Recently, the IRS Large Business & International Division announced two new audit campaigns focusing on Nonresident Aliens (NRAs). The first audit campaign, released on 14 September 2020, targets non-compliance with withholding tax on dispositions of U.S. real property interests by a foreign person. The second IRS audit campaign, released on 5 October 2020, targets NRAs who receive rental income from U.S. real property but who are non-compliant with annual tax reporting and filing requirements.
FIRPTA compliance for NRAs
The Foreign Investment in Real Property Act of 1980 (FIRPTA) taxes foreign persons on the disposition of their U.S. real property interests. Generally, the buyer/transferee is the withholding agent and is required to withhold 15% of the amount realised on the sale, file the required forms, and remit the tax to the IRS (IRS, 2020).
FIRPTA was enacted to mitigate perceived abuses by foreign investors seeking to avoid U.S. Federal income tax on the sale of U.S. property. When U.S. property is sold at a gain, a foreign person must pay U.S. Federal income tax on the gain, as it is treated as income effectively connected with a U.S. trade or business. The required 15% withholding tax on the sale of U.S. property is then used as a reduction against Ffederal tax when the foreign person files the required U.S. tax compliance forms with the IRS. Furthermore, foreign persons who hold U.S. real estate through corporate or trust structures are not exempt from FIRPTA taxes and withholding, and the entities will have US tax-filing obligations with the IRS.
In 2019, 74 billion USD of U.S. properties were sold to foreign buyers with 2.28 billion USD purchased by European investors (Rudden, 2020). Therefore, it is unsurprising that another IRS audit campaign has been launched to help scrutinise property transactions involving foreign investors buying and selling U.S. property. The IRS has issued the FIRPTA audit campaign, to increase FIRPTA voluntary compliance through issue-based examinations (audits), external education and outreach.
Rental income from U.S. property
A foreign person owning U.S. rental property is taxed on their annual rental income, in one of two ways:
- Currently, a flat 30% U.S. withholding tax is imposed on the gross amount of rents received without deductions. The foreign person, U.S. property manager or even the tenant is responsible for sending the 30% tax withholdings to the IRS and file Form W-8BEN.
- A "net election" can be made by a foreign person under the Internal Revenue Code section 871(d), which permits U.S. rental income to be treated as effectively connected with the conduct of a U.S. trade or business. This allows the foreign person to reduce the gross rental income by certain deductions, operating expenses, interest and depreciation, as long as a U.S. Nonresident Alien Income Tax Return is filed annually. The resulting net income (if any), would be taxed at the current U.S. progressive tax rates of 10% to 37%, which will most likely be beneficial compared to the 30% withholding tax, mentioned previously.
The “net election” is selected when a U.S. Nonresident Alien Income Tax Return is filed on time. In order to file an income tax return, a foreign person must obtain an Individual Taxpayer Identification Number (ITIN) from the IRS by filing Form W7.
The two international compliance initiatives introduced by the IRS, target foreign persons investing in the U.S. who may not be familiar with the U.S. tax code and the required annual tax reporting and filing requirements. Deloitte, with its team of U.S. tax professionals, can provide a holistic approach to an individual’s specific set of circumstances to help mitigate non-compliance and previous reporting inaccuracies. In addition, Deloitte can assist foreign investors with Federal and State tax planning before initial investment occurs in the U.S., either through direct ownership or through structured entities.
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