The international tax experts at LSL CPAs often find property managers caught between the mandatory withholding requirements of the IRS and the demands of foreign investors who own the property they manage. By default, rental income is considered to be passive income and, as such, is subject to 30% withholding. In most cases, a property manager who collects the rental fees acts as the withholding agent for the IRS of the foreign investor’s income. Withholding 30% of gross receipts ensures federal tax liabilities are paid in full. A property manager is responsible for making these deposits to the IRS as the withholding agent.
IRS Definition of A Withholding Agent
On the IRS website, the definition of a withholding agent is as follows:
“To enforce the system of withholding, the Internal Revenue Code defines a “withholding agent” to be any person in whatever capacity (including lessees and managers of U.S. real property) having the control, receipt, custody, disposal or payment of income that is subject to withholding. Thus, a real property manager who collects rent on behalf of a foreign owner of real property is clearly considered a withholding agent. A withholding agent is personally and primarily liable for any tax that must be withheld. The liability of the withholding agent includes amounts that should have been paid plus interest, penalties and, where applicable, criminal sanctions.“
Foreign Investors And Passive Rental Income
U.S. income realized by foreign investors generally falls into two categories: income effectively connected with the conduct of US trade or business (effectively connected income or ECI), and fixed, determinable, annual, and periodical income (FDAP). By default, all passive income, including rental income, falls into the FDAP category.
Different tax rules apply to FDAP and ECI income: FDAP income is taxed at a 30% flat rate on gross receipts. In contrast, ECI income is taxed using progressive tax rates, and gross receipts can be reduced by allowable deductions when arriving at a taxable base.
Passive Rental Income Vs. Effectively Connected Income
If the foreign investor or entity wants to avoid the 30% withholding on rental income, they need to shift from passive rental income to effectively connected income. Such a shift is a complicated process.
First, Foreign individuals and corporations must elect to have their passive rental income taxed as if it were effectively connected with the U.S. trade or business. Such an election is made by attaching a declaration to a timely filed income tax return. Once made, the election may not be revoked without the consent of the IRS. Second, they must notify the property manager by submitting Form W-8ECI with a valid U.S. tax identification number. Third, timely tax returns must be filed on Form 1040 NR every year the foreign investor owns the property.
A Deadly Financial Bind For Property Managers
Behold the grey area where many property managers get caught in a deadly financial bind. The property manager must make a 30% withholding from gross rents received until he/she receives a fully completed Form W-8ECI from the foreign investor. Only having this form on file will relieve the property manager from the withholding obligation.
Property managers who fail to make the withholdings and resulting payments to the IRS become personally liable for the entire amount owed, including interest and penalties. Such personal liability is where many property managers suddenly find themselves caught between the rock of their foreign clients and the hard place of the IRS. It is uncomfortable, but the international tax experts at LSL CPAs can help.
IRS Help For Property Managers
If you are a property manager and fall under the above definition, please pay attention. If the foreign investor you handle property for demands that you no longer withhold the 30% for the IRS, do not change your actions until you check with a tax professional. You have to ensure all the i’s have been dotted and all the t’s have been crossed with the IRS. For help, don’t hesitate to contact the international tax team at LSL CPAs before you get hit with an unexpected huge tax liability and possible criminal repercussions.
Pursuant to U.S. Treasury Department Regulations, any federal tax advice in this article is not intended or written to be used for (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any tax-related matters addressed herein.
It is important to note that this article presents only a partial view of the subject matter. It does not claim or attempt to be comprehensive or perfectly accurate. To learn more about how these issues might apply to your property management or foreign investment situation, please call LSL CPAs international tax accountant Yana Weaver at 714.569.1000.
