Foreign Owner Renting Out a U.S. Property: 30% Withholding or the Net Basis Election?

The default: 30 percent on gross rent

Rental income from U.S. real property is U.S.-source income. If a nonresident alien's rental activity is not a U.S. trade or business, the rent is treated as fixed or determinable income subject to 30 percent tax on the gross amount, withheld by the tenant or the property manager acting as withholding agent. No deductions are allowed. On a property earning $40,000 of rent with $30,000 of expenses and depreciation, the default tax is $12,000 — even though the net income is only $10,000.

The net basis election

Section 871(d) allows a nonresident alien to elect to treat income from U.S. real property held for the production of income as effectively connected with a U.S. trade or business. The owner then reports net rental income on Form 1040-NR, deducting mortgage interest, property taxes, insurance, association fees, repairs, management fees and depreciation, and pays tax at graduated rates. Foreign corporations have a parallel election under section 882(d). For many owners, net rental income after depreciation is small or negative.

How the election is made

The election is made by attaching a statement to a timely filed Form 1040-NR for the first year it applies. The statement identifies the property, the extent of ownership and the income involved. Once made, the election applies to all income from U.S. real property held for the production of income and continues in future years unless revoked, which generally requires IRS consent.

Stopping gross withholding: Form W-8ECI

To prevent 30 percent withholding, the owner provides Form W-8ECI to the withholding agent — usually the property manager or tenant — stating that the income is effectively connected. Form W-8ECI requires a U.S. taxpayer identification number, typically an ITIN for an individual owner. Without it, the property manager is required to withhold.

Timely filing matters

Nonresidents with effectively connected income can claim deductions only if they file a true and accurate return in a timely manner. The regulations generally treat a return as timely for this purpose if filed within 16 months of its original due date, subject to exceptions. Owners who fall behind for several years can lose deductions for those years and be taxed on gross income. This is one of the most consequential rules for foreign owners.

Depreciation and the eventual sale

Residential rental property is generally depreciated over 27.5 years. Depreciation reduces taxable rental income each year but also reduces the property's basis, increasing the gain on a later sale. That portion of the gain is generally taxed at up to 25 percent. The sale is also subject to FIRPTA withholding, and the owner's annual Form 1040-NR history makes a withholding certificate application considerably easier.

Ownership through an LLC

A single-member U.S. LLC that is disregarded does not change the income tax analysis: the foreign owner is still the taxpayer and makes the election personally. The LLC adds its own Form 5472 filing requirement. Ownership through a U.S. or foreign corporation changes the analysis significantly, including the potential branch profits tax for a foreign corporation.

Common mistakes

• Allowing the property manager to withhold 30 percent indefinitely without filing
• Providing a W-8BEN instead of a W-8ECI, which does not stop gross withholding on rent
• Not making the election with the first timely return
• Failing to claim depreciation, which still reduces basis on sale
• Treating short-term vacation rentals as passive when services provided may create a trade or business

Sources and official references

• IRS — Taxation of nonresident aliens
• IRS — Publication 519, U.S. Tax Guide for Aliens (rental income)
• IRS — Instructions for Form W-8ECI
• IRS — Instructions for Form 1040-NR
• IRS — Publication 527, Residential Rental Property