International Real Estate Transactions
Posted on Jul 01, 2011
Do you have any clients who are non-US citizens? How about clients who are entering into transactions with non-citizens? Are you acting as an agent for a non-citizen who owns a condominium which he or she rents to others? Do you have clients who are renting or purchasing condominiums from non-citizens? In these situations, both you and your client may be unwittingly exposing yourselves to substantial personal liability for unpaid US income taxes associated with these transactions. Attorneys John Newman, Jack Facey and Ron Morgan want to alert you to these issues so that you and your clients can avoid the headache of unanticipated tax liability.
I. Federal Residency and Tax Rules
A frequent error that we encounter in Central Vermont involves reliance on the uninformed wrong advice of local business people, and even some general practice lawyers, who believe that a noncitizen can be present in the United States for up to 182 days annually without becoming a tax resident of the United States (and therefore subject to U.S. taxation on their worldwide income, wherever derived). The actual rule is best expressed as follows: “Professional accountancy or legal advice is necessary if a noncitizen will be physically present in the United States annually more than 122 days on a regular basis.” Such advice is necessary because the so-called “183-day rule” is subject to a 3-year look-back period, and days of presence are measured on a weighted average basis.
Not many wealthy foreign citizens wish to be taxed in the United States on their income from both US and foreign sources. This is especially true of individuals who live in no- or low-tax jurisdictions such as Bermuda and Switzerland. Most foreign individuals would prefer not to violate the “days of presence” rules of our federal tax laws. If the non-citizen will be physically present here more than 122 days on a regular basis, he or she needs professional accountancy or legal advice.
Withholding Tax on Rental Income
Another issue we encounter involves responsibility for withholding a percentage of the rental income from property owned by nonresident aliens. In general, the Internal Revenue Code imposes a withholding tax on income from passive investments. A nonresident alien who rents out his ski condominium to a US citizen typically is in receipt of passive investment income. Unless a tax treaty applies, the tenant must withhold 30% of each and every rental payment and pay it over to the US Treasury with a tax return.
As far as we know, no US tax treaty overrides this 30% withholding tax. In this circumstance, the IRS may look not only to the tenant or the nonresident alien to satisfy tax obligations, but also the rental agent or property manager. A real estate agent, property management company, or even a friend who collects such income from the renter and pays it over to the foreign national may well be a “withholding agent” required to make this tax withholding. This is because the agent may be the last person with control or receipt of the rental payment before the rent is paid to the foreign person. A withholding agent is jointly and severally liable for the payment to the US Treasury. Woe unto the real estate agent who must belatedly inform his/her client that, by renting from a foreign person, s/he was incurring a 30% withholding liability to the Treasury.
Net Income Election
A timely election to pay tax, not on the basis of gross rental income but on a net income basis (hence, a “net income election”), may in some cases substantially reduce a nonresident alien’s tax liability. Provided that the nonresident alien files a timely US federal income tax return, the foreign individual can make a net income election for his/her US rental income. In a “net income election,” the individual agrees to report all of the rental income on a timely filed US income tax return and pay tax under normal federal income tax rules for rental property. A net income election cannot be made on a late-filed return, but a grace period may be available under some circumstances.
A net income election can be very favorable. Instead of paying tax at 30% on the gross rental income, the nonresident alien may elect to pay tax at regular federal rates on rental income, net of depreciation, commissions, utilities, and other valid tax-deductible expenses. Thus, it is very important that the foreign national be told of this election for taxation on a net income basis. This is a use-it-or-lose-it rule. Many foreign individuals fail to make a net income election because they are unaware of the election.
A foreign client might well have a valid expectation that a US real estate agent who sold him/her real property in the US should be familiar with this rule and inform the client of the option to avoid the 30% withholding tax. Avoid the headaches of such a potential perceived omission by spotting this issue and alerting your clients in advance, or urging them to seek professional legal or accountancy advice.
Withholding Tax on the Sale
The United States imposes a 10% withholding tax on the gross proceeds of a real estate transaction when a nonresident alien sells a US real property interest. This is a temporary withholding tax that is collected to insure payment of the proper amount of income tax on any capital gain that might be realized upon the sale. The existence of this 10% withholding tax is comparatively well known to realtors.
What is less well known is how difficult it can be to obtain a refund from the US Treasury once the property is sold, and the 10% tax has been withheld. The delay in receiving a refund can be anywhere from 12 to18 months, depending on (i) when the property was sold, (ii) when a full and complete tax return was filed, and (iii) how long it takes to obtain a valid tax identification number, which is necessary for the refund.
Your foreign clients should be made aware when they list their properties that this 10% withholding tax can be reduced or eliminated if the seller can obtain a certificate (called a “Commissioner’s Certificate”) from the Internal Revenue Service indicating that less tax is due. In general, under the best of circumstances, the Internal Revenue Service will take 90 days to respond to a full and complete request for a reduction in income tax. Any peculiarity on the filing of the reduced withholding tax request will delay or make obtaining such a Commissioner’s Certificate impossible. A similar system exists for Vermont income tax, although the withholding is only 2.5%.
The IRS has recently proposed rules which will require foreign persons to include a taxpayer identification number on withholding tax returns, applications for withholding certificates, and other notices and elections relating to United States real property interests. The purpose of these rules is to enable the IRS to better identify the foreign transferor and more easily match the documents with the transferor’s tax return for compliance purposes. A foreign person can apply for a taxpayer identification number by filing Form W-7 with the IRS.
Our office is doing research to determine whether an expedited procedure for obtaining an international taxpayer identification number is available. Our experience is that it can take upwards of 4 to 6 weeks to obtain an individual tax identification number (called an ITIN).
There are many pitfalls awaiting the foreign citizen involved in a real estate transaction. Although the following example may seem exaggerated, Murphy’s Law provides that “anything that can go wrong will go wrong, and if it hasn’t gone wrong yet, it will go wrong at the least convenient moment. . . .”:
Assume that a citizen of a tax haven country (such as Bermuda or Cayman Islands) purchased a vacation home in Ludlow in 1995 for $250,000 net of agency and closing costs. When not used by the foreign citizen, the home was rented out through a local real estate agent on a weekly or monthly basis. The real estate agent informed the foreign national that it was the real estate agent’s understanding that the foreign national could be in the United States for less than 183 days a year on a regular basis and still avoid taxation by the United States or the state of Vermont.
The foreign national, relying on this advice over a seven-year period, was present in the United States approximately 135-140 days each year. The agent rented out his vacation home for gross rental income of approximately $20,000 a year, including maid service, utilities, insurance, agency commissions, and the like. The foreign national now has decided to sell the property for approximately the same amount of money that he put into the property ($250,000). The house is under contract, and the closing is set for a month from now. The foreign national is referred to our law firm, and he has been told that a 10% withholding tax will be due unless an IRS Commissioner’s Certificate can be received indicating that less income tax is due because there is no gain. The real estate agent is not a client of the Firm, but the foreign national is a client of the Firm.
During our first meeting with the client, we are forced to tell him the following: It is unlikely that he will be able to apply for a Commissioner Certificate reducing or eliminating the ten percent withholding tax because he will have to supply tax returns showing that tax was properly paid on the rental income. Even though he did not take any depreciation on the Ludlow residence, the Internal Revenue Service will require that the property be depreciated because it was used to produce rental income. This will mean that there will be gain on the sale of the property (depreciation recapture taxed at a special 25 percent longterms capital gains rate) regardless of the fact that the net sales price is the same as the tax basis the foreign national had when he purchased the property in 1995. The tax basis has now been reduced by seven years of depreciation.
It is our experience that a foreign individual in this position could decide that he does not wish to file an IRS Form 1040. The nonresident return requires that he list his days of presence in the United States. Because his days of presence exceed the 122 days (on average) he will not qualify to file a nonresident return; he must file a resident return, with the consequences set forth below. In addition, the Internal Revenue Service presumptively may claim payment of the 30% withholding tax from the foreign national that was not paid by the renters or the agency on rental payments for the Ludlow residence.
As the foreign national’s lawyer and advocate, we would have to tell him that the renters and the real estate agent are jointly and severally liable for the withholding tax, which is a primary liability of the renters, and a secondary liability of the real estate agent. Only if these two individuals do not pay will the foreign citizen be pursued for the 30% withholding tax payment. It will be too late to make the net income election for most, if not all of the closed tax years, because the election must be made on a timely filed federal income tax return.
Worst of all, the individual has been subject to the full burden of the US federal income tax for the past seven years because the individual was present in the United States on a weighted average basis for more than 183 days. The individual was present for over 122 days each year, and the weighted average rules make the person presumptively a US tax resident. A tax treaty will not protect this individual because the United States does not sign general tax treaties with tax haven countries. If the individual is wealthy and from a low- or no-tax jurisdiction, the tax burden could be quite substantial. The liability is likely to double when penalties and interest are added to the balance of tax due the US Treasury.
A reputable accountant will not prepare a return knowing it is false, and so our foreign national must bring himself into total compliance or walk away from the withholding tax, knowing that if he is caught by the IRS and fails to comply with the US tax laws, he will owe a substantial sum to the Treasury and (if unpaid) his visa status may threatened.
This may seem to be an exaggerated example, but we have dealt in our office with all of the above issues. The situation becomes even more dramatic when the individual dies, and his/her heirs discover that an estate tax will be imposed (in addition to income taxes) on the transfer at death of that portion of the property’s fair market value that exceeds $60,000. This topic is covered in a separate client memo on the federal estate and gift of foreign-ownership of US real property. One of the frequent tax errors we encounter is a nonresidential alien adding a person to his property as a joint tenant. This transfer is a taxable gift, and (unlike US tax citizens) a nonresidential alien does not have any gift tax credit.
One final point regarding this example. Although the foreign individual in your office may be from a high-tax country, that often does not prevent the individual from behaving as if they were in a no-tax or low-tax country. Many foreign citizens do not have the same tax morality as the United States’ citizens who have to continue to live under the treat of an IRS audit. It is not unheard of for French, German, UK, Canadian, Spanish, Venezuelan, Swedish, or other nationals simply to fail to report US-source rental income to their foreign governments even though their governments have a right to tax such income.
Please let us know if our firm can be of any use in helping you structure your real estate transactions when a non-citizen is involved.