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Foreign ownership of U.S. real estate - taxes (IRS).

Rental income from a foreign owned U.S. property can be taxed at either a flat rate or after deducting expenses.

Second, in our articles on owning residential real estate in the U.S., is a short discussion of taxes and how they affect the foreign buyer of U.S. real property. A few forms and publications discussed below are IRS Publication 519, IRS form 1040NR, and IRS form 1042-S.

As a foreign owner of U.S. real estate there are generally two choices of how to be taxed on any rental income. The first, and easiest, is a simple 30% tax on any income received as rents or other related income. While this is very easy to calculate it is normally less than ideal for the owner of the property. Example. Charles buys a condo for $125,000 and rents it out for $1,000 per month. Based on the 30% rule Charles would owe $1,000 per month x 12 months x 30% = $3,600 per year in taxes regardless of the expenses of the property (management, maintenance, repairs, interest expense, etc.). This 30% would commonly be withheld by the property manager and reported to the IRS on form 1042-S. Charles would not be required to file a tax return as the IRS would already have all that they need from this form.

The second method for taxation is to elect to have the property treated as "effectively connected" to a trade or business. By doing so the buyer is now able to deduct expenses of the property before paying any tax on the remaining income. These deductions are discussed elsewhere on this web site - see Schedule E - but as a review consider the following. Example. Linda buys a condo for $125,000 and rents it out for $1,000 per month. Her property manager charges 10% of rent as a management fee or $100 per month. She also pays local property taxes of $1,500 per year. Linda incurred $500 in repairs for the year and paid $960 in condo association dues. Linda's income then, less expenses, is $7,840 ($12,000 - $1,200 - $1,500 - $500 - $960 = $7,840). At 30%, the tax bill is now $2,352 vs. $3,600 in the first example. The taxes in this case are reported on IRS form 1040NR and Schedule E.

It is important to note that the expenses mentioned are there in both of these examples. In the second example the buyer simply gets to deduct them prior to paying tax. In the first example the buyer does not. It is also very likely that the tax rate in the second example would be lower than 30%, thereby further reducing the tax bill. In the first example the tax rate is fixed at 30%. Please also note that there are tax treaties in place that can change these figures. For an overview of international tax treaties see IRS Publication 901.

If all of this sounds a little complicated it should be noted that getting the proper reporting set up can be done quickly by working with a CPA and/or tax attorney specializing in these areas. Doing this properly is not that expensive and is mostly an "up front" cost at the time of buying the property. The year to year requirements involved are not complicated and can easily be taken care of in an inexpensive manner.

Lastly, please note that the above are simplified examples. Purposely left out are concepts like depreciation which are discussed elsewhere on this site. Individual states may also have their own requirements that differ from each other. For information on the buying process for property in the U.S. see part 1 - U.S. real estate purchase process. Also see part 3 of this series - common questions on foreign ownership of U.S. property.

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