Let’s talk about non-resident aliens (NRAs) who own U.S. real estate. This is another area where people often get it wrong, and it can cost them a fortune.
- The Default Rule: The general rule for NRAs with U.S. rental income is a flat 30% tax on the gross amount of income. This is handled by a “withholding agent”—your renter or property manager—who is required to send 30% of the total rental income directly to the IRS.
- The 871(d) Election: This is where a good tax adviser comes in. Under Section 871(d), an NRA can make an election to treat their U.S. rental property as an active trade or business. The main benefit of this is that you can avoid the flat 30% tax on gross income and instead pay the normal progressive tax rates on your net income after taking all your deductions. To make this election, you must file a statement with your tax return that includes a complete schedule of all your U.S. real property and other required details.
- The “Timely” Filing Trap: The biggest problem for NRAs is that they can only claim deductions if they file a “true, accurate, and timely” Form 1040NR. The definition of “timely” is unique here. If you failed to file your first return on time, you have up to 16 months from the due date to file and still be considered “timely”. If you miss that window, you can lose all your deductions, and your tax bill will be based on your gross income.
- Getting Late Relief: If you missed the 16-month deadline, there are still options, but they’re more complicated. You can file a retroactive election within the general refund period (three years from the date you filed or two years from the date you paid the tax). If that period has also expired, you may be able to seek a private letter ruling from the IRS to get “Section 9100 relief”. The IRS will grant this if you can show you acted reasonably and in good faith and that granting relief will not prejudice the government’s interests
The Election? It’s Vague
Section 871, like many tax provisions, is vague about how to make the relevant election, limiting itself to stating that it “may be made only in such manner and at such time as the [IRS] may by regulations prescribe.”
The regulations
explain the election procedure in the following manner:
An election made under this section without the consent of the [IRS] shall be made for a taxable year by filing with the income tax return required under Section 6012 and the regulations thereunder for such taxable year a statement to the effect that the election is being made. This statement shall include:
(a) a complete schedule of all real property, or any interest in real property, of which the taxpayer is titular or beneficial owner, which is located in the United States,
(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 the 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.
The IRS provides slightly different guidance in its Publication 519 directed at NRAs. There, the IRS states the following about “making the choice” to treat U.S. rental real estate as an active trade or business:
Make the initial choice by attaching a statement to your return, or amended return, for the year of the choice.
Include the following in your statement:
That you are making the choice; Whether the choice is under Internal Revenue Code Section 871(d) (explained earlier) or a tax treaty;
A complete list of all your real property, or any interest in real property, located in the United States…Cast your fate to the wind”;
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.
Solutions for NRAs who filed Forms 1040NR but no election.
NRAs claiming net income treatment on their annual Forms 1040NR without making proper a Section 871(d) election have two main possibilities.
Making a late election pursuant to the Section 871 regulations.
NRAs might file an amended Form 1040NR within the designated period to retroactively make the Section 871(d) election, which they can do without seeking advanced permission from the IRS. The regulations provide detail about the time during which an NRA can make a late Section 871(d) election, as follows:
[An NRA] may, for the first taxable year for which the election under this section is to apply, make the initial election
at any time before the expiration of the period prescribed by Section 6511(a), or by Section 6511(c) if the period for assessment is extended by agreement, for filing a claim for credit or refund of the tax imposed by chapter 1 of the Code for such taxable year. This election may be made without the consent of the [IRS].
Making a late election thanks to Section 9100 relief.
If an NRA is unable to file a retroactive election to cover all affected years because the first Form 1040NR was filed after the general refund period contemplated by Section 6511(a), or if the NRA wants the explicit, advanced blessing of the IRS, another option remains: seeking a private letter ruling from the IRS National Office pursuant to Reg. 301.9100-3.
This is commonly known as getting “Section 9100 relief.”
Relief under Reg. 301.9100-3.
The IRS has discretion to grant reasonable extensions for filing certain elections. The regulations provide that extension requests “will be granted” by the IRS when the taxpayer provides sufficient evidence to establish that :
- The taxpayer acted reasonably and in good faith, and
- granting the extension will not prejudice the interests of the U.S. government. These two factors are examined below.
Acting reasonably and in good faith.
A taxpayer is generally deemed to have acted reasonably and in good faith if any one of the following is true:
- The taxpayer requests Section 9100 relief before the IRS discovers the failure to make the relevant election.
- The taxpayer failed to make the election because of intervening events beyond his control.
- The taxpayer failed to make the election because, after exercising reasonable diligence (taking into account the taxpayer’s experience and the complexity of the return or issue), he was unaware of the necessity for the election.
- The taxpayer reasonably relied on the written advice of the IRS.
- The taxpayer reasonably relied on a qualified tax professional, and the tax professional failed to make, or advise the taxpayer to make, the relevant election.
Not withstanding the general rules described above, a taxpayer will be deemed not to have acted reasonably and in good faith if any one of the following is true:
- The taxpayer seeks to alter a tax return position for which an accuracy-related penalty has been or could be imposed under Section 6662 at the time the taxpayer requests Section 9100 relief, and the new position requires or permits a regulatory election for which relief is requested.
- The taxpayer was informed in all material respects of the required election and related tax consequences, but chose not to file the election.
- The taxpayer uses hindsight in requesting Section 9100 relief. In other words, if specific facts have changed since the due date for making the election that make the election more advantageous to a taxpayer now, the IRS will not ordinarily grant relief. In such cases, the IRS will grant an extension request only when the taxpayer provides “strong proof ” that the tax-payer’s decision to seek relief did not involve hindsight.
No prejudice to government interests.
The regulations contain the two standards that the IRS uses in determining whether the interests of the U.S. government would be prejudiced by the granting of an extension request.
First, they provide that the interests of the U.S. government are prejudiced if granting the extension request would result in a taxpayer having a lower tax liability in the aggregate for all tax years affected by the election than the taxpayer would have had if the election had been timely made, taking into account the time value of money.
Second, the regulations indicate that the interests of the U.S. government are ordinarily prejudiced if the assessment period for the tax year in which the election should have been made, or the assessment period for any tax years that would have been affected by the election had it been timely made, are closed.
Solutions for NRAs who failed to file Forms 1040NR.
As indicated above, Section 874(a) generally deprives an NRA of the deductions related to U.S. rental property, unless he or she files a timely Form 1040NR.
The IRS can waive the duty to timely filing, though, if the NRA demonstrates to the satisfaction of the IRS that, based on all the facts and circumstances, he or she acted reasonably and in good faith in failing to file a Form 1040NR.
The IRS is supposed to consider the following factors in making this decision:
- whether the NRA voluntarily approaches the IRS before the IRS discovers the failure to file Form 1040NR;
- whether the NRA was aware of his or her ability to file a “protective” Form 1040NR;
- whether the NRA filed a Form 1040NR for earlier years;
- whether, after exercising reasonable diligence (taking into account the experience and sophistication level of the NRA), he or she was understandably unaware of the duty to file Form 1040NR;
- whether the failure to file Form 1040NR was due to intervening events beyond the control of the NRA; and
- whether other mitigating or exacerbating factors exist.
