This article describes the basic U.S. federal income tax payment obligations that apply to the income and gains from investment by foreign investors who are non-U.S. residents in private investment funds that invest in U.S. real property. These obligations will impact the total financial return on investment of investors, and in some cases will require the filing of U.S. tax returns, as explained below. This article applies only to taxation of individual persons who invest in U.S. real property or in private investment funds, such as limited partnerships (“LPs”) or limited liability companies (“LLCs”), that invest in U.S. real property.
There are different U.S. federal tax rules for U.S. residents and non-U.S. residents. A U.S. resident includes (1) any “green card” holder from the first day he or she is present in the U.S., (2) any individual who is present in the U.S. for 31 days during the current year and a combined total of 183 days during the current year and a fraction of the two prior years, or (3) any individual who elects to be classified as a U.S. resident if eligible. Any person who is not a U.S. resident under the above rules is referred to as a “non-resident alien” or “NRA” in the U.S. Tax Code. U.S. residents are taxable on their worldwide income and gains under the U.S. tax laws and are required to disclose their worldwide assets including all foreign bank accounts.. NRAs are taxable only on their income and gains that are “effectively connected” with a U.S. trade or business and on their fixed, determinable, annual or periodic income derived from the U.S.. Different rates and withholding amounts generally apply to these two categories of income, as described below.
NRAs that invest in loans made on U.S. real property are not subject to U.S. federal income tax if the loans meet the “portfolio interest exemption “requirements. NRAs that invest in LPs or LLCs that make loans to U.S. borrowers that own U.S. real property will not be required to file income tax returns or to pay any U.S. federal income tax if the requirements of the portfolio interest exemption are met. These requirements are generally that: (a) the debt instrument is in registered form that requires transfer only through surrender of the debt instrument or through a book-entry system maintained by the borrower; (b) no contingent interest (such as interest based on cash flow, income or property value) is payable on the loan; (c) the NRA does not own all or a specified percentage of the borrower of the loan; (d) the NRA is not engaged in a U.S. “trade or business” (defined below) related to the loan; and (e) the NRA provides the U.S. borrower with an IRS Form W-8 certifying that the NRA is not a U.S. person.
NRAs are subject to U.S. federal income taxes on investments that include ownership of U.S. real property. The U.S. imposes special income tax rules on NRAs who receive U.S. source income, including rental income from U.S. real property and gains on sale of U.S. real property. The amount of the tax will depend upon the character of the income from the investment in U.S. real property.
Different tax rules apply depending on whether the U.S. real property is used in a U.S. trade or business. If an NRA is a partner of an LP or a member of an LLC that is engaged in a trade or business in the U.S., the NRA is also considered to be engaged in a trade or business in the U.S. The U.S. Internal Revenue Service (“IRS“) states that a “trade or business” generally includes any activity carried on for the production of income from selling goods or performing services. For example, if an NRA invests in an LP that operates a hotel or a rental apartment building, then the NRA would be considered to be engaged in a trade or business in the United States.
Rental revenues from U.S. real property that are not part of a U.S. trade or business are subject to a 30% flat tax rate on the gross amount of the rental revenues. This tax must be withheld by the payor of the rents, and paid over directly to the IRS. This withholding tax is not usually limited or eliminated by the terms of an applicable tax treaty. NRAs are not required to file U.S. tax returns if their income tax liability is fully satisfied by the 30% withholding taxes paid to the IRS on behalf of those NRAs. NRAs may file U.S. tax returns if they wish to claim a refund for a tax overpayment.
Rental net income from U.S. real property that is part of a U.S. trade or business is subject to tax at the U.S. individual income tax rates. An NRA that invests as a partner of an LP or a member of an LLC that conducts a trade or business in the U.S. is required to file a U.S. income tax return on Form 1040NR (for NRA individuals). The income tax return is required to state the total amount of the net income derived from all U.S. trade or business activity, and the NRA is required to pay the tax at the rate that applies, based upon the total net income of the NRA, from all effectively connected income earned from the NRA’s investments in LPs or LLCs that conduct U.S. trade or business. Individual income tax rates range from 10% to 37% of the net income subject to U.S. tax. (There are certain deductions that may apply to reduce the net taxable income of NRAs, which are not discussed this article.)
Gains on sale of U.S. real property by an NRA are subject to U.S. income tax under the Foreign Investment in Real Property Tax Act (FIRPTA). FIRPTA treats all gain or loss from the sale or other disposition of U.S. real property by NRAs as effectively connected with a U.S. trade or business. This includes U.S. real property that is owned by an LP or LLC in which NRAs are investors. If a U.S. real property has been owned for less than one year, the gain is considered to be “short term capital gain,” which is taxed at the same rates as rental income on the property, as described in the paragraph above. If a U.S. real property has been owned for at least one year, the gain is considered to be “long term capital gain,” which is subject to taxation at individual long term capital gains tax rates of 0%, 15% or 20%.
Gains on sale of U.S. real property are also subject to withholding of 10% of the gross sale price under FIRPTA. The LP or LLC in which the NRA is an investor is required to withhold this amount and pay it over to the IRS. However, the FIRPTA withholding amount is treated as a credit against the capital gains tax actually due under the NRA’s U.S. income tax return. The NRA will receive a tax refund if the amount withheld exceeds the tax due. The NRA will be required to file a U.S. tax return on IRS Form 1040NR in order to apply for a refund of the excess amount withheld.
NRAs may also be subject to the Net Investment Income tax. The net investment income tax imposes a 3.8% tax on income from investments. That includes interest, dividends, and short- and long-term capital gains, as well as rental and other income. The net investment income tax only applies to the adjusted gross income of NRAs above $200,000 for single NRAs or $250,000 for NRAs that file a joint U.S income tax return with a spouse.
This article is a summary of general rules that apply to investments by individual NRAs in U.S. real property and related investments. Different rules apply to investments made by foreign corporations, foreign irrevocable trusts, or U.S. entities with foreign corporate or trust owners. This article does not discuss investments in real property investment trusts (“REITs”), which are a special form of tax exempt entity under U.S. law, or investments in foreign entities that invest through U.S. “blocker” corporations in U.S. real property. In addition, this article does not discuss state or local taxes that may apply to specific investments in U.S. real property. Foreign investors should consult their own tax advisors in connection with any potential investment in a U.S. private investment fund to determine the effect of the U.S. tax requirements based on their personal circumstances. To achieve optimal tax results it is often necessary to diligently plan the structure of ownership of real property and to make certain tax elections in a timely manner.
Please contact Scott Harshman at 949.623.7224 or SHarsman@jmbm.com if you have further questions.