For tax purposes, a non-U.S. citizen is either a nonresident alien or a resident alien. All aliens are considered nonresident aliens, unless they pass the green card test or the substantial presence test. A person meeting either of these tests is considered a resident alien. Since aliens are taxed differently depending on their status, it is important to carefully consider what is involved.
For federal tax purposes, a resident is anyone who is a lawful permanent resident of the U.S. at any time during the calendar year. This is otherwise known as the green card test. A person who passes this test is issued an alien registration card, form I-551, also known as a green card, from the United States Citizenship and Immigration Services (USCIS). This status continues unless voluntarily abandoned, administratively terminated by USCIS, or judicially terminated. If one meets the green-card test but fails the substantial presence test for that year, the individual’s residency start date begins the first day in which that person is present in the U.S. as a lawful permanent resident. A lawful permanent resident is responsible for all responsibilities of a U.S. citizen regarding tax laws.
The substantial presence test determines a person’s residency status based on the total number of days a person is physically present in the U.S. at any time during the year. For purposes of this test, the term United States includes:
1. all fifty states of the U.S., including the District of Columbia,
2. U.S. territorial Waters, and
3. all seabeds and subsoil adjacent to those waters and over which the U.S. maintains exclusive rights to explore and exploit.
An individual passes the substantial presence test, by being physically present for 31 days during the current year and 183 days
during the 3-year period which includes the current year and the previous two years immediately before that. For purposes of counting the 183 days, a person includes:
1. all the days the individual was present during the current year,
2. one-third of the days present in the first year before the current year, and
3. one-third of the days present in the first year before the current year, and
4. one-sixth of the days present in the second year before the current year.
Once a person passes the substantial presence test, they are considered a U.S. resident for tax purposes and may be subject to all tax law responsibilities as a U.S. citizen unless an exemption or exception applies.
There are several exemptions that one may use to deduct days from their substantial presence test day count and remove themselves from resident alien status. Days are not counted for:
1. a foreign government-related individual (A, G visa),
2. a temporarily present teacher or trainee (J, Q visa) who substantially comply with their visa requirements,
3. a temporarily present student (F, J, M, Q visa), who substantially comply with their visa requirements, or
4. a temporarily present professional athlete competing in a charitable event.
Additionally, if one is unable to leave the U.S. due to a medical condition, said person may fill out a Form 8843, Statement for Exempt Individuals and Individuals With a Medical Condition, with their tax return to exclude those days from their day count. While qualifying for one of these exemptions may preclude U.S. resident qualification and the corresponding tax responsibilities of a U.S. citizen, there are still applicable non-resident tax laws.
Without an exemption, one would need an exception to the substantial presence test, in order to demonstrate nonresident alien status. There are two exceptions available, based on showing a closer connection to a foreign country, that may apply. One of the closer connection exceptions is available to all aliens that qualify,1 while the other exception is only available to qualifying students.2 For both exceptions, there are numerous factors that influence whether or a person has maintained more substantial contacts with the foreign country than with the U.S.3 Such factors include, but are not limited to:
1. location of permanent home,
2. location of family members,
3. location of the majority of personal belongings,
4. location of social, political, or religious organization ties,
5. location of bank accounts,
6. location where personal business activities are conducted,
7. location of jurisdiction of driver’s license,
8. location of jurisdiction used for voting,
9. country of residence listed on forms, and
10. type of alien status forms filed.
The closer connection exception available to all aliens requires threes things. First, the individual must be present in the U.S. for fewer than 183 days in the current year. Second, the individual must maintain a foreign tax home during the current year. Third, the individual must have a closer connection, as evidence by the factors listed above, during the current year to that foreign country
The closer connection exception available to a foreign student applies if he or she does not intend to reside in the U.S. permanently; has substantially complied with the laws and requirements governing his or her student nonimmigrant status; has not taken any steps to become a permanent resident of the U.S.; and has a closer connection, as evidenced by the factors listed above, to a foreign country.
Finally, along with their tax return, one must file either Form 8840, Closer Connection Exception Statement for Aliens,or in the case of a student exception, Form 8843,Statement for Exempt Individuals and Individuals With a Medical Condition.4
Again, determining one’s alien status is significant, because resident and nonresident aliens are taxed differently. Resident aliens, generally, are taxed the same as U.S. citizens—all income earned within or outside of the U.S. must be reported. Nonresident aliens are generally taxed only on their U.S. source income. This income may either qualify as “effectively connected income” (ECI) and/or as “fixed or determinable, annual, or periodic (FDAP) income. Basically, ECI is derived in the U.S. from operation of a business also in the U.S., or it is personal service income earned in the U.S. A nonresident alien with ECI is subject to the same U.S. person graduated rates. FDAP income, withheld at the source, on the other hand, is passive income (i.e., interest, dividends) and, so long as it is not also ECI, is subject to a flat 30% tax rate, unless a tax treaty allows for a lower rate. For a full list of income tax treaties see here.
While nonresidents gain the benefit of access to the straightforward 30% treaty rate for FDAP income, nonresident aliens with ECI benefit from being able to use deductions, itemized deductions, tax credits, and exceptions—subject to limitations. For example, nonresident aliens may only claim personal exemptions for themselves on U.S. tax returns, while residents can claim exemptions for themselves and dependents. Additionally, other than personal exemptions and certain itemized deductions, nonresidents are only allowed to claim deductions to the extent they are connected to ECI, while residents have access to the same deductions as U.S. persons. Lastly, non-resident aliens cannot claim standard deductions unless exceptions apply, while resident aliens have access to the standard deduction and all itemized deductions available to U.S. persons.
Significantly, non-U.S. residents who invest in U.S. property, may elect ECI treatment rather than subject themselves to FDAP treatment.5 The choice between FDAP and ECI treatment may result in substantially different effective tax rates. Consider the following examples (which do not include depreciation):
Example 1: NR receives $1000 rent from tenant. NR incurs expenses related to his rental property in the amount of $500. NR is subject to the FDAP withholding rate of 30%. Reducing the $1,000 rent by $500 expenses and $300 tax—NR is left with a net profit of only $200. The effective tax rate is 60% ($300/$500).
Example 2: NR receives $1000 rent from tenant. NR incurs expenses related to his rental property in the amount of $500. NR elects ECI treatment and is allowed to deduct expenses. This leaves only $500 subject to tax. If we assume a tax rate of 37%, NR pays tax of $185—leaving him with a profit of $315. The effective tax rate is 37% ($185/$500).
A taxpayer makes the ECI election by filing a statement with their return. If the taxpayer fails to attach the statement with the original return, he or she may make the election on an amended return, so long as it is within the statute of limitations (usually 3 years).6 The statement must include the following:
1. an affirmation of the choice to make the election under I.R.C. §871(d),
2. a complete list of all real property, as well as any interest in real property, that is located in the U.S.,
3. a description of the extent of the taxpayer’s direct or beneficial ownership in the real property,
4. the real property’s location,
5. descriptions of any substantial improvements made to the property, and
6. an identification of any taxable year(s) in which an I.R.C. §871(d) revocation or new election has previously occurred.7
Failure to file and pay taxes as a visa or green card holder may lead to several penalties handed out by the IRS or the USCIS. These penalties may harm a person’s chances in being approved for adjustment of status, visa extensions or renewals, or the naturalization and citizenship process. Additionally, if deemed serious enough, deportation or removal from the U.S. may result. For these reasons, knowing your status and tax responsibilities that come along with your status is very important for all non-citizens. For a full list of visas and the taxes that apply to them visit here.The election does not otherwise result in the property being treated as a trade or business for other purposes under the Code. For example, it does not convert the property from capital gain property to ordinary income property because of being used in a trade or business.
If you have tax questions or concerns about your alien tax status and the ECI election, contact Frost & Associates, LLC today.
1 I.R.C. §7701(b)(3)(B) and (C).
2 I.R.C. §7701(b)(5)(D) and (E).
3 Treas. Reg. §301.7701(b)-2.
4 SeeTreas. Reg. §301.7701(b)-8(d)(2) for a very limited exception for failing to file Form 8840.
5 I.R.C. §871(d).
6 I.R.C. §871(d)(3); Reg. §1.871-10(d)(1)(iii). Note that once the taxpayer makes the ECI election, the taxpayer should notify the withholding agent on Form W-8ECI.
7 I.R.C. §1.871-10(d)(1)(ii).