Nonresidents are subject to U.S. income tax on two different categories of income:
1. Income that is effectively connected with a U.S. trade or business, (often referred to as “ECTB” income, which after certain deductions is taxed at graduated rates, similar to the income tax rates that apply for U.S. citizens and residents. This income generally consists of salary and wages, commissions, and net earnings from a trade or business in which the nonresident actively participates.
2. Income that is not effectively connected with a U.S. trade or business. This income is taxed at a flat 30% rate, or at a lower rate if the provisions of a tax treaty apply.
Fixed, Determinable, Annual, Periodical (FDAP) Income
The 30% (or lower treaty) rate applies on what is termed U.S. source “fixed or determinable income”, provided this income is not effectively connected with a U.S. trade or business. Income is considered “fixed” when it is paid in amounts that are known ahead of time, and is determinable when there is a basis for figuring the amount to be paid. The income can be periodic, but does not have to be paid annually or at regular intervals to be considered fixed and determinable.
According to the Internal Revenue Service (IRS), FDAP income includes all income except:
· Gains from the sale of real or personal property, and
· Income that is excluded for income tax purposes, regardless of the U.S. or foreign status of the owner of the income.
Fixed or determinable income would therefore comprehend a wide range of income, including:
· Interest and original issue discounts on bonds,
· Rents from real or personal property (but not gains on sales)
· Salary, wages, and other compensation for personal services,
· Scholarships or fellowships (the taxable portion)
· Pensions and annuities,
· Distributions from a partnership,
· Distributions from an estate or trust,
· Prizes and awards.
If these types of income are not effectively connected with a U.S. trade or business, and are U.S. source income, they would be subject to the flat 30% tax, or a lower rate if a tax treaty applies.
Social Security Benefits
A nonresident alien is subject to U.S. income tax on 85% of U.S. Social Security benefits. This 85% of the benefits would be included in U.S. source FDAP income subject to the 30% tax. Social security benefits may be exempt from U.S. tax if a tax treaty applies. You should see IRS Publication 901, U.S. Tax Treaties, to see if there is a tax treaty in effect that would exempt your Social Security benefits from U.S. income tax.
You will be subject to the 30% tax on any gains from the sale or exchange of capital assets (real or personal property) if you were present in the United States for 183 days or more during the tax year and are still considered a nonresident alien. This 183-day rule applies regardless of whether the transaction generating the gain or loss occurred while you were present in the United States.
For purposes of the 30% tax, capital assets do not include assets deriving from, or used in a trade or business, such as inventory, supplies, and accounts and notes receivable. Capital assets also exclude depreciable and real property used in a trade or business.
If you were present in the United States for less than 183 days during the tax year, you are not subject to U.S. income tax on your net capital gains, except for the following:
· Gains effectively connected with a U.S. trade or business,
· Gains on the disposal of timber, coal, or domestic iron ore if you retain an economic interest,
· Gains on contingent payments from the sale or exchange of patents, copyrights, or similar intellectual property after October 4, 1966,
· Gains on transfers of all substantial rights to, or an undivided interest in, patents, if the transfer occurred on or before October 4, 1966,
· Gains on the sale or exchange of original issue discount (OID) obligations.
Capital gains may also be exempt from U.S. income tax according to the provisions of a tax treaty, so here again, if applicable, you should see IRS Publication 901.
Figuring Net Capital Gain
If you have both capital gains and capital losses, you are subject to the 30% tax on your net overall gain. But in determining your net overall gain, certain amounts are not taken into consideration. A deduction for a capital loss carryover, for example, is not used to offset capital gains. And taxable income is not reduced for capital losses that exceed capital gains (a net capital loss would generally not be deductible). Losses from the sale or exchange of property held for personal use are also excluded when determining net overall capital gain. And, the exclusion of gain from the sale or exchange of qualified small business stock is not included.
Reporting Capital Gains
Capital gains and losses must be separated between those that are effectively connected with a U.S. trade or business and those that are not. Capital gains and losses not effectively connected (those that are subject to the 30% tax) are reported on page 4 of Form 1040NR. Capital gains and losses that are effectively connected are reported on Schedule D (from Form 1040) and the result from Schedule D is reported on page 1 of Form 1040NR.
Income from Real Property
If you have income from real property located in the United States, you may be able to elect to treat that income as effectively connected income, rather than FDAP income subject to the 30% flat tax. It may be to your advantage to do this, for example, if you have a property you rent, and you have rental expenses that would offset your rental income. If you elect to have this net income treated as effectively connected income, it will be subject to tax at the graduated rates. So you would have to determine whether your overall tax burden would be higher or lower by paying the 30% flat tax on your gross income from the rental property, or by paying the effective tax rate, based on your tax bracket, on your net income from the rental property.
Choice to Treat as Effectively Connected
You can make this choice for real property that you own, or that you have an interest in, and that you hold for the production of income. The choice is only available for real property that is not effectively connected with a U.S. trade or business. If the real property is effectively connected, it will be subject to the graduated rates, and not the 30% flat tax, and you will have no election.
If you choose to make the choice to have income from real property treated as effectively connected income, all income from all real property you own in the United States, or have an interest in, and that you hold for the production of income, will be included in your election. This includes rents, royalties from mines, oil or gas wells, or other natural resources, and any gain on the sale or exchange of timber, coal, or domestic iron ore with a retained interest. If you make this choice, you can deduct expenses attributable to the real property income and you will be subject to tax on your net income (gross income minus attributable expenses). A nonresident alien who makes this choice, and who is not otherwise actually engaged in a U.S. trade or business, is not treated as being engaged in a U.S. trade or business. The choice only affects net taxable income from real property in the U.S.
How To Make The Choice
You make the choice to have income from real property in the U.S. treated as effectively connected income by attaching a statement to your tax return for the year you make the choice. This could be your return for the current filing year, or an amended return for a prior year. Once you make the initial choice, it remains in effect for all later years, unless you revoke it. You can revoke the choice for the first year you made it, and for all later years, by filing amended returns on Form 1040X. But if you make the choice for one year and wish to revoke the choice for a later year, you will need IRS approval.
The statement you attach to your return should indicate that you are making the choice, and should indicate whether you are making this choice based on Internal Revenue Code section 871(d), (explained above), or based on a tax treaty. The statement must also include the following information:
· A complete list of all the real property you own in the United States or in which you have an interest, indicating the extent of your interest (% ownership),
· The location of each property,
· A description of any major improvements to each property,
· The dates you owned the property, or an interest in the property,
· Your income from the property.
The statement should also indicate any previous choices or revocation of choice to treat income from real property as effectively connected income.
If you are a nonresident subject to the 30% flat tax on fixed, determinable, annual, periodical income, this tax should be withheld by the payer or withholding agent. You will receive a Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding, showing your total income and the tax withheld.
Your income from real property is also subject to the 30% withholding status, even if you make the choice to have this income treated as effectively connected.