Rental Property Owned by a Nonresident Alien: How U.S. Rental Income Is Taxed

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Yes, a nonresident alien who owns U.S. rental property can report that rental on Schedule E. The catch is that Schedule E attaches to Form 1040-NR, and it applies once the owner elects to treat the rental as effectively connected income. Until that election is made, the IRS taxes the full gross rent at a flat 30%.

This article explains both treatments, how to make the election, and the filing traps that cost foreign owners money every year.

The default rule: 30% of gross rent

By default, U.S. rental income of a nonresident alien is treated as fixed, determinable, annual or periodical (FDAP) income under IRC Section 871(a).

• Tax is 30% of gross rent, or a lower rate if a treaty allows it.
• The tax applies to the full gross rent, before mortgage interest, property tax, insurance, repairs, management fees or depreciation.
• The tenant or property manager is the withholding agent and must withhold 30% of each rent payment under Section 1441.
• The income is reported on Schedule NEC of Form 1040-NR.

For most rentals this is a bad result. A property with $24,000 of rent and $18,000 of expenses and depreciation owes $7,200 under the default rule, even though it produced only $6,000 of real profit.

The net-basis election puts the rental on Schedule E

IRC Section 871(d) lets a nonresident alien elect to treat U.S. real property income as effectively connected with a U.S. trade or business. A foreign corporation makes the same choice under Section 882(d) and files Form 1120-F.

Once the election is in place:

• The rental is reported on Schedule E attached to Form 1040-NR.
• Ordinary expenses are deductible, and the building is depreciated, generally over 27.5 years for residential property.
• Net income is taxed at the regular graduated rates rather than a flat 30%.
• A net loss can generally be carried forward under the passive activity rules.

Nonresident aliens are generally limited to itemized deductions in place of the standard deduction, so the example applies the first bracket directly to net rental income.

How to make the election

1. Get an ITIN. An owner who lacks a Social Security number applies for an Individual Taxpayer Identification Number on Form W-7, usually filed with the first return.
2. Stop the 30% withholding. Give the tenant or property manager Form W-8ECI, stating that the rent is effectively connected income. The agent can then pay the full rent.
3. Attach an election statement to the Form 1040-NR for the first year. Under Treasury Regulation 1.871-10, it should state that the election is being made and list:
   • every U.S. real property interest the owner holds, with its location and the extent of ownership
   • any substantial improvements
   • any earlier elections or revocations
   • the sources and types of income from the property
4. Report the rental on Schedule E and carry the net amount to the effectively connected income section of Form 1040-NR.

The election covers all of the owner’s U.S. real property income, every property at once. It stays in effect for every later year until revoked, and revocation generally requires IRS consent.

Traps that cost foreign owners money

• Late filing can erase the deductions. Under Treasury Regulation 1.874-1, a nonresident alien who files Form 1040-NR more than 16 months after its due date can lose all deductions. The owner is then taxed on gross rent even with the election in place. Form 1040-NR is due April 15 when there are U.S. wages subject to withholding, and June 15 in every other case.
• Some rentals are business income even before an election. Short-term rentals with hotel-type services, or several properties actively managed by the owner, can rise to a U.S. trade or business on their own. That income is effectively connected either way.
• A single-member LLC keeps the owner on Form 1040-NR. A foreign-owned single-member LLC is disregarded, so the owner still files Form 1040-NR. The LLC also generally files a pro forma Form 1120 with Form 5472 each year, and the penalty for missing it starts at $25,000.
• Most treaties keep U.S. rent taxable in the U.S. Under most U.S. treaties, the United States keeps the right to tax income from U.S. real property. A treaty-based position that does reduce tax is disclosed on Form 8833.
• The sale is taxed too. Under FIRPTA, the buyer generally withholds 15% of the gross sale price when a foreign person sells U.S. real property. The owner files Form 1040-NR to report the actual gain and claim back any excess.
• State returns still apply. A property in Illinois, for example, creates an Illinois filing on Form IL-1040 with Schedule NR, even for an owner who lives abroad.

When a C corporation saves money over time

For the right owner, holding U.S. rental property through a corporation can save far more than it costs. The biggest savings usually come from estate tax, reinvested profits and a planned exit. The structure has to be chosen with care, though, and it works best when it is set up before the property is bought.

Where the savings come from

• U.S. estate tax protection. A nonresident alien who owns U.S. real estate directly faces U.S. estate tax of up to 40%, with an exemption of only $60,000. Shares of a U.S. corporation are still U.S. property for estate tax purposes. The protection comes from a foreign holding company that owns the U.S. corporation or the property.
• A 21% flat federal rate on reinvested profit. Rent kept in the company to pay down debt or buy more property is taxed at 21%, compared with individual rates up to 37%.
• Net-income taxation in place of the 30%-of-gross rule. A U.S. corporation is taxed on net income automatically. The owner sidesteps the Section 871(d) election and the 16-month filing rule, and often skips the personal U.S. return altogether.
• A cleaner exit. Under the cleansing rule in Section 897(c)(1)(B), the corporation can sell the property, pay corporate tax on the gain, and then liquidate. The liquidating distribution to the foreign owner is then generally outside FIRPTA and U.S. tax. This also avoids the 25% rate individuals pay on depreciation recapture.

Example: estate tax on a $700,000 rental

The figures assume the property is owned free and clear, with treaty relief left out. A treaty with the owner’s home country can change the result.

What a corporation costs

• Dividends are taxed twice. Profit paid out to a foreign shareholder faces 30% withholding, or 5% to 15% under many treaties.
• State tax can be higher. In Illinois, corporate income tax plus replacement tax is 9.5%, compared with 4.95% for individuals.
• Gains are taxed at the corporate rate. Gain inside the corporation is taxed at 21%, while the lower long-term capital gains rates stay with individual owners.
• More filings. Form 1120, Form 5472 for 25% or greater foreign ownership, a state corporate return and records of any loans from the owner.

Who benefits most: owners with estate tax exposure, owners who reinvest rental profit, and owners who plan to sell as a single transaction. An owner of one property who takes every dollar of rent out each year is often better off holding it personally or through an LLC.

Timing matters. Moving a property into a corporation after purchase can trigger tax and transfer costs. The best time to decide the structure is before closing, which is why we ask foreign buyers to talk with us before they sign.

Why QuickBooks bookkeeping protects your deductions

The net-basis election only saves tax if every deduction can be proven. For a foreign owner, clean books are what separate a tax on real profit from a 30% tax on every dollar of rent.

• Deductions need records. Interest, property tax, insurance, repairs and management fees are deductible when they are documented and tied to the property.
• Depreciation needs a basis history. The purchase price, closing costs, land allocation and every improvement feed the depreciation schedule now and the gain calculation at sale.
• Deadlines are firm. Books that are current at year end make it realistic to file Form 1040-NR on time and protect the deductions under the 16-month rule.
• Form 5472 needs a transaction trail. A foreign-owned LLC must report its dealings with its owner, including money put in and taken out. That report stays accurate when those transfers are recorded as they happen.
• A FIRPTA refund depends on proof. When the property sells, the owner recovers excess withholding by showing the adjusted basis and the real gain.
• Exams go faster. A clean QuickBooks Online file with separate bank accounts answers most IRS questions before they become adjustments.

How Ozfield helps foreign owners

Ozfield Insurance & Tax Services works with owners and founders abroad who hold U.S. property or run U.S. businesses. Our office handles the full picture:

• Ownership structure planning before you buy, comparing personal ownership, an LLC, a U.S. C corporation and a foreign holding company on estate tax, annual tax and exit tax
• Company formation and setup, including the EIN, registered agent and bank-ready records
• QuickBooks Online setup and ongoing bookkeeping, with a chart of accounts built for rental property and mapped to the tax return
• Form 1040-NR and Schedule E preparation, including the Section 871(d) election statement
• Form W-8ECI so tenants and property managers stop the 30% withholding
• Foreign-owned LLC compliance, including the pro forma Form 1120 and Form 5472
• Corporate returns, including Form 1120, Form 5472 and Illinois corporate and replacement tax returns
• State filings, such as Illinois nonresident returns
• Planning for a sale, including FIRPTA withholding, the cleansing rule and the gain calculation
• Landlord and property insurance through our insurance agency

As a CPA, I handle the problems when they come up, whether that is an IRS notice, a withholding mistake by a tenant or a late filing from a prior year.

Frequently asked questions

Can a nonresident alien file Schedule E? Yes, attached to Form 1040-NR, once the net-basis election is made or the rental is otherwise a U.S. trade or business.

Is the election made every year? It is made once and carries forward to all later years until revoked.

What if the tenant already withheld 30%? The withholding is credited on Form 1040-NR. With the election in place, the excess over the actual tax is refunded.

Does owning through an LLC avoid Form 1040-NR? A single-member LLC is disregarded, so the owner files Form 1040-NR, and the LLC adds its own Form 5472.

What happens if prior years are still unfiled? Late returns can still be filed, but deductions may be at risk under the 16-month rule. The sooner the returns are filed, the more options remain.

Should I buy U.S. rental property through a C corporation? It depends on your estate tax exposure, whether you will reinvest the rent and how you plan to sell. For many foreign buyers a foreign holding company over a U.S. corporation saves the most over time, and the decision is best made before closing.

Can I switch to a corporation later? Yes, but moving an existing property can trigger tax, transfer costs and lender approval. Planning the structure first is almost always cheaper.

If you own U.S. rental property from abroad, or plan to, talk with us at Ozfield Insurance & Tax Services. We will compare ownership structures before you buy, set up your company and your books, and keep every filing on time so your rental is taxed on real profit. Call 773-536-9272, email tax@ozfield.com, or book a time at https://www.ozfield.com/contact-our-offices/.

Let’s get this filed.