IRS Actions to Solve Non-Compliance of Canadians Earning US Rental Income

September 14, 2017

In August, the U.S. Treasury Inspector General for Tax Administration (TIGTA) issued a final report #2017-30-048 entitled “Additional Controls Are Needed to Help Ensure That Non-resident Alien Individual Property Owners Comply with Tax Laws”1. While the TIGTA needs to work on their titles2, the report contains some interesting recommendations for Canadians that own U.S. real property.

TIGTA estimates that non-resident alien investors’ investment in U.S. real property increased by approximately 1/3 or almost US$10 billion between 2013 and 2016. They conducted an audit to help evaluate the Internal Revenue Service’s (“IRS”) efforts to identify and address non-resident alien individuals who should be paying income tax on rental income earned from U.S. real property.

TIGTA recommended three items: 1) Revision of IRS Form 1040NR for non-resident aliens to make appropriate elections under the Internal Revenue Code to pay income tax on net income, 2) use withholding credits claimed on U.S. tax returns showing a sale of property against information in databases to determine if US property was rented out and if so, to verify the adjusted cost basis amount used in a tax return reporting the sale of the property and 3)develop a compliance initiative addressing non-reporting of rental income from US properties owned by non-resident aliens

  1. Tax Election

    Under Internal Revenue Code section 871(d), a taxpayer can elect to pay US income tax on their net income from U.S. real property. This allows the owner to deduct all expenses. Failure to make this election can result in the individual paying US tax on gross income at a rate of 30%. In their audit, TIGTA noted that only 32% of taxpayers are including the election statement with their tax returns in accordance with the Code and concluded that absent a proper election, approximately $56 million of US withholding tax was not being paid annually.

    TIGTA recommended that IRS Form 1040NR be revised to enable the taxpayer to make an election directly on the return. TIGTA also recommended that the IRS revised internal procedures to track properties owned by the taxpayer to assist the IRS with audit and verification when properties are sold. The IRS agreed with the recommendation but cautioned that implication may be delayed due to budget and information technology constraints.

  2. Verification of Information

    A sale by a non-resident alien generally requires the purchaser to withholding 15% of the gross proceeds and remit them to the IRS on behalf of the seller. The seller uses this withholding tax to offset any tax on the gain on sale. The seller includes IRS Form 8288-B showing the amount of the tax withheld with their U.S. federal income tax return and the IRS verifies this withholding amount when assessing the tax return.

    TIGTA recommended that the IRS undertake a verification step when review tax returns showing sales of properties. Specifically, as the IRS verified withholding tax credits against information on the seller in their database, they also compare the activity to the taxpayer’s master file to see if the property was rented out. If so, IRS could compare their estimate of the cost basis of the property after considering deprecation and ensure the gain reported by the taxpayer was reasonable. While the IRS agreed in theory, it stated that significant enhancements to its systems would be required to make this recommendation feasible and absent upgrades, it rejected the recommendation.

  3. Compliance Initiative

    US tax law requires payors of rent to non-resident owners withhold tax of 30% or receive confirmation in prescribed form from the owner that they are not required to withhold since the owner conducts a trade or business when renting the property. Either way, the payor is required to file IRS Form 1042-S to report rental payments made.

    In their audit, TIGTA found that less than 5% of property owners received IRS Form 1042-S, some in cases of direct payments and others in cases where a property management firm was likely involved. TIGTA concluded that putting the existing enforcement rules on tenants and renters was not effective.

    TIGTA recommended the IRS develop a compliance initiative that addresses non-resident aliens and their failure to report rental income from U.S. real property. The IRS agreed with this recommendation and is considering strategies to improve compliance. Such strategies could include coordination with state property databases, taxpayer education and other tax law enforcement.

Overall Observations

Canadians that own U.S. real property and earn rental income are subject to U.S. federal income tax. They can choose to do nothing which results in U.S. federal income tax at a rate of 30% of their gross income. Such an amount will generally exceed the U.S. federal income tax on net income after deducting expenses. Choosing to pay U.S. federal income tax on net income requires the owner to file an election and annual U.S. federal income tax returns. State income tax may also apply.

The IRS recognizes the significant amount of revenue it is losing by not enforcing compliance and is planning initiatives to combat lost tax revenue. If you need assistance to determine the U.S. tax implications of your ownership of U.S. real property including help with filing current and past U.S. federal and state income tax returns, please contact us.