This piece builds on two previous posts regarding foreign investors. The first covered how international buyers are increasing their presence in New York City’s real estate while the second contemplated various ownership structures, including corporate and partnership and their tax considerations.
Despite the mundane-sounding title of this article, we believe it is an important topic that can have an impact on annual returns. In this article, we discuss the tax implications for foreign investors on rental income. There are other areas of taxation such as capital gains and inheritance, but we prefer to concentrate on this one area given the complexity of the tax code.
Foreign investors should note that there are two distinct ways in which rental income can be taxed, and it is important to notice the differences. The method depends on whether someone is considered “engaged in a U.S. trade or business” or not.
The first category is passive investors, or those not engaged in a U.S. trade or business. This includes owners in which the renter pays items such as all of the associated taxes, operating expenses, repairs, mortgage, and insurance on the property. An example of this situation might be a commercial property. Generally speaking, residential real estate will fall into this category since it will not meet the criteria for engaging in a U.S. trade or business. This rental income is subject to a 30% withholding tax, and any of the expenditures, such as those above, are included in the owner’s income.
There are obvious disadvantages. Although it may be simpler since in a net lease the tenant pays rent plus all of the other items including the principal on your mortgage, it can result in a higher tax bill. First, you pay the flat 30% tax. Second, the income is “grossed” up to include the items the renter is paying.
If you fall into the passive category, you can elect to have your rental income taxed as if it were connected to a U.S. trade or business. However, once you go down this road, it cannot be reversed unless the IRS approves it.
Meanwhile, the other category is those engaged in a U.S. trade or business. An example includes those that develop, manage, and operate a shopping center. If this applies, the rental income will not be subject to withholding and will be taxed at a progressive rate, rather than a flat 30% that is required from passive investors. Even more critical, expenses such as mortgage interest, property taxes, maintenance, repairs, and depreciation, can be deducted from rental income.
This is an intriguing option for foreign investors. The rate could very well be lower than the 30%, and expenses can be deducted to get the taxable income. There is a certain amount of paperwork that goes along with it, and nonresidents must make estimated tax payments.
This article merely seeks to provide information to investors to better arm him or her in the decision-making process. Those seeking something more in-depth should consult an expert such as a tax attorney or CPA that knows this specific area.