U.S. Taxation for Real Estate Investors
What Is Covered Here
When investing in the U.S. you need to be aware of the basics of U.S. taxation. Certain taxes such as sales and use taxes typically would not concern a real estate investor, while other taxes such as income tax and property taxes are crucial to understand. We will cover these two types of taxes in this article.
Let’s start from a little disclaimer: U.S. taxation of nonresidents can be a fairly complex issue and involves many specific fact points that determine if the non-residents are subject to US taxation or not. This article attempts to capture the most typical scenarios and analyze them in the context of current (2014-2016) U.S. taxation rules. Beware that U.S. taxation of non-residents can be a complex topic and simply changing one fact can change your tax reporting obligation.
It is impossible to know your specific tax obligations without a lot more information about your U.S. related business, so please use the information presented here for reference only. If you need more specific tax advice refer to the information at the end of this article.
Ok, now that we have cleared this very important point, let’s move on and analyze a few of the most common cases. If you don’t find your case among those listed here no worries - just ask your questions here and we will try to help.
Explaining Types of Taxes
U.S. Income Tax
How does U.S. income tax works? This is a simple question, however it’s U.S. income tax we are talking about. Technically, each taxpayer must pay tax on the income created in the U.S., and in some cases (such as the case of U.S. citizens or permanent residents) on income created abroad. The income tax is paid to the federal government (IRS), and in many cases to the state of residence, and in some cases even to the local jurisdiction (e.g. New York City).
However, we created this article precisely for the reason we cannot just simply answer this otherwise great question - the real answer is “it depends, because it’s complicated”. Keep reading the next items to see if U.S. income tax applies to you, and how.
Property taxes are paid to the local jurisdiction (city, county, etc.) where the property is located and are due once a year. Property taxes cover government services such as government administration, fire, police, schools, infrastructure maintenance, etc.
If your property carries a mortgage then the lender typically takes over the responsibility of paying the property tax to the authorities. The lender would then collect prorated tax payments together with monthly or byweekly mortgage payments, accumulate it in escrow, and then remit to the authorities by due date.
If your property carries no mortgage but is managed by a management company then paying property taxes could be part of the services provided by such company. Otherwise it is your responsibility as the property owner to pay the tax on time. Nonpayment of property taxes would result in tax lien being attached to the property, which might result in you loosing the title to the property.
U.S. Company Owned by Non-U.S. Person(s)
LLC Owned by a Sole Foreign Owner
Per IRS guidelines: Rental income from real property located in the United States and the gain from its sale will always be U.S. source income subject to tax in the United States regardless of the foreign investor's personal tax status and regardless of whether the United States has an income treaty with the foreign investor's home country.
In simple words: if you are a non-U.S. person living abroad, are a sole owner of a U.S. LLC, and that LLC holds a cash-flowing real estate property in the U.S., you still must file a U.S. tax return and report your income for taxation. To do so you would need to obtain an Individual Tax Identification Number (ITIN) and file personal tax return that includes the return of your LLC.
LLC Owned by Two or More Foreign Owners
LLC that has more than one owner (partnership), or if it is elected to be taxed as C Corporation (any number of owners), must file federal tax return, even if it has zero income. Each owner then must file individual tax return, and report their share of the LLC income.
Corporation Owned by Foreign Owners
A corporation is a separate tax entity from its owners. That means the corporation files its own tax return and pays its own tax liability. That also means that one cannot freely transfer money between the owners (shareholders) and the corporation. The corporation can reimburse the owners for expenses they pay on behalf of the business, and the corporation can pay owners for services they provide to the corporation, both of which are tax deductions for the business.
The only other option for the shareholders to take funds from the business is if the corporation pays them dividends. Dividends are not a tax deduction and are generally taxable income to shareholders as the individuals. As a shareholder, your personal income is subject to the income tax rules in your country of residence.
Choosing Entity Type
So given all the owners are non-U.S. persons, from income tax point of view is it more beneficial to register LLC or Corporation?
Thats a tricky question that depends on lots of factors. As was mentioned above, it is highly recommended to select LLC registered in the state where property is located as the entity type for holding the actual investment property. If you choose to own all your property-holding LLCs with one holding entity, that entity could be LLC or C-Corporation registered in an incorporation-friendly state.
Since using each of the entity types fot that purpose has its pros and cons before reaching a conclusion you should analyze your specific situation, make some forecasts on how your business will evolve, and also - consult a CPA, it will help you a lot.
Keep in mind, there is not always a “right” and “wrong” answer - often times either entity that you would form for your business would work just fine.
U.S. Company Owned by U.S. and Non-U.S. Partners
Any disadvantage of having a U.S. partner in the company qwned by non-resident aliens?
Not that we know of. The rules of taxation apply first on the entity, and only then on each individual partner, based on each partner’s individual tax situation.
I am US citizen and I want to open a business with a 50% partner who is a non-resident alien living abroad. What type of taxes will my partner pay if we form a C Corporation?
There are pros and cons to both structures for a non-resident. A C-Corp would mean your partner is not necessarily required to file a US tax return. He can be paid dividends from the C-Corp, but as with any C-Corp there is no tax deduction for dividends paid out so the earnings are likely to be double taxed, once by the corporation and then by the owners - in the US for you and in your partner’s country for him - as dividend income.
Double taxation doesn’t sound like a good idea. What if we choose LLC (taxed as partnership) instead?
An LLC taxed as partnership would eliminate the double taxation, but definitely subjects the non-US partner to U.S. taxation for his share of earnings and profits from the business. The partner would then have to file a 1040NR and report his share of profits and pay US tax on those profits. The partnership would also need to withhold tax at 30% for the foreign partner. Depending on his earnings the withheld tax would be credited and potentially refunded against what he may owe when he files his individual non-resident tax return.
U.S. Company Wholly-Owned by a Foreign Company
Can a non-U.S. company own a U.S. company?
Yes, it can, provided the U.S. company is not S Corporation (or LLC taxed as S Corporation).
Is it better to own the U.S. company with my non-U.S. company from tax point of view?
Not necessarily. Ownership does not control if tax is due on U.S. operations of the business. You will need to consider U.S. taxation of non-resident aliens, and if the profits earned in the US are what is known as income effectively connected to operation of a US business, to understand how taxation would work in your specific case.
Other Important Tax Related Issues
Ways to Reduce the Taxable Income of Your U.S. LLC or Corporation
Most businesses have both revenues and expenses. The IRS keeps a list of eligible business expenses, and it is safe to say that expenses that can are obviously related to maintaining and running your real estate investment business (e.g. fees to contractors, management company, etc.) are considered deductible expenses. Other expenses might be partially deductible, and it is best to have your CPA handle the question which of your expenses are deductible and to what degree.
To minimize your tax obligation you would want to report as many eligible expenses as possible, however you should be able to prove these expenses were real, so keeping receipts and/or bank and credit card statements is a must.
Working for Your U.S. Company
If you are non-resident alien you probably don’t have work permit, which means you cannot receive a salary as a resident alien or U.S. citizen would. Sorry.
You could however provide services, such as management services, to the U.S. company, and receive payment in form of consulting fees. You will then be required to report this income in accordance with your country tax rules.
Providing Services to Your U.S. Company
What if you spend all or most of the income of the U.S. company on services provided by your other company, registered in your country?
You could do that, provided you can prove services were necessary for proper management of your real estate investment, and were indeed provided and properly documented. You also want to make sure these services are provided outside of the U.S., in order not to be considered U.S. sourced, and as such subject to 30% withholding requirement (more about it below).
Retaining Corporate Profit
If your country has very high personal income tax, or you just want to reinvest the profits of your company instead of distributing them to owners, you could use C-Corporation as the tool for all your U.S. business holdings.
You are still required to pay the corporate tax on those profits, but since you are not limited in the choice of stte we always recommend picking a state with no corporate income tax such as Wyoming (this way your company profit is only subject to federal corporate tax).
How and When to File Tax Return?
Best way to file your U.S. taxes is to hire a knowledgeable U.S. CPA (accountant). The deadline in most cases is or around April 15 (each year can be a bit different). You can file extension by that date, and the new due date is September 15 for companies and October 15 for individuals.
Keep in mind, corporations have to file quarterly reports, while LLCs taxed as partnerships file once a year. This could result in slightly higher cost of accounting services for corporations.
Individual Tax Identification Number
Whether you need to obtain an ITIN will depend on if you have personal U.S. tax reporting obligations due to your U.S. business interests. As mentioned above, it is most certain that you will need an ITIN if you have membership interest (ownership) in an LLC, but most probably you won’t need one as a shareholder of a corporation.
KEEP IN MIND: Individuals must have a filing requirement and file a valid federal income tax return to receive an ITIN, unless they meet an exception.
State Income Tax
This tax is only applicable to C-Corporations, not LLCs. It applies to income earned by the corporation in the state, unlike federal income that applies to all U.S. sourced income. For your holding C-Corporation we recommend using incorporation-friendly state of registration such as Wyoming.
Even though LLCs don’t pay income tax, it is a good idea to check with your CPA if there are any filing requirements for the LLC in the state of registration.
I heard as non-resident alien I need to pay 30% income tax on my U.S. income. Is it true?
It is true in case of rental income. It is called NRA (non-resident alien) withholding, meaning your payee keeps 30% of the sum they are paying you, and remits this sum to the IRS.
According to IRS rules “in order for a payment to be subject to NRA withholding, it must be a payment of FDAP income. FDAP is an acronym for Fixed or Determinable, Annual or Periodic. Some of the more common expenses paid by US withholding agents which would result in FDAP income to their vendors and other service providers are interest, royalties, compensation for personal services, rents, pensions or annuities and gains from the sale or exchange of the patents, copyrights and similar intangibles...” (see more details here).
Since the rental property is located in the U.S., the rental payment is U.S. sourced and as such the person paying rent must withhold 30% of the rent to be paid to the IRS. If you are using a management company to handle rents then the withholding can be done by the management company.
For the purpose of such withholding the IRS uses a form called W-8BEN. Form W-8BEN is a Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding. You need to fill this form out and give to the withholding agent (such as your management company) or payer if you are a foreign person and you are the beneficial owner of an amount subject to withholding. In other words, if you have U.S. sourced FDAP income your payer will be responsible to withhold the 30% tax based on the information listed on the W-8BEN.
Keep in mind, you need to submit Form W-8BEN when requested by the withholding agent or payer whether or not you are claiming a reduced rate of, or exemption from, withholding.
How do you avoid such withholding? One of the sure way to do so is to use C-Corporation as the holding entity for all your LLCs. This way you still need to pay the corporate income tax, but avoid paying further U.S. income tax on that profit.
International Tax Treaties
If you as foreign investor that is a resident in a country that has a tax treaty with the United States, the 30% rate may be reduced. Each treaty has specific provisions which determine the reduced withholding rate. These provisions reduce the withholding rate based on the type of income and the status of the recipient.
To know if your country has tax treaty with the U.S. please visit this page. You can study the text of the treaty to understand how it influences your withholding situation, although I would recommend using the help of a CPA for that as well.
Well, as we mentioned earlier, U.S. taxation is anything but trivial. We hope this article was educational enough to give you some idea on how U.S. taxation works, and what to do next.
Keep in mind two important points:
No matter what your situation is, it is always a good idea to consult a knowledgeable U.S. tax expert who will be able to analyze your specific situation, and give you qualified advice. Knowledge gained from this article will already save you some time, so you can focus on understanding the deeper issues related to your situation. Those $50 or $100 spent on a 30 minute tax consultation might be the best money spent on our business.
Chances are there is no "right" or "wrong" solution - a few solutions that you would consider to your particular situation might all be "more or less right".
If you think you have a tax question that deserves to be answered and published in this article by all means email it to us, and we will do our best to answer and publish it. For other, more specific questions we recommend our 30 minute tax skype or phone consultation that you can order directly here.
Good luck with your business!