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December 28, 2011

Net-Basis Elections Can Reduce Tax Burden of Foreign Investments in U.S. Property

By Cindy Spetalnick,
Principal, Gumbiner Savett Inc.

Foreign corporations and other non-residents who invest in U.S. real property may benefit from the net-basis elections permitted by Sections 871(d) and 882(d) of the Internal Revenue Code. A foreign person who is not engaged in a U.S. trade or business (e.g., a single real property leased on a triple-net basis) will generally suffer a flat 30 percent withholding tax on U.S.-source gross rent receipts. If this rental activity, however, constitutes a U.S. trade or business, the net rental income will be taxed as income that is effectively connected with a U.S. trade or business at graduated rates. Often, it is difficult to determine whether or not an investor’s real estate activities rise to a level consistent with the conduct of a U.S. trade or business.

To mitigate this uncertainty, a Section 871(d) or 882(d) election (or treaty equivalent) will generally treat all U.S. real property income of the taxpayer as effectively connected income regardless of whether the rental activities in fact constitute a trade or business under the general rules. Because the election allows the nonresident to deduct depreciation, real estate taxes, and other expenses related to the real property from the gross rent to determine the net income subject to tax, in many situations, the net-basis method of taxation will result in a lower effective rate than the flat 30 percent tax. Often these expenses exceed income and therefore no U.S. tax is due. The effect of the net election is limited to treating all U.S. real property income of the taxpayer as effectively connected income. It does not cause the taxpayer to be engaged in an actual trade or business in the United States.

To be eligible for the election, the foreign corporation or the nonresident alien individual must derive gross income during the taxable year from U.S. real property (or from an interest therein) and, in the case of a nonresident alien individual, the property must be held for the production of income.

The election cannot be made with respect to the following types of income:

  • Interest on a debt obligation secured by a mortgage on U.S. real property;
  • Any portion of a dividend paid by a corporation or a trust, such as a real estate investment trust, that derives income from real property;
  • In the case of nonresident alien individual, income from real property, such as a personal residence, that is not held for the production of income or from any transaction in such property that was not entered into for profit;
  • Certain rentals from personal property, or certain royalties from intangible personal property;
  • Income that is otherwise treated as effectively connected for the taxable year with the conduct of a trade or business in the United States.

The election for the first applicable taxation year can be made, without consent of the Commissioner, at any time before the expiration of the statute of limitations for filing a refund claim. Once made, the election remains in effect for all subsequent taxation years and can be revoked only with the consent of the Commissioner unless it is revoked before the statute of limitations for filing a refund claim expires.

An income tax treaty to which the United States is a party may also contain similar provisions that permit the making of a net election.

When making the net election, a foreign corporation should consider the effect that making the election might have on the treatment of net operating losses and other losses incurred by the entity and the imposition of both the branch profits tax and the excess interest tax on its U.S. operations. In general, seek the advice of an international tax specialist.