IRS New Compliance Campaign Targeting Nonresident Aliens with Real Property Located in the U.S.
IRS Sets Its Sights on Nonresident Aliens With U.S. Rental Property
A non-resident alien is someone who is not a US Citizen, does not hold a Green Card and has not spent enough time in the US to meet the substantial presence test. A report by TIGTA (Treasury Inspector for Tax Administration) revealed a significant number of NRAs were claiming net income treatment on Forms 1040NR, despite the fact that they never made a proper Section 871(d) election.
Second, TIGTA learned that some NRAs are double dipping in order to acquire two improper benefits.
- The initial benefit is deducting rental expenses and paying tax on the remaining net income, often less than the standard 30% withholding rates on gross income.
- The additional benefit comes when the property is later sold. At the time of selling the property, they conveniently forget to reduce their basis in the property by the amount of the depreciation expenses deducted over the years, thereby diminishing the total gain.
In short, some NRAs recognize the Section 871(d) election (even if they did not properly claim it) for purposes of reducing annual taxes on rental income, and then fail to acknowledge such election when it comes time to sell.
Following the results of the report, the IRS started a new Compliance Campaign. The goal of the campaign is to identify noncompliance in reporting of income from rental property located in the U.S. by nonresident aliens.
NRA income from property, general rule
Income from real property located in the United States and owned by a nonresident alien is considered not effectively connected with U.S. trade or business. As such, gross rental income is taxed at a 30% rate.
If you are a nonresident alien with ownership or interest in real property located in the United held for the production of income, you can elect to treat all income from that property as income effectively connected with a trade or business in the United States.
- If you make the election, you can claim deductions attributable to the real property income and pay tax on the net income at the lower graduated rates. If you did not make the election, you cannot claim deductions and must pay tax on gross income.
- This election stays in effect for all later tax years unless you revoke it.
- The purpose of the election is to notify the IRS that at the time when the property is sold the nonresident alien owner will reduce their basis in the property by the amount of the depreciation expenses they took in the past.
Making the election
As provided in Treasury Regulation 1.871-10(d)(1), an NRA utilizes the initial election by attaching a statement to their return, or amended return, for the year of the election.
There is no statute of limitations on making the election. It can be made retroactively on the amended return for the first year of rental activity, with the attachment of a reasonable cause statement.
Solution for NRAs who filed Forms 1040NR but did not make the election
NRAs claiming net income treatment on their annual Forms 1040NR without making a Section 871(d) election can make a late election on amended Form 1040NR to retroactively make the Section 871(d) election. No advanced permission from the IRS is required to make such an election.
What happens if the IRS identified the NRA as noncompliant in reporting income from rental property without proper election.
The IRS will recalculate prior year returns. It will disallow all rental expenses previously taken as deductions, which will make the entire gross income taxable. Further, the gross rental income will be taxed at 30%.
In addition to penalties and interest for late payment of tax for each audited year, the IRS will assess a 20% accuracy-related penalty on underpayments, additionally augmented by the interest accumulated overtime.