How Are Non-Resident Aliens Taxed?
Resident and nonresident aliens are taxed in different ways. Resident aliens are generally taxed in the same way as US citizens. Nonresident aliens are taxed based on the source of their income and whether or not their income is effectively connected with a US trade or business. A nonresident alien’s income that is subject to US income tax must be divided into two categories:
1. Income that is effectively connected with a trade or business in the US, and
2. Income that is not effectively connected with a trade or business in the US.
The difference between these two categories is that effectively connected income, after allowable deductions, is taxed at graduated rates. These are the same rates that apply to U.S. citizens and residents. Income that is not effectively connected is taxed at a flat 30% (or lower treaty) rate and does not allow any deduction for expenses. Rental real estate is defined as income that is not effectively connected income and, therefore, would be subject to the 30% withholding.
However, if you have rental real estate you can elect to have it treated as a US trade or business for tax purposes. If you make this choice, you can claim deductions attributable to the real property income and only your net income from real property is taxed. The choice applies to all income from real property located in the United States and held for the production of income and to all income from any interest in such property. If you make this election, you must attach a statement to your tax return that addresses the following:
• That you are making the choice.
• Whether the choice is under Internal Revenue Code section 871(d) (explained above) or a tax treaty.
• A complete list of all your real property, or any interest in real property, located in the US.
• The extent of your ownership in the property.
• The location of the property.
• A description of any major improvements to the property.
• The dates you owned the property.
• Your income from the property.
• Details of any previous choices and revocations of the real property income choice.
As an example, let’s assume you are a nonresident alien and you are not engaged in a U.S. trade or business. You own a single family residence in the US that you rent out. Your rental income for the year is $10,000 and this is your only US source income. In addition, you have $6,000 in expenses, which includes property management fees, insurance, property taxes, repairs and maintenance, depreciation and other miscellaneous costs. The rental income would normally be subject to a tax at a 30% (or lower treaty) rate, which would amount to $3,000.
But if you make the election discussed above, you can offset the $10,000 income by all of your rental expenses. You are then taxed on the net income of $4,000 (reduced by your exemption and any itemized deductions). Any resulting net income is taxed at graduated rates. The result is a tax savings of potentially thousands of dollars.
Visiting or Residing in the US
Even if you do not permanently reside in the US, you may end up staying long enough to qualify as a resident for tax purposes. Aliens may be considered a resident alien for tax purposes if they pass either the green card test or the substantial presence test.
Green Card Test
You are a US resident (for tax purposes) if you are a Lawful Permanent Resident of the US at any time during the calendar year. This is known as the “green card” test. You are a Lawful Permanent Resident of the US, at any time, if you have been given the privilege, according to the immigration laws, of residing permanently in the United States as an immigrant.
Generally, you will have this status if the US Citizenship and Immigration Service (USCIS) has issued you an alien registration card. This will be on Form I-551, which is also known as a “green card.” With this test, you continue to have resident status unless you voluntarily renounce and abandon this status in writing to the USCIS. In addition, your status can be administratively terminated by the USCIS, or your immigrant status is judicially terminated by a federal court.
Substantial Presence Test
Most foreign real estate investors will not meet the green card test. However, because of vacations and extensive stays in the US, they can find themselves meeting the substantial presence test for the calendar year. To meet this test, you must be physically present in the United States for at least:
1. 31 days during the current year; and
2. 183 days during the 3-year period that includes the current year and the 2 years just before that, counting:
• All the days you were present in the current year, and
• 1/3 of the days you were present in the first year before the current year, and
• 1/6 of the days you were present in the second year before the current year.
For example, assume you were physically present in the US for 120 days in each of the years 2011, 2012, and 2013. To determine if you meet the test for 2013, you would count the full 120 days present in 2013, 40 days in 2012 (1/3 of 120), and 20 days in 2011 (1/6 of 120). Because the total for the 3-year period is 180 days (less than 183 days), you would not be considered a resident under the substantial presence test for 2013. Accordingly, you would be taxed as a non-resident alien.