Tak: I personally believe that an LLC would be a good entity for a foreign investor to purchase and own real property while engaging in a trade or business in the U.S. You should however be clear on the IRS Guidelines for the taxation of real estate for a foreign owner. A portion of these guidelines follow. However, it will be very important that your client discuss this with the proper accounting specialists and legal specialists in your respective state.
"U.S. real estate professionals and rental agents/property managers are encountering an increasing number of situations that involve foreign persons' acquiring U.S. real estate as a part-time residence, for investment or in some cases to conduct a U.S. business. The U.S. tax rules that apply to ownership and dispositions of U.S. real estate by foreign persons are different in some important respects from the rules that apply to U.S. persons.
“U.S. real estate professionals must know how to properly deal with foreign investors in U.S. real estate in order to be in compliance with the federal tax laws affecting real estate transactions. They must be familiar with the rules that determine whether an individual or entity is to be treated as a U.S. person or a foreign person. In addition, they must also be familiar with the fundamentals of U.S. federal income taxation of foreign investors with U.S. rental income. Under U.S. tax law, a taxpayer can depreciate the property. There are different depreciation rates for residential and commercial properties. This annual depreciation is deducted from income as an expense on an income tax return. However, it may be recaptured if the property is sold.
Foreign Property Owner’s Tax Return Responsibility During Ownership and Rental of Real Property Interest
“Before agreeing to manage U.S. real property for a foreign taxpayer, a real estate professional or rental agent should discuss with 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 U.S. trade or business,” without withholding (although the owner may have to file estimated tax returns). Rental income from real property located in the United States and the gain from its sale will always be U.S. source income subject to tax in the United States regardless of the foreign investor's personal tax status and regardless of whether the United States has an income treaty with the foreign investor's home country.
The method by which rental income will be taxed depends on whether or not the foreign person who owns the property is considered ‘engaged in a U.S. trade or business.’ Ownership of real property is not considered a U.S. trade or business if it consists of merely passive activity such as a net lease in which the lessee pays rent, as well as all taxes, operating expenses, repairs, and interest in principal on existing mortgages and insurance in connection with the property. Such passive rental income is subject to a flat 30 percent withholding tax (unless reduced by an applicable income tax treaty) applied to the gross income rather than the "net rent" received. Thus, the real estate taxes, operating expenses, ground rent, repairs, interest and principal on any existing mortgages, and insurance premiums paid by the lessee on behalf of the foreign owner-lessor, must be included in gross income subject to the 30 percent withholding tax. The gross income and withheld taxes must be reported on Form 1042-S, Foreign Persons U.S. Source Income Subject to Withholding (PDF) to the IRS and the payee by March 15 of the following calendar year. The payor must also submit Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons (PDF), by March 15. ”If, on the other hand, the foreign investor is engaged in a U.S. trade or business such as the developing, managing and operating a major shopping center, the rental income will not be subject to withholding and will be taxed at ordinary progressive rates. Expenses such as mortgage interest, real property taxes, maintenance, repairs and depreciation (accelerated cost recovery) may then be deducted in determining net taxable income. The nonresident must make estimated tax payments for the tax due on the net rental income, if any. The only way these expenses can be deducted, however, is if an income tax return Form 1040NR for nonresident alien individuals and Form 1120-F for foreign corporations is timely filed by the foreign investor.
Foreign individuals and foreign corporations may elect to have their passive rental income taxed as if it were effectively connected with the U.S. trade or business. Once such an election is made by attaching a declaration to a timely filed income tax return, there is no obligation to withhold even in a net-lease situation". Good Luck Tak....Rob Baird, CA RE License #544165 (One of the oldest, active licenses in CA) 951 515-5855
Jan 11, 2011