IRS Claims on Non-Residents
What happens when former residents who are not citizens or Green Card holders leave the U.S.? Many of them will leave financial or real estate assets within the U.S. for a variety of reasons.
Additionally, there are a number of foreign citizens who seek to own U.S-based assets, even though they may have never lived here. The U.S. is considered a desirable place in which to invest, due to our robust markets and strong regulatory protections.
This group, who generally do not live in the U.S. and are not U.S. taxpayers, are technically referred to as “Non-Resident Aliens” by the IRS.
Often, when foreign citizens permanently leave the United States, they will usually (but not always) liquidate their regular taxable investments and transfer the resulting cash, along with their other savings, on to their next destination. But it is very common to leave behind 401(k)s, IRAs, and other tax-advantaged accounts because of the unique benefits of those structures and the substantial taxes and penalties that are incurred if they are liquidated. Because the income from inside these accounts is tax-deferred, there is no tax reporting to the IRS (nor any withholding tax) required for non-resident owners. There are, however, significant tax consequences when non-residents make distributions from these accounts.
Departing families also will frequently hold on to tangible property, as a result of their natural predisposition to hold real estate as a long-term investment.
Permanent residents who leave the U.S. for good and choose to surrender their Green Card may be considered a “covered expatriate” and owe an exit tax if they have been permanent residents in at least 8 out of the prior 15 years.
The basic taxation of assets owned in the U.S. by foreign citizens who relinquish their U.S. taxpayer status, or by foreigners who have never lived in the U.S., is discussed below.
Interest Income, Dividends, and Capital Gains
There are special tax rules that exempt certain types of passive income from U.S. taxation when the person receiving the income is a non-resident, regardless of whether or not there is a tax treaty available. Interest earned from debt instruments issued by U.S. entities is not taxable; this includes interest on bank deposits as well as bond interest.
Additionally, capital gains on most types of passive investments, such as stocks and stock funds, are generally not taxable in the United States to a non-resident, unless the capital assets are U.S. business assets or U.S. real property interests.
However, U.S.-sourced dividends and withdrawals from tax-qualified plans are not exempt for non-residents, and are subject to U.S. tax at a flat 30% withholding rate (or lower treaty rate).
Over-Withholding Tax on Bond Interest inside a Fund
We have observed that many large U.S. financial institutions are over-withholding tax for non-residents who own investment funds holding bonds (bond funds) in their accounts, thus creating the potential for double taxation. The rules about mandatory tax withholdings are meant to apply only to the dividends of U.S. companies. As stated before, interest earned from debt instruments (bonds) issued by U.S. entities is not subject to tax withholding. However, we’ve found that many U.S. financial institutions routinely withhold tax at the 30% rate (or lower treaty rate) on the dividends from bond funds, even though those “dividends” are actually just the pass-through of interest income paid from the various underlying bonds within the fund. Because of this, non-residents may be wise to avoid investing large amounts of money into pooled bond funds registered in the United States.
Rental Real Estate Property in the United States
Many non-residents own U.S. rental properties in the U.S., whether they are former residences or were purchased with the original intention to be an investment property. This type of income is usually classified as passive income, with gross rental income subject to the 30% withholding tax (or a lower tax treaty rate)—without the benefit of any expense deductions. Because this form of taxation could result in a significant burden and discourage foreign investment in U.S. real property, non-residents can, and nearly always do (when properly advised), elect to treat any rental activity as business income by attaching a special statement to the first tax return that includes the rental property. This allows the nonresident landlord to be taxed on a net basis using graduated tax rates, often resulting in a significantly lower U.S. tax liability.
When a non-resident sells a U.S. property, any gain is taxed in the same manner as if the property had been sold by a U.S. citizen or resident. Therefore, a gain may qualify for lower long-term capital gain tax treatment, provided it meets the test and has been owned for more than 12 months. Even though the gain or loss is ultimately taxed on a net basis through the filing of a tax return, a severe 15% non-resident withholding tax is still levied on the gross receipts (sale proceeds) of the transaction unless you have received a specific exemption from this withholding (which can be difficult to obtain). A lower rate of 10% applies to dispositions under $1 million for U.S. property that was acquired as a personal residence.
The taxation of rental properties owned by non-residents is very complex, and is subject to very specific rules. We recommend foreign residents take great care to ensure that they fully understand these rules, which often can mean seeking out professional guidance and assistance.
Estate Tax Exemptions for Non-Residents
A final area of importance for non-residents holding U.S.-based assets concerns the lower estate tax exemption than U.S. citizens and permanent residents receive. When a non-resident, or any non-U.S. domiciled person passes away (some U.S. tax residents may not be considered domiciled in the U.S. for estate and gift tax purposes, and thus could also be included here), instead of receiving an exemption from the U.S. estate tax of approximately $11.2 million per person (for 2018), non-residents with U.S. assets only receive a $60,000 exemption, after which they owe U.S. estate tax on their assets here. Obviously, the difference between these exemptions is very large, and non-residents in this situation may potentially face high U.S. estate tax liabilities. There are also, however, a very small number of countries that exempt their residents from U.S. estate tax on certain types of assets here through their estate tax treaties.
We at Worldview always recommend to clients that they work with professional tax preparers familiar with cross-border issues, due to their inherent complexity.