Hallmark Property Management

Orange County Property Management Company in California


Call Today 714-841-4500
Loading

Foreign Investor Property Owner Withholding

Property managers, acting as withholding agents, for a foreign investor may be required to withhold 30% of gross rental receipts for passive rental income. However, the IRS allows the foreign investor the choice of electing to forego withholding on passive rental income, and instead be taxed on a net income basis (although the owner may have to file estimated tax returns).  Failure to withhold when required may make the property manager personally and primarily liable for any tax that must be withheld. The liability of the property manager includes amounts that should have been paid plus interest, penalties, and where applicable, criminal sanctions.  Even if the foreign investor elects to forego the 30% federal withholding, he or she may still be subject to the California Franchise Tax Board 7% withholding. 

 

Who is a Foreign Investor?

 

In this article we use the term “foreign investor” in place of the legally accurate term “foreign person” used by the IRS. According to the IRS, the term “foreign person” means:

 

A nonresident alien individual;

A corporation created or organized in a foreign country or under the laws of a foreign country;

A partnership created or organized in a foreign country or under the laws of a foreign country;

A foreign trust;

A foreign estate; or

Any other person that is not a U.S. person.


What is passive rental activity?

 

Ownership of real property is considered passive when the foreign investor who owns the property is not “engaged in a US trade or business.” Ownership of real property is not considered a US trade or business if it consists of merely collecting rents. If the foreign investor hires a property manager then that will likely be passive rental activity.

 

However, if the foreign investor manages the property him or herself then that will likely be active rental activity, and thus, he or she will be considered engaged in a US trade or business. (Di Portanova v. U.S., Ct.Cl.1982, 690 F.2d 169, 231 Ct.Cl. 623) In general, you are usually considered to be engaged in a US trade or business when you perform personal services in the United States. For a more complete explanation of when a foreign investor may be considered engaged in a US trade or business, see the  IRS’s article “Effectively Connected Income (ECI)”.

 

What is “effectively connected income”?

 

When a foreign investor is engaged in a US trade of business the income generated from that business is called “effectively connected income.”  As stated in the previous question, you are usually considered to be engaged in a US trade or business when you perform personal services in the United States. In that case your income is effectively connected to US trade or business. The significance of this is that no withholding is required when income is effectively connected.

 

Who is the withholding agent?

 

The law uses the phrase “withholding agent” and defines it as any person, US or foreign, that has control receipt or custody of an amount subject to withholding or who can disburse or make payments of an amount subject to withholding. For our purposes, this withholding agent is almost always the property manager. So when we say that the property manager may be required to withhold, we technically mean the withholding agent.

 

Is the property manager always required to withhold income for foreign owned passive rental activity?

 

No. The foreign investor may elect to forego withholding from income generated by passive rental of real property. In opting out of withholding, the foreign investor is electing to have passive rental income treated as effectively connected income. (See questions two and three.)  In this way, no withholding will be required (although the owner may have to file estimated tax returns). (26 U.S.C  Sec. 871(d)(1)(B); 26 C.F.R. Sec. 1.871-10).

 

How can the foreign investor elect to have passive rental income treated as effectively connected income and thus avoid the withholding requirement?

 

The foreign investor must do three things: One, the foreign investor must inform the property manager that the rental income is to be treated as “effectively connected income” by submitting to the property manager a fully completed IRS form W-8ECI, Certificate of Foreign Person’s Claim for Exemption From Withholding on Income Effectively Connected With the Conduct of a Trade of Business in the United States. Two, before completing Form W-8ECI, the foreign investor must obtain a tax ID number from the IRS to properly complete the W-8ECI (and this will also allow the foreign investor to file estimated tax returns if necessary).  And three, an election must be formally made to the IRS by attaching a declaration to a timely filed income tax return (26 C.F.R. sec. 1.871-10(d)(1)(ii)). Effectively Connected Income (ECI)

 

Who is Form W-8ECI given to?

 

A fully completed form is given to the property manager. It is not submitted to the IRS. 

 

Is a tax ID number required to properly fill out form W-8ECI?

 

Yes. A fully completed Form W-8ECI must include a valid US tax identification number for the foreign investor. In other words the rental agent must withhold and remit the 30 percent tax to the IRS until this requirement is satisfied (26 C.F.R. Sec. 1.1441-4(a)(2)(i)).

 

How is the declaration made?

 

The declaration is to be included with the timely filed tax return (Form 1040NR (or 1040NR-EZ if eligible)  or Form 1120-F for foreign corporations) and shall include the following: (1) That you are making the choice and whether the choice is under IRS 871(d) or a tax treaty (2) a complete schedule of all real property, or any interest in real property, of which the tax payer is the title holder or beneficial owner of any interest in real property in the US (3) the extent to which the tax payer has direct or beneficial ownership in each item of real property (4) the location of the real property (5) a description of major improvements in the real property (5) the income from property and (6) details of any previous choices and revocations of the real property choices. (26 C.F.R. sec. 1.871-10(d)(1)(ii)).

 

What happens if the foreign investor elects to have income treated as effectively connected, but then fails to submit a timely filed income tax return?

 

If the foreign individual fails to submit a timely filed income tax return then he or she loses the ability to claim deductions against the rental income causing the gross rents to be subject to the 30 percent tax.  The IRS states that, “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.”

 

Even if the foreign investor has elected to have rental income treated as effectively connected, will he or she still have to make estimated tax payments?

 

Yes. The foreign investor must make estimated tax payments for the tax due on the net rental income, if any.  In determining net taxable income, expenses such as mortgage interest, real property taxes, maintenance, repairs and depreciation (accelerated cost recovery) may then be included in the calculation. But to formally deduct such expenses, an income tax return (on Form 1040NR, 1040NR-EZ if eligible or Form 1120-F for foreign corporations) must be timely filed.

 

What if the foreign investor doesn't elect to have the income treated as effectively connected?

 

In that case the gross rental income will be subject to the 30 percent withholding (unless reduced by a tax treaty, see http://www.irs.gov/Individuals/International-Taxpayers/Tax-Treaties). Gross income would include real estate taxes, operating expenses, repairs and interest and principal on any existing mortgages if paid by the lessee on behalf  of the foreign investor-lessor (such as might be the case in a net lease). The withholding agent (i.e., the property manager receiving the rents) must report the gross income and withheld taxes on Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding to the IRS and the payee (owner) by March 15 of the following year. The withholding agent (property manager) must also submit form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons to the IRS also by March 15.

 

If the foreign investor doesn't elect to have the income treated as effectively connected, must the property manager still get permission in writing from the owner before withholding?

 

Yes. The permission to withhold from the owner must be in writing. Withholding without such permission will be a BRE violation as well as a breach of fiduciary duty.

 

How should the foreign investor decide to either forego withholding and pay taxes by filing US returns, or just allow the property manager to make the deductions from gross income?

 

Before agreeing to manage US real property for a foreign investor, a property manager should ask the foreign client whether the rental income will be taxed as investment income through withholding, or on a net income basis as effectively connected with a US trade of business without withholding (although the owner may have to file estimated tax returns). The investor’s decision to do either is a decision that must be made through consultation with a tax professional. Important considerations include whether the person is treated as a US person or foreign person; whether there are any applicable tax treaties; whether the property can be depreciated and by how much including the consideration of recapture upon sale; and the fundamentals of US federal income taxation of foreign investors with US rental income. (See IRS Publication 519 “U.S Tax Guide for Aliens” and “Taxation of Nonresident Aliens”.

 

But what if the foreign investor doesn't elect to forego withholding and at the same time refuses to allow the property manager to withhold?

 

Then the property manager is in a very difficult position. You must have permission in writing from the owner before withholding taxes. The permission should be stated in the property management agreement. Withholding taxes without permission from the owner will likely be treated by the California Bureau of Real Estate as both a breach of fiduciary duty and a violation of the Business and Professions code -- even if the IRS requires withholding.

 

Therefore, if you can’t get permission to withhold, and the owner has failed to properly make the election by, for example, failing to provide you with form W-8ECI, then you have a stark choice. You can withhold 30% of gross income and risk BRE disciplinary action and a claim of breach of fiduciary duty by the owner. Or you can refuse to withhold, and risk financial and criminal sanctions from the IRS. Or you could withdraw as property manager altogether, which saves you from trouble with the law, but you are no longer managing property and probably won’t get paid. 

 

If the foreign investor properly elects to forego withholding, is the property manager still responsible for withholding 7% under California law?

 

Yes. Federal withholding and the state withholding are two separate laws so both must be complied with. But there are several ways to avoid California withholding as well. Please see our Q&A on California withholding for out of state owners (“Nonresident Property Owner Withholding”).

 

Courtesy of CALIFORNIA ASSOCIATION OF REALTORS®

 

The information contained herein is believed accurate as of January 13, 2012. It is intended to provide general answers to general questions and is not intended as a substitute for individual legal advice. Advice in specific situations may differ depending upon a wide variety of factors. Therefore, readers with specific legal questions should seek the advice of an attorney. Written by Robert Bloom, Esq.


Tags: Property Management Withholding, Foreign Owner Property Management, House Property Management, Property Management Homes, Property Management Services, Professional Property Management, Rental Property Management, Property Management Firms, Property Management Experts, Residential Property Management Huntington Beach, Condo Property Management, Investment Property Management, Withholding Agent Property Management, Property Management Listings, Condominium Property Management, Leasing Property Management, Foreign Investor Property Management.