THE INTERNATIONAL TAX ADVISOR

by:  Douglas J. Kingston, CPA/MBA  • Mailing Address: 16443 N 59th Place; Scottsdale, AZ 85254

• Telephone: +1 (602) 595-5885 (GMT-7) • E-Mail: doug@iTaxCPA.com • URL: http://www.iTaxCPA.com/

NET BASIS ELECTION FOR FOREIGN INVESTORS IN U.S. REAL ESTATE

 

Background

 

 

Example of Net Basis Election Results

 

 

Election Deadline

 

 

Procedures for Making the Election

 

 

Effect of Making the Election

 

 

Sample Picture

 

It is important for foreign investors in U.S. real estate to make the net basis before the deadline.

 

Background

 

All foreign individual or corporate investors in U.S. income-generating real property should file timely U.S. income tax returns.  Passive foreign investors should also first consider whether or not it is advantageous to elect to be taxed on a “net basis” (with deductions and using graduated tax rates).  If no return is filed (or if no net basis election is made), foreign investors risk owing tax computed on a “gross basis” (with no deductions).

 

In two recent court cases it was made painfully clear that if a foreigner invests in U.S. real property, timely annual tax returns must be filed or expenses that would otherwise be deductible can be lost forever.  See Guillermo Baez Espinosa v. Commissioner 107 T.C. No. 9 and Jesus A. Florez v. Commissioner T.C. Memo 1995-358.

 

Example of Net Basis Election Results

 

A simple example illustrates the potential severity of not filing on time.  Assume a passive foreign investor owns a U.S. rental property costing $150,000 which generates $15,000 of gross rental income before expenses of $13,000 for interest, property tax, insurance, repairs and management fees for the year.  If the investor timely files a U.S. tax return electing to be taxed on a net basis, his or her U.S. tax would be zero.  However, if no return is filed, the investor’s tax liability would be $4,500 (30% statutory tax rate for nonresidents times $15,000 gross rental income without benefit of deduction for actual expenses).

 

Election Deadline

 

Two separate rules determine the deadline for making an effective net basis election.  The election must be made before expiration of the statute of limitations on refunds (this period ends 3 years from the time the return for the year was filed, or 2 years from the time the tax was paid, whichever is later).  In order to be entitled to the benefit of any otherwise allowable deductions, a foreign individual investor must file a true and accurate tax return within 16 months of the

 

Election Deadline (continued)

 

return’s ordinary due date.  For a foreign corporate investor, the return must be filed within 18 months of its ordinary due date.  However, the 16 or 18 month period is not absolute.  If a required tax return was not filed for the immediately prior year, the 16 or 18 month period ends on the date the IRS mails a notice advising that the return has not been filed and that no deductions may be claimed by the taxpayer.

 

Procedures for Making the Election

 

IRS regulations provide that the net basis election may be made for a taxable year by filing, with the income tax return for the year, a statement that the election is being made.  The statement must include (a) a complete schedule of all U.S. real property owned, (b) an indication of the extent to which the taxpayer has direct or beneficial ownership in each item of real property, (c) the location of the real property, (d) a description of any substantial improvements on each property, and (e) an identification of any taxable year or years in respect of which a revocation or new election has previously occurred.  For property held through a partnership, the election is separately made, or not made, by each foreign partner.

 

Effect of Making the Election

 

The election applies to all items of U.S. real property owned by the taxpayer (it may not be applied selectively to some, but not all, properties).  The Regulations take the position that the election cannot be made for a year the taxpayer derives no income from U.S. real property.  Following this line of reasoning, the IRS has ruled that interest and real estate taxes paid by a foreign individual investor with respect to undeveloped non-income producing U.S. land cannot be expensed or capitalized and are therefore lost.  Foreign investors in this situation should aggressively seek to generate at least some income from such properties in order to avoid this harsh result.  Once the election is properly made, it remains in effect for each subsequent year unless properly revoked.  It should be noted that some older U.S. tax treaties may provide a more flexible net basis election.

 

Douglas J. Kingston is an Arizona certified public accountant (CPA) specializing in international tax planning and compliance for U.S., Canadian, European, Latin American and Asian business and individual clients and may be reached by:

Telephone: (224) 595-5885E-Mail: doug@iTaxCPA.com • URL: http://www.iTaxCPA.com/