Community Accounting & Tax, LLC., Chester, Virginia, Serving Metro Richmond and Southside Virginia.

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“Whether or not a foreign person is subject to U.S. taxation depends on two critical factors: Is the foreign person considered a U.S. resident; and is the income received attributable to U.S. sources.”

“The substantial presence test involves totaling the days a foreign citizen is in the U.S.”

Whether or not a foreign person is subject to U.S. taxation depends on two critical factors: (i) Is the foreign person considered a U.S. resident and, (ii) is the income received attributable to U.S. sources. After determining residency and source of income, the final issue concerns the tax owe d to the U.S.

The U.S. taxes its citizens on their worldwide income, regardless of residency. The U.S. also taxes a foreign citizen on his worldwide income if he meets U.S. residency requirements. Therefore, a foreign citizen who is also a foreign resident escapes U.S. taxation on his worldwide income, but the portion of income derived from U.S. sources is subject to taxation.

Whether or not a foreign person is subject to U.S taxation depends on two critical factors: Is the foreign person considered a U.S. resident; and is the income received attributable to U.S. sources. After determining residency and source of income, the final issue concerns the tax owed to the U.S.

The U.S. taxes its citizens on their worldwide income, regardless of residency. The U.S. also taxes a foreign citizen on his worldwide income if he meets U.S. residency requirements. Therefore, a foreign citizen who is also a foreign resident escapes U.S. taxation on his worldwide income, but the portion of income derived from U.S. sources is subject to taxation.

“The substantial presence test involves totaling the days a foreign citizen is in the U.S.”

“If a foreign citizen meets the substantial presence test, he still may qualify as a nonresident under the closer connection test.”

“A foreign citizen who is a nonresident is taxed only on income
derived from U.S. sources.”

“An nonresident alien can deposit funds in a bank account in the U.S. and not pay tax on the interest. Also, the funds are not subject to U.S. estate taxes.”

“To derive the U.S. income tax liability for a foreign citizen, first determine the residency, then the source of income.”

“Sales of real property by non-U.S. residents are generally subject to a 10% withholding of the sales price...”

A foreign citizen who is considered a U.S. resident is taxed as though he were a U.S. citizen; he is entitled to the same deductions, credits and exclusions. In addition, he could be subject to state income tax if the state where he resides has adopted the same federal tests for residency. A foreign person who receives an Immigrant Visa ("green card") is considered a U.S. resident. Residency is established under the "substantial presence test," but a determination of residency may be rebutted under the "closer connection test."

The substantial presence test involves totaling the days a foreign citizen is in the U.S. For the substantial presence test to apply, a foreign citizen must be in the U.S. at least 31 days during the current calendar year and must be present at least 183 days (partial days are counted as whole days) during the current year plus the preceding two years under the following formula: Each day of the current year is counted in full; one-third of the days present in the preceding year are counted; and one-sixth of the days present in the second preceding year are counted. Therefore, a foreign citizen can avoid becoming a U.S. resident by limiting their stay to 120 days annually.

Foreign citizens exempted from the substantial presence test include diplomats and their families; teachers and trainees; students; commuters from Mexico and Canada; persons in transit between foreign destinations who are in the U.S. for less than 24 hours; persons medically incapacitated because of a medical condition that arose while present in the U.S.; and professional athletes competing in certain charitable sporting events.

If a foreign citizen meets the substantial presence test, he still may qualify as a nonresident under the closer connection test. A foreign citizen, who has not applied for a green card and is in the U.S. less than 183 days in the current year, might retain his foreign residency if he has a tax home in a foreign country and has a closer connection to the foreign country. A closer connection to a foreign country involves such factors as the individual's permanent place of residence; place of employment or business activities; where he voted or filed tax returns; where he registered his vehicles; location of valued personal possessions; and location of his religious or social affiliations.

A foreign citizen who is a nonresident is taxed only on income derived from U.S. sources. U.S. source income
includes income and rents derived from an interest in U.S. real estate; compensation earned while in the U.S.; dividends from U.S. corporations, any other type of "fixed or determinable, annual or periodic" income (this definition has been broadly interpreted by the courts to include gambling winnings and one-time payments that would be taxed as ordinary income to a U.S. taxpayer); distributions made by U.S. partnerships and trusts; sales of property located in the U.S.; and income that is effectively connected with a trade or business in the U.S. The concept of U.S. real property is broad and encompasses leases, cooperatives, and interests in U. S. real property corporations.

Interest income from bank deposits has traditionally been excluded from taxation since the U.S. government recognizes that money can be deposited anywhere in world. Therefore, the U.S. would be economically disadvantaged if it taxed foreign deposits while other countries did not.

Example:

A nonresident alien wants to open a U.S. dollar bank account in the U. S. What are the tax consequences?
 
Answer:

A nonresident alien can deposit funds in a bank account in the U.S. and not pay tax on the interest. Also, the funds are not subject to U.S. estate taxes. They should contact a bank, explain that they are a foreign person, and complete the paperwork (usually, Form W-8BEN). If they become a U.S. resident or citizen, they'll pay tax on the bank interest. The initial deposit of funds is never taxable under our income laws, although for a U.S. taxpayer, bank deposits are part of the gross estate for federal estate-tax purposes.

Portfolio Interest Exception: Another exception to the U.S. source rules involves portfolio interest. Portfolio interest is generally interest income (or original issue discount income) derived from government or corporate debt instruments issued in registered form after July 18, 1984. The portfolio interest exception does not include interest paid to a foreign citizen by a corporation which that foreign citizen owns, directly or indirectly, greater than a 10% voting interest. Similar related party rules apply to partnerships.

In general, a nonresident foreign citizen who sells stock of a U.S. company is not taxed on gains and cannot deduct any losses. This applies to both short-term and long-term capital gains and losses. Thus, a nonresident alien can “speculate” or day-trade stocks and all gains will be tax-free.
 
Of course, none of his losses are deductible.

Income -- received as compensation, wages, salaries, rents, royalties, dividends, U.S. partnership and trust distributions, and certain gains from the sale of property- is taxed at a flat 30%, unless there is a lower applicable treaty rate. There are no deductions allowed. Income that is effectively connected with a U.S. trade or business is taxed as though it was earned by a U.S. resident and may be reduced by the same deductions, exemptions and credits given U.S. residents. Therefore,
characterizing income as effectively connected with a trade or business could have significant advantages, depending on the deductions, exemptions and credits available to the foreign taxpayer under the Internal Revenue Code. Also, an owner of real property may elect to be taxed as a U.S. resident rather than be subjected to a flat 30% tax on rental income.
 
In general, the U.S. collects taxes owed by nonresidents through an elaborate withholding system that obligates the person paying the foreign taxpayer to withhold 30% of the amount being paid and then pay it to the U.S. government. Treaty provisions may reduce the taxes paid by foreign taxpayers or affect withholding requirements.

To derive the U.S. income tax liability for a foreign citizen, first determine the residency, then the source of income. Finally, calculate the tax, either under the Internal Revenue Code or applicable treaty. If the foreign taxpayer is not a U.S. resident and has U.S. source income, the person paying the foreign taxpayer must withhold the applicable tax and pay it to the U.S. government.

Many "foreign" individuals invest in U.S. real property without fully comprehending their tax consequences. A foreign individual for U.S. tax purposes is a non-U.S. resident and a non-U.S. citizen. In most cases, with proper tax planning, taxes can be minimized or even avoided.

Sales of real property by non-U.S. residents are generally subject to a 10% withholding of the sales price under the Foreign Investment in Real Property Tax Act (FIRPTA). Some states have also enacted FIRPTA withholding regulations for sales of real property within their borders. Foreign taxpayers may file a U.S. tax return to reclaim any amounts withheld in excess of the actual tax owing.
 
The following examples illustrate tax issues facing foreign individuals acquiring U.S. real estate and are based on a foreign investor ("Investor") who purchases a small house in San Francisco, California, for $500,000.
 
Example 1:

Assume Investor rents out the house for $2,000 per month for 12 months. Investor's expenses and deductions are $1,250 per month for 12 months. At year's end, Investor has income of $24,000, deductions of $15,000, and therefore, a profit of $9,000. Which statement is correct?

A. Investor is a foreign individual and therefore owes no federal or state income tax.
 
B. Investor owes federal and California income tax on the "net" profit of $9,000.
 
C. Investor owes federal income tax on 30% of the "gross" income, $24,000.
 
Answer:

"C" is correct.

 "A" is wrong because the income is considered "U.S.- source income," and the U.S. taxes foreign individuals on their U.S. - source income. Investor could, however, avoid the tax on 30% of the gross income by electing to treat the house as a "business" under U.S. tax law and then by filing U.S. income tax returns. If the election is properly made, then "B" becomes the correct answer, and Investor could pay little, if any, income tax.

Example 2:

Three years later, Investor sells the house and receives $550,000 after sales costs. Which statements are correct?

A. Investor is a foreign individual and therefore owes no federal or state income tax.

B. The purchaser is required to withhold $71,500 (13% of the purchase price of $550,000) and pay it to the federal and state tax authorities.

C. Investor only owes tax on the profit from the house (assume $50,000) and will be taxed as though Investor were a U.S. resident or citizen.
 
Answer:

 "B" and "C" are correct.

"A" is wrong because the sale of real property is now taxable. "B" is the correct answer because the purchaser(or those involved in the sale) is required to withhold 10% and pay it to IRS and to withhold another 3% and pay it to the California Franchise Tax Board. Investor can then file tax returns reporting the profit of $50,000 and claim a refund for any excess tax that has been withheld.

The Investor could have avoided the overwithholding with an exemption from IRS prior to the sale. In any case, Investor must pay tax under "C, "unless Investor had engaged in a "tax-free" exchange of real property in which case, no income tax would be due.

 Example 3:

Investor owns his house for 10 years until his death, when the house is worth $750,000. Which statement is correct?

A. Investor is a foreign individual and therefore owes no federal or state income tax.

B. Investor owes income tax on the profit from the house (assume $250,000) and pays tax on that profit as though Investor were a U.S. citizen or resident.

C. Investor owes estate tax on the house measured by its full fair market value on the date of his death, ($750,000 minus a credit worth $60,000) and thus owes approximately $225,000 in estate taxes.

D. Investor owes both an income tax under "B" and an estate tax under "C."
 
Answer: "C" is correct.

"A" is wrong because the real property is in the United States, and therefore subject to U.S. estate tax. "B" is wrong because the United States does not tax "profit" at death. "C" is correct: foreign individuals are taxed on the full value of their U.S. holdings, including U.S. real property and stock, upon death. Unlike U.S. residents or citizens who receive a $600,000 estate tax credit, Investor is entitled to a $60,000 credit. If Investor becomes domiciled (lives permanently) in the U.S. for estate tax purposes, then his estate tax would be approximately $38,000, the same as a U.S. citizen, rather than the approximately $225,000 he owes as a foreign individual.
 
Example 4:

With proper tax and estate tax planning, which of the following is (are) true?

A. Under Example 1, Investor owes tax on the "net" income (after deductions).
 
B. Under Example 2, Investor could avoid taxes entirely if he "exchanges" the house for other real property, rather than selling the property. If, however, Investor sells the property and receives the cash, Investor would pay tax only on the profit and thus avoid the federal and state withholding tax of $71,500.

C. Under Example 3, Investor could avoid estate tax entirely, and even transfer the house without court intervention.
 
D. All of the above.
 
Answer: "D" is correct. Foreign taxpayers by properly structuring their investments through the use of foreign corporations and foreign trusts and by making the proper tax elections can minimize income tax consequences from owning U.S. real estate (and other U.S. - source property), and can also eliminate all estate taxes.

Further, tax planning opportunities exist for Investor to borrow funds from foreign individuals (including, in some cases, relatives) to buy U.S. real property.

An Investor may deduct the loan interest from his U.S. tax return which will reduce or eliminate any income tax due, and in addition, the foreign lender will receive interest payments which are free of U.S. tax!