Form 1042-S – US Source Income Subject To US Income Tax Withholding
The US real estate market continues to be an attractive one for foreign investors, despite the fragile economy, the uncertainty that comes with the upcoming elections and despite the less than favorable regulatory environment heavily influenced by FIRPTA and the rest of the tax code. One of those elements experienced by foreign persons with US rental real estate is receiving a rent check with a 30% tax deduction that is then reported after the end of the year on the Form 1042-S .
If you bought a property and are simply renting it out, you are by definition from the US tax code, engaged in a passive activity. The US tax code states that such an activity by a foreign person is subject to a flat 30% withholding tax on the gross proceeds. All foreign investors owning U.S property are responsible for paying taxes on any and all rental income they earn in the United States and this mandatory withholding is designed to encourage filing compliance and the payment of income taxes.
Rental income from real property located in the United States and the gain from its sale will always be U.S. source income subject to tax in the United States regardless of the foreign investor’s personal tax status and regardless of whether the United States has an income treaty with the foreign investor’s home country.
Rental Income Withholding For Foreign Persons With The Form 1042-S
Your real estate professional or rental agent should discuss with you whether the rental income will be taxed as investment income through withholding, or on a net income basis as engaged in a U.S. trade or business, without withholding. This collection responsibility falls on the payor, your property manager, for example, and if they fail to withhold, the IRS can hold them personally liable for failing to withhold 30% of your gross rents in order to ensure that you will file a tax return and that the income taxes are paid. Thus, your property manager will start withholding immediately. The gross income and withheld taxes must be reported on the Form 1042-S, Foreign Persons U.S. Source Income Subject to Withholding to the IRS and the payee by March 15 of the following calendar year.
Election To Treat Rental Income As Effectively Connected With U.S. Trade Or Business
Foreign individuals may elect to have their passive rental income taxed as if it were effectively connected with the U.S. trade or business. Once such an election is made by attaching a declaration to a timely filed income tax return, there is no obligation to withhold by the payor. However, once made, the election may not be revoked without the consent of the IRS.
Further, unless the foreign investor has properly informed the property manager that the rental income is to be treated as “effectively connected income” by submitting to the property manager with a fully completed Internal Revenue Service Form W-8ECI, Certificate of Foreign Person’s Claim for Exemption From Withholding on Income Effectively Connected With the Conduct of a Trade or Business in the United States , the property manager will withhold thirty percent (30 percent) of the gross rental receipts so as to avoid personal liability. A fully completed Form W-8ECI must include a valid U.S. tax identification number.
Withholding Agent Issues A Form 1042-S
A real property manager who collects rent on behalf of a foreign owner of real property is considered a withholding agent and is personally and primarily liable for any tax that must be withheld and must issue a Form 1042-S following the end of the year. The liability of the withholding agent includes amounts that should have been paid plus interest, penalties, and where applicable, criminal sanctions. Property managers who do not comply with these rules will be held liable (either individually or through their company) for 30 percent of gross rents, plus penalties and interest.
To enforce the system of withholding, the Internal Revenue Code defines a “withholding agent” to be any person in whatever capacity (including lessees and managers of U.S. real property) having the control, receipt, custody, disposal or payment of income that is subject to withholding. Thus, a real property manager who collects rent on behalf of a foreign owner of real property is clearly considered a withholding agent. A withholding agent is personally and primarily liable for any tax that must be withheld. The liability of the withholding agent includes amounts that should have been paid plus interest, penalties and, where applicable, criminal sanctions. The statute of limitations does not start until a withholding return is filed by the withholding agent. Once the return has been filed, the statute of limitations begins to run at the later of two dates: the date of actual filing of the correct return or April 15 of the calendar year in which the return should have been filed. The withholding agent will remain liable if he actually knows that the foreign owner’s statements are false. The withholding agent’s duty of inquiry seems to be a “reasonably prudent test,” measured by all facts and circumstances.
A nonresident who fails to submit a timely filed income tax return loses the ability to claim deductions against the rental income, causing the gross rents to be subject to the 30 percent tax. Generally, the nonresident will need to retroactively file at least six years of delinquent income tax returns, or all prior year tax returns, if they have held the rental property for less than six years. However, the ability to elect to treat the rental income as effectively connected with a U.S. trade or business will be lost after 16 months from the original due date of the return, and the remaining back years may be subject to tax under the gross income method. Rental income from real property located in the United States and the gain from its sale will always be U.S. source income subject to tax in the United States regardless of the foreign investor’s status and regardless of whether the United States has an income treaty with the foreign investor’s home country.
You will need an Individual Taxpayer Identification Number or ITIN, which you can obtain through the submission of a Form W-7. See the IRS website for more details about obtaining an ITIN. Once an ITIN has been received, which we can assist with the preparation and application of, we can then assist with the preparation and submittal of a Form W-8ECI to your property manager.
Following the end of the year, your nonresident income tax return will need to be filed. By providing your withholding agent with a completed Form W-8ECI, not only does it release your agent from their withholding responsibilities, but also more importantly you will be able to deduct rental expenses from your gross revenue to arrive at a lower amount of taxable income.
Listed below are some of the most common rental expenses that can be eligible for deduction:
- Auto and travel expenses.
- Cleaning and maintenance.
- Interest (other).
- Legal and other professional fees.
- Local transportation expenses.
- Management fees.
- Mortgage interest paid to banks, etc.
- Rental payments.
Do keep in mind that real estate professionals are required by law to inform you, and help in the compliance of any transactions involving foreign individuals. They are your best first line of defense, but do expect to hire a tax professional to pick up where they leave off!
When planning your investment in U.S. real estate, be sure to consider selecting a real estate professional experienced working with foreign investors. There are enough taxes , licenses, permits and other regulatory requirements that when not handled properly can carry hefty penalties. A Form 1042-S should just be another form for you to provide your tax professional for your annual U.S. tax return preparation.
Our goal at Tax Samaritan is to provide the best counsel, advocacy and personal service for our clients. We are not only tax preparation and representation experts, but strive to become valued business partners. Tax Samaritan is committed to understanding our client’s unique needs; every tax situation is different and requires a personal approach in providing realistic and effective solutions.
If you would like a quote, please click on the button below for a free, no obligation Tax Preparation quote and/or free 30-minute consultation to discuss your situation regarding the 1042-S further:
Tax Samaritan is a team of Enrolled Agents with over 25 years of experience focusing on US tax preparation and representation. We maintain this tax blog where all articles are written by Enrolled Agents. Our main objective is to educate US taxpayers on their tax responsibilities and the selection of a tax professional. Our articles are also designed to help taxpayers looking to self prepare, providing specific tips and pitfalls to avoid.
When looking for a tax professional, choose carefully. We recommend that you hire a credentialed tax professional such as Tax Samaritan that is an Enrolled Agent (America’s Tax Experts). If you are a US taxpayer overseas, we further recommend that you seek a professional who is experienced in expat tax preparation, like Tax Samaritan (most tax professionals have limited to no experience with the unique tax issues of expat taxpayers).
Randall Brody is an enrolled agent, licensed by the US Department of the Treasury to represent taxpayers before the IRS for audits, collections and appeals. To attain the enrolled agent designation, candidates must demonstrate expertise in taxation, fulfill continuing education credits and adhere to a stringent code of ethics.
Every effort has been taken to provide the most accurate and honest analysis of the tax information provided in this blog. Please use your discretion before making any decisions based on the information provided. This blog is not intended to be a substitute for seeking professional tax advice based on your individual needs.