How These Tax Rules Affect Foreign Investors Of U.S. Real Estate

How These Tax Rules Affect Foreign Investors Of U.S. Real Estate

According For a foreigner who wants to invest in the US, our tax laws are nothing if not confusing.  The same goes if you happen to be a real estate professional assisting a foreign buyer.  And it remains the same whether the foreigner wants to buy real estate to establish a part-time residence or for investment.  Despite the same, real estate remains a critical component of any investment portfolio.

The tax rules for foreign persons at the time of disposition of US real estate are significantly different from the rules that would apply to US persons in the same situation, and this extends even to property managers who manage properties for foreign persons.  What we do have are rules that guide us through the complexities.

Foreign Engaged In A US Trade Or Business

Many foreigners ‘elect’ to be treated as a ‘foreigner engaged in a US trade or business – such as the development, management and operation of a major shopping center.  This means that the rental income will not be subject to withholding, and it will be taxed at ordinary progressive rates.  Expenses like mortgage interest, real property taxes, maintenance, repairs and accelerated cost recovery will then be deductible from gross income.

Estimated payments for taxes due on the net rental income will then be required from the nonresident.

Expenses can only be deducted if income tax return Form 104NR for nonresident alien individuals and Form 1120-F for foreign corporations are filed on time.

Make Election

To make the election for treatment as engaged in a US trade or business, a declaration must be attached to a timely filed income tax return.  Once the nonresident made this election, it can only be revoked by him with the consent of the IRS.

To make this election, the nonresident has to file Form 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.

Income Tax Returns

Foreigners that rent out or sell US property is obligated to file annual US tax returns.

  • Nonresident Alien Individuals Form 1040NR
  • Foreign Corporations Form 1120-F

It does not mean that a single-member LLC would require only this one form, it all depends on the nonresident’s domicile.  Canadians that hold a single-member LLC has to file a Form 1120-F because Canada does not recognize flow-through entities.

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Legal Structuring

Foreigners can opt for one of three basic structures to hold their US real estate assets.

  • C Corporation
  • Limited Liability Company (LLC)
  • Limited Partnership (LP)

As a rule, the preference is for LLCs when the goal is to minimize taxes and reporting requirements.  However, if the nonresident’s home country has a unique Tax Treaty with the US, the use of an LLC might be catastrophic.

Canadians who use an LLC to hold US investment property will face perilous double and even triple taxation obstacles.

Real Estate Professionals

Real estate professionals who manage property, or buy and sell property from or to foreign persons need special skills to remain in compliance with federal tax laws on real estate transactions.

They must understand whether a person or entity is deemed to be a US person or a foreign person
They need to understand the fundamentals aspects of US federal taxation of foreign investors with US rental income.
They need to fully understand the withholding rules and requirements that obligate them.

Withholding Tax

Withholding tax is the US government’s way to make sure they get their money from nonresidents before they leave the US and it is done by obligating specific withholding agents to withhold taxes from rent or the sale of property on behalf of the IRS.

Sale of Property

The Foreign Investment in Real Property Tax Act (FIRPTA), requires a withholding tax of ten percent of the amount realized when a foreign person disposes of any US real estate property interests. The buyer of the real estate as the transference is the withholding agent. The onus is on the buyer to determine if the seller is a foreign person, and if he fails in this duty to withhold, he will be held responsible for the tax.

The seller must report the sale of his real property interests to the IRS by filing a US Federal Tax Form 1040-NR (or Form 1120-F).

Passive Investor

The name might be misleading. A passive foreign investor in the US has nothing resembling an inactive existence.

What Is A Passive activity?

A typical rental property with a net lease in which the lessee pays rent and taxes and operating expenses, for repairs, principle interest on existing mortgages, and insurance.

  • Passive rental income is subject to a whopping 30% withholding tax if it is not reduced by any tax treaties. The 30% withholding is on the gross rental income.
  • Gross income and withheld taxes are reported on Form 1042-S, Foreign Persons US Source Income Subject to Withholding, and this has to reach the IRS and the payee on or before March the 15th of the following calendar year.
  • The payer must also submit Form 1042, Annual Withholding Tax Return for US Source Income of Foreign Persons at the same time.
  • The seed of the “problem” is the US Fixed, Determinable, Annual or Periodic (FDAP) Income Tax for Nonresident Aliens.
  • Described in US Title 26, IRS section code § 871(a)(1), FDAP income includes all rental real estate income received on rental property in the form of passive income.
  • FDAP income is taxed at a flat rate of 30% of the “Gross Rental Income” for the calendar year or a lower tax rate under a tax treaty between the investor’s country of residence and the US.
  • It applies to foreign persons earning rental income in the US

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The IRS determines taxable income (FDAP) as the total rental income collected during the tax year. No expenses are deductible on the IRS Form Schedule-E “Supplemental Income and Loss” including:

  • Management Fees
  • Property Taxes
  • Mortgage Interest Expenses
  • Depreciation
  • Repairs and Maintenance
  • Other Rental Costs

The only way any deductions can be made is if the Effectively Connected Income incentive (ECI) is filed. This allows Nonresident Alien investors to submit an IRS election to be taxed on a net basis.

Effectively Connected Income

In terms of US Title 26, IRS 871 (d) “net basis” election, the IRS code allows foreign real estate investors to elect to ‘treat real property income as income connected with a United States business.  This allows a nonresident alien individual who derives income from real property held for the production of income to deduct qualified rental expenses.

To Qualify For ECI Benefits, This Must Be Done:

  • Obtain an ITIN or EIN number from the IRS
  • Under IRS 871(d), treat rental income as EIC
  • Make EIC election for every year the property is rented on annual Form 1040NR
  • Provide Form W-8 to the management company

Readers should note that this article is only intended to convey general information on these issues and that FAS CPA & Consultants (FAS) in no way intended for the contents of this article to be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services.  This article cannot serve as a substitute for such professional services or advice.  Any decision or action that may affect the reader’s business should not rely solely on the contents of this article, but should rather be consulted on with a qualified professional adviser. FAS shall not be responsible for any loss sustained by any person who relies on this presentation.  This article is subject to change at any time and for any reason.

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Fulton Abraham Sanchez, CPA

Fulton Abraham Sánchez, CPA I am Certified Public Accountant, specialized in Tax Planning & Offshore Strategies for Real Estate, Hedge/Equity Funds, Fintech, Crypto, Expats, IRS Debt Resolution. You can email me and follow us on Facebook : FAS CPA & Consultants.

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