experienced advisor
The complications that exist with international real estate transactions are abundant and each situation is unique. As a result, it is necessary that if you are doing business internationally, you’ll need a knowledgeable tax advisor. RINA has expertise in both real estate and international tax.
RINA has extensive experience helping foreign real estate investors optimize their US tax situation. Please reach out to us if you need assistance.
This content is prepared solely to provide general information to our clients and community.
This content does not constitute accounting, tax, investment, or legal advice, nor is it intended to convey a thorough treatment of the subject matter.