Posted by: Steven Toscher | March 31, 2020

IRS Announces New Campaign Targeting Rental Income for Nonresident Aliens by Steve Toscher and Tenzing Tunden

The U.S. real property market has always been attractive to foreign investors, not just for it’s potential for profit, but also because of the country’s robust financial and legal system in case investors need to efficiently liquidate their ownership or if a dispute arises.

For the 12 months ending in March 2016, NRAs purchased $43.5 billion of U.S. property.

Tax compliance in this area has historically been limited.   While there have been improvements in this area for tax compliance and reporting, it is not yet sufficient for the U.S. Treasury and IRS.

The Large Business & International Division (LB&I) of the IRS recently launched a new compliance campaign on rental income of nonresident aliens (NRAs).  IRS campaigns are intended to improve tax compliance with respect to certain ”hot” tax issues. This new campaign will target taxpayers through several treatment streams, from soft letters (pre-audit notices to taxpayers identifying potential campaign issues and encouraging compliance) to issue-based examinations. It also contemplates education and outreach to promote tax compliance. The LB&I has indicated that the majority of the future examination workload will be selected using various campaigns.[i]

Relevant Law and Reporting Obligation

A nonresident alien’s US taxable income is divided into the following two categories:

(i) Income that is effectively connected to a trade or business in the United States

(ii) Income that is not effectively connected to a trade or business in the United States (“FDAP income”)

Income that is effectively connected to a U.S. trade or business, after allowable deductions, is taxed at the graduated rates applicable to U.S. citizens and resident aliens, while income that is not effectively connected to a U.S. trade or business is subject to tax at a flat rate of 30% that is withheld at the source.[ii]

Nonresident aliens who own U.S. property that generates rental payments are subject to the flat 30 % withholding tax on the gross rent unless the nonresident alien makes an election to treat the rental income as effectively connected to a U.S. trade or business.[iii]  Nonresident aliens who make this election can reduce their rental income by offsetting rental income with expenses pertaining to the rental activity.

For those that make the election they must report  on Schedule E of Form 1040NR. For those that do not make the election, the withholding agent is responsible to remit the  30 % withholding tax. They must submit a Form W-8BEN to the withholding agent.

A withholding agent is a U.S. or foreign person that has control, receipt, custody, disposal, or payment of any item of income of a foreign person that is subject to withholding.[iv]  A withholding agent may be an individual, corporation, partnership, trust, association, or any other entity, including any foreign intermediary, foreign partnership, or U.S. branch of certain foreign banks and insurance companies.[v]  Thus, in the real estate context, a withholding agent would be either the tenant or the property manager since they have control and custody over the property owned by the NRA.

TIGTA Report[vi]

This campaign is in part influenced by a Treasury Inspector General  for Tax Administration (TIGTA) report published in August 2017. The  report pointed out the failure  to  identify NRAs  who failed to report U.S. property rental income. The TIGTA conducted a random stratified sample of 149 filers from over 33,000 Tax Year 2013 Form 1040 NR Schedule E filers who were first-time filers that year.[vii]  The random stratified sample was conducted to determine whether or not taxpayers were in compliance with the IRC §871(d)(1) election and Treasury Regulation §1.871-10 (statement that accompanies the election to have the income be effectively connected income with a  U.S. trade or business).[viii] The TIGTA report noted a considerable number of NRAs were claiming net income treatment on annual Forms 1040NR despite never making the appropriate election to treat the income as effectively connected income. Only 47 (32%) of the 149 taxpayers complied with the reporting requirements of rental income by NRA and included the mandatory election statement in accordance with IRC §871(d)(1).[ix]  Only six of the election statements included all of the elements required by the Treasury Regulation §1.871-10.[x] The 68% that did not attach the election statement still reported their rental income as effectively connected to a U.S. trade or business. These taxpayers should have been subject to the flat 30% tax on gross income, which would have yielded the IRS approximately $534,000 in income taxes (30% of $1.78 million).[xi] When this is projected over the entire population, the TIGTA estimates that the IRS loses about $56 million per year.[xii] The TIGTA report also found that some NRAs taking inconsistent positions – e.g. deducting rental expenses and subjecting remaining net income to IRC §1 tax rates while not reducing their basis of property when later disposing of the property. Other issues that  TIGTA discovered are some NRAs never filing Form 1040NR and never notifying withholding agents that they should be subject to a 30% tax rate on gross income.

Furthermore, based on a reported sample data from 5 counties in four states, 13% of foreign property owners failed to pay tax in 2013.[xiii] The TIGTA estimated that 5,600 NRAs may not have complied with filing requirements in those counties.

Conclusion

The Commissioner of the IRS has stated  that the IRS will have a much greater presence on enforcement  and that “we will be in every neighborhood that we can be.”[xiv] The new LB&I campaign makes clear that if you  are a NRA landlord, the IRS will be visiting your neighborhood.   With the extra focus now on NRA taxpayers by the IRS , it is important for   taxpayers and withholding agents to  review  their compliance or otherwise face costly deficiencies, penalties, and interest.

Steven Toscher is a Principal at Hochman Salkin Toscher & Perez P.C., and specializes in civil and criminal tax litigation. Mr. Toscher is a Certified Tax Specialist in Taxation, the State Bar of California Board of Legal Specialization and represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation.

Tenzing Tunden is a Tax Associate at Hochman Salkin Toscher Perez P.C. Mr. Tunden recently graduated from the Graduate Tax Program at NYU School of Law and the J.D. Program at UC Davis School of Law. During law school, Mr. Tunden served as an intern at the Franchise Tax Board Legal Division and at the Tax Division of the U.S. Attorney’s Office (N.D. Cal).

[i] IRS Advisory Council 2017 Public Report at 31-32. Available at https://www.irs.gov/pub/irs-utl/2017-irsac-public-report.pdf.

[ii] IRC §1 for income that is ECI and IRC §871(a) for income that is not ECI.

[iii] IRC §871(d).

[iv] IRS Publication 515 at 3.

[v] Id.

[vi] Treasury Inspector General For Tax Administration, Additional Controls Are Needed to Help Ensure That Nonresident Alien Individual Property Owners Comply With Tax Laws, August 23, 2017, available at https://www.treasury.gov/tigta/auditreports/2017reports/201730048fr.pdf.

[vii] Id. at 7.

[viii] Id.

[ix] Id.

[x] Id.  The election statement includes: (A) a complete schedule of all real property, or any interest in real property, of which the taxpayer is a titular or beneficial owner, which is located in the U.S. (B) an indication of the extent to which the taxpayer has direct or beneficial ownership in each such item of real property, or interest in real property (C) the location of real property or interest therein (D) a description of any substantial improvements on any such property and (E) an identification of any taxable year or years in respect of which a revocation or new election under this section has previously occurred.

[xi] Id. at 9.

[xii] Id.

[xiii] Id. at 17-18.

[xiv] Joshua Rosenberg, Rettig’s Vow To Have IRS in Every Neighborhood A Tall Order, LAW360 Tax Authority, Nov. 7, 2019 (comments from his speech at various tax law conferences). Also see Daniel Hood,  IRS Commissioner: You’re Going to Be Seeing A Lot of Me, Accounting Today, June 10, 2019.


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