Nonresident Owns a U.S. House

The scenario is a common one: a nonresident individual owns a house in the United States. Having purchased it, what will happen next? Well, the new owner will do one of the following:

• House Sits, Empty. Leave the house empty and hold it for capital appreciation.
• Personal use. The nonresident individual, family, and friends will use the house from time to time for personal purposes.
• Attempt to rent the house. The owner may put the house on the market and hope to attract a tenant.
• Actually rent the house. The attempts to find a tenant may be successful, and a tenant moves in and starts to pay rent.

Let’s ignore “yeahbut” and “whaddabout” situations: flipping back and forth between personal use and rental, bad faith attempts at rental (setting the rent at well above market rates, for instance). And I’m just talking about a human being as owner—no holding structures.

Can I Deduct or Capitalize Property Taxes?

The question in the AMA focused on capitalizing carrying costs for the house—specifically, property tax—when the house isn’t actually rented and isn’t being used for personal purposes.

I’m going to discuss the rules generally here – for deduction or capitalization of the property taxes paid.

Personal Use

The nonresident owner uses the house for personal purposes, and pays property tax. What income tax benefits can be obtained, if any? Can the owner claim a tax deduction? No.

Property taxes are allowable as a deducting in computing taxable income. IRC Section 164(a)(2).

However, nonresidents are not permitted to claim the full panoply of tax deductions. Only deductions that are effectively connected with the conduct of a trade or business in the United States are deductible. IRC Section 873(a) says:

In the case of a nonresident alien individual, the deductions shall be allowed only for purposes of section 871(b) and (except as provided by subsection (b)) only if and to the extent that they are connected with income which is effectively connected with the conduct of a trade or business within the United States; and the proper apportionment and allocation of the deductions for this purpose shall be determined as provided in regulations prescribed by the Secretary.

The nonresident owner is not engaged in a trade or business in the United States with respect to this property: the house is used by the owner and the owner’s family.

Therefore, the property tax expense cannot be deducted because IRC Section 873(a) limits deductions to those “connected with income which is effectively connected with the conduct of a trade or business within the United States.”

Simple enough.

Capitalize only if deductible

You cannot capitalize the property tax expense (i.e., increase adjusted basis of the house). IRC Section 266 allows an election to treat otherwise-deductible expenses to be capitalized.

No deduction shall be allowed for amounts paid or accrued for such taxes and carrying charges as, under regulations prescribed by the Secretary, are chargeable to capital account with respect to property, if the taxpayer elects, in accordance with such regulations, to treat such taxes or charges as so chargeable.

But the adjustment to basis is only allowed for “otherwise deductible” expenses. Reg. Section 1.266-1(b)(1) says, in relevant part:

The taxpayer may elect, as provided in paragraph (c) of this section, to treat the items enumerated in this subparagraph which are otherwise expressly deductible under the provisions of Subtitle A of the Code as chargeable to capital account either as a component of original cost or other basis, for the purposes of section 1012, or as an adjustment to basis, for the purposes of section 1016(a)(1). . . .

For a nonresident owner of a U.S. residence that is used by the owner and family for personal purposes, the property tax is expressly NOT deductible, because of IRC Section 873(a). Therefore, adjusting basis upwards for property taxes paid is impossible.

If deductible, capitalize only if allowed by Regulations

If an expense is otherwise deductible, the question of whether you can capitalize the expense or not under IRC Section 266 depends on whether Reg. Section 1.266-1 will let you.

We don’t have to worry about the Regulations since the property tax deduction is disallowed, so capitalization of the expense is not permitted, no matter what the Regulations say about the capitalization of property taxes.

IRC Section 212 deduction?

Now consider the house sitting, empty. The nonresident owner pays property tax. This is a “held for investment” situation. The owner is holding the real estate for eventual capital gain.

Can the nonresident owner claim a tax deduction for property taxes paid by invoking IRC Section 212? That Code section allows deductions to individuals for expenses connected with investment assets.

In the case of an individual, there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year—

(1) for the production or collection of income;

(2) for the management, conservation, or maintenance of property held for the production of income[.]

No tax deduction is allowed for a nonresident individual owner under Section 212. The reason is IRC Section 873(a), which limits deductions to situations where the nonresident is engaged in a trade or business in the United States. “Held for production of income” is not a trade or business.

House is rented

Assume now the house is rented to a tenant, and rent collected. The nonresident owner is either engaged in a trade or business based on provable facts or by making the net election authorized by IRC Section 871(d).

The entirely expected and unremarkable consequence is that property taxes are deductible. A “trade or business” exists (the business of being in the Landlord Business) and you can draw a straight line from the property tax paid for the house and the business of renting that house to a tenant.

The rental income is taxed under the provisions of IRC Section 871(b), and IRC Section 873(a) permits the deduction of expenses associated with that rental income.

I will ignore the concept of attempting to capitalize the property tax expense rather than taking an immediate tax deduction in the year it is incurred.

Attempting to find a tenant

An AMA discussion we had centered on the nether world of “attempting to find a tenant”.

The owner has listed the property for rent, and is actively (and presumably in good faith) attempting to find a tenant. How do you shoehorn your facts and circumstances into satisfying the “engaged in trade or business” position needed to satisfy the requirements of IRC Section 873(a)?

We had interesting first-hand experiences shared by participants in the AMA. Since this was ephemeral and related to real world situations in play right now, I will not recount that discussion here.

But just understand the deductibility of an expense is tied to the existence of a trade or business in the United States. That is the pivotal issue. Once you have resolved that question, the conclusions (deduction or capitalize?) follow as described above.

• Prove that first, because you need a deductible expense to use it as a tax deduction or to capitalize the cost.
• Then go on to the second step—whether the otherwise-deductible expense can be capitalized under IRC Section 266. If it can, great. Reg. Section 1.266-1 tells you the answer.

Conclusion

Capitalizing a carrying cost for a nonresident investor involves navigating through two portals to unknown worlds: (1) is the expense deductible? Then (2) Is the deductible expense eligible to be capitalized?

You will be analyzing this question using IRC Section 873(a) and IRC Section 266.