Tax Planning Considerations for Non-U.S. Persons Investing in U.S. Real Estate

Summary: Non-U.S. persons investing in U.S. real estate may be subject to 30% gross withholding on rental income unless they qualify for or elect effectively connected income (ECI) treatment under IRC Sections 871(d) or 882(d). Understanding FDAP vs. ECI, related withholding rules, partnership considerations, and U.S. filing requirements is essential for effective tax planning and compliance.

Investing in U.S. real property can be lucrative. Often, as a result of favorable tax rules in the Internal Revenue Code (IRC), deductions such as depreciation, interest expense, and operating costs can partially or completely offset rental income. However, for non-U.S. persons, the default tax and withholding rules can be unfavorable unless addressed proactively.

It’s important to note that treaties play a role when analyzing the treatment of how items are taxed for non-U.S. persons with U.S. income. A discussion of income tax treaties is outside the scope of this article.

Different Treatment for U.S. and Non-U.S. Investors

Many areas of the income tax code differentiate between U.S. and non-U.S. persons. Rental income is one area where that distinction can be especially significant.

• For U.S. persons, rental income is generally taxed on a net basis (gross rents less allowable deductions).
• For non-U.S. persons, rents from real property located in the United States are U.S.-source income and may be taxed under one of two regimes, depending on the facts.
  • FDAP (Fixed, Determinable, Annual, or Periodic) Income: If the rental activity is not treated as effectively connected with a U.S. trade or business, the rents are generally treated as FDAP and subject to a 30% tax on gross rents (subject to treaty reductions). When rents are treated as FDAP, no deductions are allowed in computing the tax.
  • Effectively Connected Income (ECI): If the rental activity rises to the level of a U.S. trade or business, the net rental income is treated as ECI and taxed at graduated rates (for individuals) or at the corporate rate (for corporations). In that case, ordinary and necessary deductions are generally allowed, but the foreign taxpayer must file a U.S. income tax return to report the ECI.
  • Practical Issue: The line between FDAP and ECI is not always clear, especially for relatively passive rental arrangements. To remove uncertainty and ensure net-basis taxation, the IRC allows an election under Section 871(d) (individuals) or Section 882(d) (corporations) to treat U.S. real property rental income as ECI even when it would otherwise be FDAP.

Election Opportunities and Details

When rental income is not otherwise part of a U.S. trade or business, a non-U.S. person may elect under IRC Section 871(d) (individuals) or 882(d) (corporations) to treat the U.S.-source rental income as ECI. The election generally allows the taxpayer to compute U.S. tax on net rental income (gross rents reduced by allowable deductions) rather than on gross rents.

This often results in a significantly lower effective tax burden, particularly where depreciation or other deductions are substantial. This election addresses rental income characterization and does not change FIRPTA rules on dispositions of U.S. real property interests.

Once the election is made, the U.S. payor of the rent (for example, a tenant or a property manager) can generally stop withholding the 30% FDAP tax if it receives a properly completed Form W-8ECI. Without that documentation, the payor may be required to withhold under the Chapter 3 rules (IRC Sections 1441/1442) and report the withholding on Forms 1042 and 1042-S. It’s important to note that in practice, tenants often don’t withhold unless advised, even though the legal obligation for the withholding does exist.

To obtain and maintain the benefits of the election, the non-U.S. person generally must:

1. Have a U.S. taxpayer identification number (SSN or ITIN for individuals, or an EIN for entities, as applicable), and
2. File a U.S. income tax return each year the election applies.

Nonresident individuals generally file Form 1040-NR, and foreign corporations generally file Form 1120-F. The election is made by attaching a statement to the first timely filed return for the year the election is to apply (or to a timely filed amended return, as discussed below). Once made, the election applies to all U.S. real property interests held by the taxpayer at the time it is made (and subsequently acquired) and remains in effect for future years unless properly revoked.

The election requirements are found in Treas. Reg. Section 1.871-10(d)(1)(ii). The required statement must include:

1. A complete schedule of all U.S. real property (or any interest in U.S. real property) in which the taxpayer has an ownership interest or beneficial interest;
2. An explanation of the taxpayer’s ownership interest in each item of real property;
3. The location of each real property interest;
4. A description of any substantial improvements made to any of the property; and
5. An identification of any taxable year for which the election was previously made and remains in effect (or, if applicable, when it was revoked).

If the taxpayer did not attach the statement to the original return for the relevant year, the return can generally be amended to include the election statement, provided the statute of limitations remains open.

Additional Considerations for Investments Held Through Partnerships

The Section 871(d)/882(d) election is often most important for foreign persons investing through U.S. partnerships that own rental real estate. When a partnership holds rental property, it is not always clear whether the partnership’s rental activity constitutes a U.S. trade or business. This can be particularly true where the partnership’s leases are triple-net leases and there is limited additional activity at the partnership level.

Because that classification can drive the applicable withholding regime, foreign partners often take a protective approach by making the Section 871(d)/882(d) election to ensure their allocable share of rental income is treated as ECI (and therefore eligible for deductions).

This would ensure that any withholding would be done on a net basis rather than gross. If the activity is already ECI at the partnership level, the election does not change the characterization – it just removes the risk and ambiguity.

Foreign partners should generally provide the partnership with Form W-8ECI to document the election. Absent that certification, the partnership may need to treat the partner’s share of rental income as FDAP and withhold 30% on gross rents under the Chapter 3 rules, rather than withholding on net effectively connected taxable income under IRC Section 1446(a).

Finally, it is critical to recognize that making the election generally creates (or confirms) a U.S. return filing obligation for the foreign partner. Withholding alone does not eliminate the filing requirement when rental income is treated as ECI.

Effective planning for non-U.S. persons investing in U.S. real property is critically important. Please consult your tax advisor for assistance with analyzing FDAP versus ECI treatment and with preparing the Section 871(d)/882(d) election statement.

For further guidance or to discuss potential planning strategies, reach out to your KSM advisor or complete the form below.