The Power of the 871(d) Election for Nonresident Aliens Investing in U.S. Rental Property
Tax Treatment of a Nonresident Alien
Let’s start by discussing, in general terms, how the U.S. taxes a nonresident alien.
A foreign national who neither has a green card nor satisfies the Substantial Presence Test is considered to be a U.S. nonresident. As such, he/she is taxed under an entirely separate regime from the one that applies to U.S. citizens and resident aliens.
A nonresident’s income is divided into two distinct categories: income which is effectively connected with a U.S. trade or business, and that which is not. Both categories of income are subject to tax under a completely different set of rules, referred to as “ECI” and “Non-ECI.” Note that foreign-sourced income earned by a nonresident alien is not subject to U.S. tax.
ECI – Effectively Connected Income – is income earned as a result of an individual’s direct involvement in a trade or business, such as employee compensation, U.S. workdays, or self-employment income. ECI is taxed similarly to the rules that apply to U.S. citizens, in that graduated tax rates apply and deductions which are incurred to create ECI income are allowed, so that that the net ECI, after deductions, is taxable. However, there is no standard deduction available, no deduction is allowed for mortgage interest and taxes, and Married Filing Joint filing status cannot be claimed on a Form 1040NR with exceptions for citizens of Canada, Mexico or South Korea.
Non-ECI income is income not effectively connected with a trade or business, such as interest, dividends, capital gains, or rental property. Non-ECI is taxed only to the extent it is deemed to be derived from U.S. sources. Different sourcing rules apply to the various categories. Interest is sourced by the location of the payor, dividends by the country of incorporation, capital gains by the tax home, and real estate by the country of location. U.S. rental property is Non-ECI by definition. A stark contrast between ECI and non-ECI is that no deductions are allowed from non-ECI income. Therefore, non-ECI gross income is generally taxed at a flat rate of 30%, unless a lower treaty rate applies.
U.S. Rental Property – Note that whether a nonresident alien owns a direct interest in a U.S. rental property, or owns a share of the property through a partnership interest, does not affect the non-ECI designation. Therefore, this can be particularly tax burdensome for a nonresident alien, as gross rental income needs to be reported on the nonresident alien’s U.S. tax return, and rental expenses including depreciation are not allowed. In the case of a K-1, as the net rental income/loss is reported after deductions are taken into account, the tax preparer needs to determine what the allocable gross income is to the nonresident alien partner; the gross amount needs to be reported on Form 1040NR.
Effect of Election under 871(d) – Under IRC 871(d), a U.S. nonresident alien can elect to treat U.S. rental real estate as if it were U.S. ECI and, therefore, be able to claim both rental expenses and depreciation as deductions from gross rental income. This, of course, significantly reduces the U.S. tax liability, as net rental income (versus gross rental income) is taxable.
Filing Deadline for Tax Returns – What if the nonresident alien did not make the 871(d) election, or did not file a return, in prior years? We see this often, particularly when the property is held through a partnership interest. As the K-1 frequently shows a net loss from rental property, nonresident aliens may erroneously assume there is no U.S. tax filing required, nor U.S. tax due. Returns may be amended and/or prepared and filed late; however, this must happen within 16 months of the initial due date of the return, per IRC 874.
Manner of Electing – A statement must be attached to the Form 1040NR in order to properly make an 871(d) election. Note that the election must include:
- Amount of gross rental income to which the election pertains.
- Description, address, and Location of property.
- Acquisition date.