Navigating the capital gains tax implications for non-residents selling US property can be a complex undertaking. This guide aims to provide a comprehensive understanding of US tax law for foreign investors, covering who is subject to capital gains tax, the relevant tax rates, and potential strategies for reducing tax obligations. Whether you retained a home in the US after moving abroad or invested in US property as a foreign national, comprehending these nuances is essential for a smooth and compliant sale.
Understanding Capital Gains Tax on US Property
Capital gains tax (CGT) is a tax levied on the profit realized from the sale of certain assets. These assets commonly include investments such as stocks, real estate, cryptocurrency, and personal property. If you sell US-based assets and generate a profit, you may be subject to US capital gains tax. For US citizens and resident aliens, capital gains form part of their worldwide income and are thus subject to US taxation.
For non-resident aliens (NRAs), the rules are more specific. Generally, NRAs are subject to a 30% tax rate on US-source net capital gains if they are physically present in the US for at least 183 days in the taxable year during which the gain occurs. In such cases, the tax is typically withheld at the source of the payment. However, this particular provision applies only if the NRA is not already taxed as a resident under the substantial presence test (discussed further below). Crucially, capital gains derived from US real property interests are taxable for NRAs regardless of their physical presence in the US. Furthermore, capital gains earned by non-residents from the sale of US partnerships with effectively connected income (ECI) are also subject to US tax, and specific withholding requirements on the gross proceeds apply to both US real property interests and partnerships with ECI.
Who is Considered a Non-Resident Alien for Tax Purposes?
The Internal Revenue Service (IRS) classifies taxpayers into two main categories: resident aliens and non-resident aliens (NRAs). A resident alien typically meets the substantial presence test or holds a US Green Card. Conversely, NRAs are individuals who do not possess Green Cards and have a limited physical presence in the US. Examples of individuals generally categorized as non-resident aliens include international students, visiting scholars, and employees of foreign governments or international organizations.
To clarify the distinction, you will be considered a Resident Alien for tax purposes if you meet the Substantial Presence Test. This test primarily evaluates the number of days you were physically present in the United States during the tax year in question and the two preceding years.
Here’s how the Substantial Presence Test works:
- Current Year: You must be present in the US for at least 31 days during the current year. If you are present for less than 31 days, you do not meet the test for that year.
- Three-Year Period Calculation: If you meet the 31-day minimum for the current year, the test then uses a weighted formula over a three-year period:
- Count all the days you were present in the US during the current year.
- Count each day you were present in the US during the first preceding year as 1/3 of a day. For example, 30 days of presence count as 10 days for this purpose.
- Count each day you were present in the US during the second preceding year as 1/6 of a day. For example, 60 days of presence count as 10 days for this purpose.
If the sum of these calculated days over the three-year period totals 183 days or more, then the Substantial Presence Test is met for the current tax year, and the individual is consequently taxed as a Resident Alien for that year. If the calculated total is less than 183 days, the test is not met, and the individual remains classified as a Non-Resident Alien.
General Rules for Non-Residents Selling US Property (Non-Real Estate)
When it comes to NRAs selling investments held in a brokerage account, such as stocks or bonds, they are typically not required to pay US capital gains tax. This exemption generally applies provided the NRA does not meet the substantial presence test for the tax year in question and the gains are not effectively connected with a US trade or business. It’s crucial for NRAs to be aware that while the US brokerage firm may not withhold any tax in these instances, they may still be responsible for paying capital gains tax on these profits in their home country, based on their domestic tax regulations.
It is worth reiterating that certain non-resident aliens, such as students, scholars, and employees of foreign governments and international organizations, can be subject to the 30% capital gains tax if they have been in the US for more than 183 days and if their tax home has also shifted to the US. This scenario is distinct from real property sales and pertains more to the individual’s overall tax residency status.
The FIRPTA Exception: Real Estate Withholding
The Foreign Investment in Real Property Tax Act (FIRPTA) introduces a specific and critical rule for NRAs selling US real estate. Under FIRPTA, the buyer of the US real property interest is required to withhold a portion of the sale proceeds and remit it directly to the IRS. This withholding acts as an advance payment toward any potential US capital gains tax liability that the foreign seller may incur on the sale. The primary purpose of FIRPTA is to ensure that foreign persons do not escape US income taxation on gains from the disposition of US real property interests.
The withholding rate under FIRPTA is generally 15% of the gross sale price. However, this rate can vary based on the sale price and specific circumstances:
- Sales exceeding $1 million: A 15% withholding rate applies.
- Sales between $300,001 and $1 million: The withholding rate is generally 15%, but it may be reduced to 10% if specific conditions are met (see previous section for details on buyer being an individual, intent for personal residence, etc.). If these conditions are not fully met, the 15% rate applies.
- Sales of $300,000 or less: The withholding rate is generally 15%, but in certain situations, it could be reduced to $0 if specific conditions are met, such as the buyer being an individual who intends to use the property as a personal residence and the sale price is $300,000 or less. However, it is critical for sellers to understand that the burden is on them to apply for reduced or zero withholding through an IRS withholding certificate if they believe they qualify.
Filing a US Tax Return to Recover Withheld Amounts
If you are an NRA and believe that you are eligible for a reduced or zero capital gains tax rate on your US real property sale (perhaps due to a tax treaty benefit, a small actual gain, or qualifying for an exclusion), you can file a US tax return to recover some or all of the amount withheld under FIRPTA. This procedure involves filing Form 1040-NR, U.S. Nonresident Alien Income Tax Return. When filing, you must attach the IRS-stamped copy of Form 8288-A to claim credit for the FIRPTA tax that was withheld.
To proactively address potential over-withholding, sellers can apply for a withholding certificate by filing IRS Form 8288-B, Application for Withholding Certificate for Dispositions by Foreign Persons of U.S. Real Property Interests. This form allows you to request the IRS to authorize a reduced or even zero withholding amount if you can demonstrate that your actual tax liability will be less than the amount that would otherwise be withheld. Form 8288-B must be submitted to the IRS before or on the day of closing. If the form is pending at closing, the buyer is still obligated to withhold the standard FIRPTA amount but may delay remitting it to the IRS for up to 20 days after the IRS responds with a decision on the certificate application. This provides a window for the seller to potentially receive a reduced or no withholding amount if their application is approved.
Factors Affecting Capital Gains Tax Liability for NRAs
While most NRAs are exempt from capital gains tax on non-real estate US property, certain circumstances can trigger tax liability. As noted, if an NRA meets the substantial presence test for a tax year, they may be subject to capital gains tax on the sale of any US property, including stocks and bonds, as they are then treated as resident aliens for tax purposes.
Additionally, if the US property is deemed “effectively connected” with a US trade or business, any capital gains from its sale might be taxable. Effectively Connected Income (ECI) refers to income earned directly from an actively run business based in the United States. For instance, if an NRA owns a rental property in the US and actively manages it (beyond passive investment), the income and any capital gains from its sale could be considered ECI and therefore subject to US tax.
The typical US capital gains tax rate for NRAs is 30% for US-source net capital gains if you are present in the US for 183 days or more in a tax year. If you reside abroad for the entire tax year and invest in US stocks, you generally won’t pay CGT in the US, but you may still be liable for it in your home country. Other US-sourced investment income, such as dividends and interest (excluding interest from US bank accounts), is typically taxable and requires filing a Form 1040-NR. The actual tax payable depends on several factors, including:
- Tax Treaties: The US has tax treaties with many countries, which can significantly reduce or even eliminate capital gains tax liability or FIRPTA withholding for NRAs. It is crucial to understand the specific provisions of the tax treaty between your country of residence and the US to determine any potential benefits. These treaties can prevent double taxation and offer preferential rates. If you are eligible for treaty benefits, ensure you provide the necessary tax forms (e.g., Form W-8BEN) to identify yourself as a foreign person qualifying for treaty benefits. Failure to do so could result in the standard 30% withholding.
- Income Level: For effectively connected income, your overall income level can influence your tax rate, with higher incomes generally facing higher rates.
- State Laws and Regulations: Beyond federal taxes, some US states may impose their own capital gains taxes or other taxes on property sales. It’s crucial to research both federal and state tax implications to avoid unforeseen liabilities.
- Duration of Stay: As previously discussed, an NRA’s physical presence in the US (specifically 183 days or more in a calendar year) can trigger US capital gains tax liability, even on non-real estate assets, as it can lead to being treated as a resident alien under the substantial presence test.
Strategies for Minimizing Capital Gains Tax Liability
For non-resident aliens selling property in the US, several strategies can help minimize the capital gains tax burden:
- Claiming Tax Treaty Benefits: If applicable, filing the appropriate forms to claim tax treaty benefits can significantly reduce or eliminate withholding requirements and overall tax liability.
- Accurate Cost Basis Calculation: Ensure you include all amounts used to purchase and improve the asset when calculating your cost basis. All major repairs, improvements, and renovations can be added to a property’s cost, thereby reducing the calculated capital gain.
- Tax-Deferred Exchanges: For real estate, consider a Section 1031 Like-Kind Exchange. This allows capital gains tax to be deferred by reinvesting the proceeds from the sale of one qualifying US property into another qualifying US property, typically of a similar nature. This can be a powerful tool for deferring tax liability, though it comes with strict rules and timelines.
Reporting Capital Gains and Professional Tax Advice
It is essential to accurately report your income, including income from capital gains, on your US tax return. Non-resident aliens generally use Form 1040-NR to report their capital gains. For property transactions, Form 1042-S is used to report and pay the tax withheld, with specific income codes (24, 25, and 26) used for transactions involving these entities. Maintaining detailed records of all your transactions is crucial in case of an audit by the IRS.
Given the complexities of US tax law, especially for NRAs, seeking professional tax advice is highly recommended. A qualified tax advisor can analyze your specific situation, identify potential tax liabilities, and suggest strategies to minimize your tax burden. They can also assist with filing US tax returns, claiming applicable tax treaty benefits, and helping you stay informed about changing tax laws or regulations that might impact you. This expertise can help ensure compliance and optimize your tax outcome, even potentially assisting with issues like monitoring for potential tax liens if errors or missed payments occur. Remember, while this guide focuses on federal capital gains tax, some states and localities may impose additional taxes on the sale of US property, and NRAs may have information reporting obligations even if not subject to capital gains tax. Consulting a tax professional ensures all requirements are met.
