In this global society, it is common to seek pastures further afield. Many people purchase property in the US either as a holiday home or as an investment. When doing so, scant regard is often given to the international taxation implications of the transaction, but careful tax planning should be an integral part of the process.
Rental income and any income, gain or profit related to the disposition of a US real property interest are treated as income from sources within the US and could give rise to a US tax liability.1 Many non-resident aliens may not be aware of the impact these provisions have on the US property they own, or the importance of understanding the different taxation regimes to make the appropriate elections and to file the appropriate tax returns.
A non-resident alien is any individual who is neither a US citizen nor a resident alien.2 A resident alien is a person who either is lawfully admitted to the US for permanent residence, satisfies a substantial presence test (generally those present in the US for more than 183 days over a three-year period), or makes a first-year election.3Therefore, if an individual has a connection to the US, albeit not a permanent one, it is likely they will fall into the non-resident alien category and be subject to US taxation accordingly.
US tax is charged at either graduated rates or a flat rate depending on the source of the income or gain.
The US insists on limitation of benefit provisions in its double taxation treaties
US source income
The starting point for establishing the source of income from the use of tangible property, either real or personal in nature, is the place or situs of use, so rental income from property located in the US is US source income. Accordingly, the source of income of immovable property is the situs of the property, and the place of residence or organisation of the owner is irrelevant from a US tax perspective.4
The basis on which tax is charged on US source income is determined by whether or not the income is effectively connected with the conduct of a trade or business within the US. The effectively connected income rules apply to non-resident alien individuals or foreign corporations engaged in a trade or business in the US. A trade or business within the US includes the performance of personal services within the US at any time in the taxable year, but there are exclusions.5
Where the income is effectively connected with a US trade or business it will be subject to tax on a net basis, after taking into account effectively connected deductions, at the graduated rates applicable to US citizens.6
In contrast, income which is fixed or determinable, annual or periodic (FDAP), and not connected with a US trade or business, is subject to and collected through a withholding tax at source, and a flat rate of 30 per cent of gross income will be used to calculate the amount of tax due, without taking any deductions into account.7
Where a non-resident alien owns real property in the US and derives rental income from it, such income would not normally be treated as being effectively connected with the conduct of a US trade or business. The income will be treated as FDAP income and thus subject to withholding tax at source at the flat rate of 30 per cent of gross income, with no allowance for the expenses incurred in relation to the property, e.g. management and letting fees. US tax may therefore be payable when, in reality, a loss has been made because of the expenses incurred.
However, a non-resident alien can elect for the property to be treated as effectively connected with a US trade or business and accordingly elect for tax to be imposed at the graduated rate of tax on taxable income, i.e. rent received, minus effectively connected deductions.8 If a non-resident alien makes this election it will remain in effect for subsequent years until revoked, with the consent of the Internal Revenue Service.
US real property interest
The general rule is that gains are sourced according to the residence of the seller. As a result, a non-resident alien is not usually subject to US income tax on gains made from US situs property. However, gains, profits and income from the disposition of a US real property interest (USRPI) are considered US source income.9 As a result, non-resident aliens can be subject to tax on the realised gain from the disposition of an interest in US real property, whether held directly or through ownership interests in certain entities that own such interests.
Where a non-resident alien makes a gain or loss from the disposition of a USRPI, this is treated as if the taxpayer was engaged in a trade or business in the US during the taxable year and that the gain or loss was effectively connected with such trade or business,10 whether or not the foreign person is, in fact, engaged in a US trade or business during the taxable year. As a result, deductions can be taken into account to arrive at the taxable income, which is then taxed at the graduated rates applicable to US citizens.
Tax on gains is usually collected by the buyer withholding, in most cases, a 10 per cent flat rate of the gross amount realised by the non-resident alien of the disposition, at source. However, the non-resident alien is usually required to file a return to compute the actual gain on the disposition and the graduated rate tax due.
In cases where the gain is not from real property, it will only be subject to tax if it is effectively connected to a US trade or business, or if the non-resident alien is present in the US for 183 days or more. The distinction between real property and other property is therefore important.
A USRPI11 is any interest in real property located in the US or the Virgin Islands, and any interest (other than solely as a creditor) in a US domestic corporation unless it can be shown that such a corporation was at no time during the measuring period (generally the five years prior to the disposition) a US real property holding corporation (USRPHC).12
A US domestic corporation will be a USRPHC if the fair market value of the corporation’s USRPIs is at least 50 per cent of the total fair market value of the corporation’s USRPIs, plus the corporation’s interests in real property located outside the US, and the corporation’s other assets that are used in, or held for use in, a trade or business.
A USRPI does not include a class of stock of a corporation that is regularly traded on an established securities market, unless more than 5 per cent of the fair market value of that class of stock is held.
Gains or losses on the sale of the stock in a US domestic corporation by a non-resident alien are subject to US tax if the corporation is a USRPHC. Careful regard should, therefore, be had to the assets owned by a US domestic corporation ensure a non-resident alien is not subject to US tax on the disposal of stock.
Income and capital gain from the ownership of US real property may be subject to taxation in both the US and the country in which the owner is resident. Regard should be given to the measures available to alleviate double taxation under the domestic laws of each jurisdiction, and to the terms of any double taxation treaty between the contracting states. The US is one of the few jurisdictions that insist on limitation of benefit provisions in all of their double taxation treaties.
A careful analysis is therefore required, both of the domestic legislation of each jurisdiction and of any double taxation treaty, to ensure no double taxation arises. So it is important for clients to seek advice about their ownership of US property as this may affect their tax residence, income tax liability, liability to capital gains tax and double taxation.
All footnotes refer to the Internal Revenue Code of 1986
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