Originally posted on February 16, 2023
Taxes Associated With Rental Properties - What Owners Need to Know
Owning U.S. real estate in your personal name or the name of an entity such as a corporation, partnership, or trust can result in U.S. federal and, in some cases, state income tax. Whether you already own a rental property or are thinking about investing in the real estate market, it’s essential to understand how U.S. taxes work. Since many foreign investors are also interested in buying rental properties, particularly in South Florida, it is important to understand how some of these tax rules differ for non-US citizens and foreign entities investing in U.S. real estate.
Generally speaking, owners of rental investment property need to be aware of and comply with two distinct kinds of income taxes — those that relate to income generated by their rental properties and those that relate to the eventual sale of that property. We will also touch on the Florida Sales Tax that is paid to the State of Florida when you rent a residential property on a short-term rental or rent a commercial property. It is important to note that real estate tax assessed annually by the county the property is located in is separate from the income tax a person may owe based on the income generated from the property. Real estate taxes are assessed at the same rates for both foreigners and U.S. persons; however, if a person uses the home as their principal residence, they may be able to claim a deduction known as the homestead exemption.
When a U.S. person or U.S. entity rents their property, the income is reported on their U.S. income tax return. However, when a non-US person or foreign entity receives rental income, the IRS defaults to a flat 30% tax on the gross rental income. If the tax is properly withheld and reported to the IRS, then an income tax return is not required, and you have met your U.S. tax obligations. As the 30% tax on the gross rental income can be excessive, an election may be made to file a U.S. income tax return and pay tax on the net income. Once this election is made, it will apply to all real property and will remain in effect for all subsequent tax years unless revoked within three years of filing the election or with the consent of the IRS Commissioner.
When an election is made to file an income tax return, you may be able to lower your tax burden by claiming certain deductions for operating the activity as a business. The net rental income (total income less expenses) is taxed as “ordinary income,” which means it is taxed at the appropriate graduated tax rates for individuals or a flat 21% federal tax for corporations (not taking into consideration any state income taxes).
- You can deduct expenses related to owning, maintaining, and operating an income property, including but not limited to mortgage interest, property insurance, association dues, real estate taxes, and utilities if the utilities are not paid by your tenant.
- Depreciation, also known as Capital Cost Allowance in some countries, is mandatory in the United States. This allows you to expense a portion of the cost of the real estate each year. For example, you can take an annual depreciation deduction at a rate of 3.636% for 27.5 years on residential rental property, not taking into account the initial and final year of deprecation. Commercial real estate also has an annual deduction but over a period of 39 years. Certain assets placed in service with a life expectancy of more than one year will need to be depreciated as opposed to expensed out, but may qualify for bonus depreciation and/or other tax strategies to accelerate depreciation and deductions.
- Cost segregation may be an option for you as well; depending on the cost of the property and your intentions, a portion of the purchase price may qualify for bonus depreciation.
What Qualifies as Rental Income?
According to the IRS, rental income is “any payment received for the use or occupation of the property.” In addition to regular rent payments, rental income may also include the following:
- Security deposits – If you return all of your tenant’s security deposit when they leave at the end of their lease, it will not count as rental income. However, if you keep some or all of the deposit to cover wear and tear or damage to your rental property, the amount you retain is considered rental income in the year you are no longer obligated to return it to the tenant. In addition, non-refundable security deposits, such as for pets, are considered rental income in the year received.
- Lease cancellation payments – If a tenant pays you to “break” a lease, the amount that you receive in compensation is considered rent and counts as income.
- Tenant-paid owner expenses – If a tenant pays any of your expenses to operate or maintain the property and deducts the amount from their rent payment or in lieu of rent, then the amount paid by the tenant counts as rental income. Some examples of this are real estate property taxes assessed by the county, insurance, and condo or homeowner association dues.
- Property or services received instead of rent – If your tenant does any work to maintain or improve the property in exchange for rent, for example, if he is a contractor by trade and offers to redo your kitchen counters and cabinets in exchange for two month’s rent, the fair market value of the service counts as rental income, even if the value is greater than the two months of rent you would have received.
- Lease with an option to buy. If you have entered into an “option to buy” agreement with your renter, the payments that you receive may either be considered rental income or installment sale income, depending on the specific facts and circumstances.
- Partial interest. If you own only a part of a rental property, you must report your share of the rental income. A common misconception is that a jointly owned property only needs to be reported on one of the owner’s returns, when in fact, each owner of the property is required to report their share of the rental income based on their interest in the property. Gifting your rental income to another person does not remove your obligation to report the income to the IRS.
Sales Taxes for Short Term or “Transient” Rentals and Commercial Properties
Owners or prospective owners of residential rental properties in Florida also need to be aware that you are required to collect the State’s 6% sales tax on what it considers to be short-term or transient rentals. Per the state statute, “Florida’s 6% state sales tax, plus any applicable discretionary sales surtax, applies to rental charges or room rates paid for the right to use or occupy living quarters or sleeping or housekeeping accommodations for rental periods six months or less, often called “transient rental accommodations” or “transient rentals.” Therefore, if you lease the residential property for six months and one day, you will not be required to collect and remit Florida sales tax. However, this only applies to residential properties — rental of commercial real estate must always collect and remit the applicable sales tax, regardless of the term of the lease.
Taxes Imposed on the Sale of Rental Property.
When you sell U.S. real estate, the U.S. has the right to tax the sale of the property. This will apply whether your U.S. real estate was used as a rental property or vacation home. For individuals, the sale of real estate held less than one year would be taxed at ordinary tax rates, whereas if the property was held longer than one year, it would get the preferential capital gains tax rate, which is a maximum of 20% for individuals, not taking into account net investment income tax which may apply to U.S. persons. For corporations, the federal tax rate is a flat 21% on the gain. However, if depreciation was claimed on the assets sold, then it must be recaptured. Recapture of depreciation will be subject to tax at a maximum rate of 25% of the depreciation subject to recapture for individuals. Corporations are also subject to depreciation recapture on a portion of the depreciation claimed, but you generally won’t see an effect on the tax due to the federal return has a flat tax rate of 21%. As mentioned above, depreciation is mandatory, and you cannot avoid the depreciation recapture by not claiming it on your annual returns. When you sell the property, if the property was subject to depreciation, then you must recapture what was required, whether you took a deduction for it or not.
FIRPTA stands for Foreign Investment in Real Property Tax Act. This is a tax that applies to non-US persons or non-US entities at the time they sell their U.S. real estate. This is only a prepayment of tax, and a credit will be provided for the tax remitted when the income tax return is filed. The FIRPTA remittance is not your final tax obligation, and, in many instances, you will get a portion, if not all, of it back when a U.S. tax return is filed. Whether you get any FIRPTA withholding back or owe additional tax with the filing of your U.S. tax return reporting the sale will depend on the overall net taxable income.
U.S. Estate Tax
An often-overlooked area of tax for foreign investors of U.S. real estate is the U.S. Estate tax.
For a U.S. citizen or a person domiciled in the U.S. at death, the person will get an Estate tax exemption of $12.92 million ($25.84 million per married couple) for the 2023 tax year. A U.S. citizen or U.S. domiciliary will be subject to U.S. Estate tax on their worldwide assets. However, for a non-US person, the exemption is only U.S. $60,000, but they will only be subject to U.S. Estate tax on the U.S. situs assets. U.S. situs assets include but are not limited to tangible assets located in the United States, such as real estate, furniture, boats, cars, collectibles, and so forth. It will also include shares of a U.S. corporation held directly or through a U.S. or foreign grantor trust, certain debt obligations, some partnerships, and trusts in certain situations.
At the time of passing, assets will be assessed at their fair market value to determine if they have exceeded the threshold and if an Estate tax return is required. If an Estate tax return is required, then the value of the assets less the unified credit will be taxed at rates up to 40%. As a U.S. person, they are entitled to a marital deduction if they are married to a U.S. citizen allowing the assets to defer taxation until their spouse passes away. If the spouse is not a U.S. citizen, then a Qualified Domestic Trust (QDOT) may be set up to allow the deferral of tax.
A non-US person is not able to claim the marital deduction under the Internal Revenue Code (IRC); however, they are able to set up a QDOT for their spouse as long as the trustee is a U.S. citizen or U.S. corporation. In addition, we have Estate tax treaties with 14 countries, and the Canada income tax treaty covers U.S. Estate tax under Article XXIX B.
If you are not able to take advantage of the QDOT or an Estate tax treaty, then planning should be done to ensure you minimize U.S. Estate tax. This may be accomplished by purchasing a life insurance policy to cover the U.S. Estate tax or holding the property in a foreign corporation, also known as a “blocker corporation.”
A common misconception when it comes to non-US persons owning U.S. real estate is that only fifty percent of the value of the property will be included in their estate if the property is jointly owned or that they don’t need to file an Estate tax return as the property was jointly owned or held through a Revocable Trust. None of these assumptions are correct. Owning property jointly with another person or through a revocable trust will only avoid probate, which is the process of going to court to determine who is entitled to inherit the property. In addition, when a non-US person jointly owns property with other persons, the full value of the property will be included in the first person to dies estate unless they can prove contribution. This is different from where a U.S. citizen and their U.S. spouse jointly own the property, as in that situation, only fifty percent of the value will be included in their estate.
For the most part, there is no difference between taxes on rental income for a U.S. citizen and a foreign property owner. However, one important difference for foreigners investing in the USA has to do with U.S. Estate Taxes.
Generally speaking, U.S. tax law allows for the taxation of property that transfers from the estate of a deceased U.S. citizen or resident. This Estate Tax applies to all property owned by the deceased, including rental or income property.
For nonresident, non-US citizens (nonresident aliens), the estate and gift tax apply to property that exists within the U.S. that physically exists within the U.S., known as “U.S. situs assets” under tax law.
One important difference between foreign individuals and U.S. citizens is the exemption of the Estate Tax. Generally speaking, foreigners have an exemption of $60,000 (sixty thousand dollars), while U.S. Citizens’ exemption is currently at $12.92 million ($25.84 million per married couple). When foreigners own a U.S. situs asset under their personal names, they are exposed to hefty taxes at time of death. The U.S. asset will be valued at fair market price at the date of death, the tax will be calculated based on rates that could go up to 40%, and exemptions are applied.
Some of the available strategies to mitigate the Estate Tax for foreign nationals include having life insurance or setting up a corporate structure that would shield the foreign individual.
How AbitOs Can Help
At AbitOs, as specialists in international taxation, we are quite familiar with all of the laws, regulations, and nuances regarding real estate taxes and rental properties for both domestic and foreign owners.
With the competent advice of knowledgeable International Tax experts like ours, we can help make sure that your income properties are in complete compliance with all U.S. income and real estate tax laws while minimizing your taxes.
AbitOs specializes in the unique accounting needs of high net-worth individuals with international lifestyles, LATAM, Canadian, and other non-US entities doing business in the U.S., as well as U.S. entities doing business in those countries and across the globe. Understanding the tax implications of owning and operating rental properties can be quite complex. If you would like to benefit from our expertise in these areas or if you have further questions on this Alert, do not hesitate to contact us.