Wealth Podcast Post

Taxes on Rental Income with Brent Nelson

George Grombacher January 27, 2023

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Taxes on Rental Income with Brent Nelson

LifeBlood: We talked about taxes on rental income when the property is owned by a foreign entity or individual, common and costly mistakes people make and how to avoid them, and how taxes work on the sale of property under similar circumstances, with Brent Nelson, Estate Planning and Tax Partner with Rimon Law, and host of the Wealth and Law podcast.

Listen to learn the IRS forms you need to be using!

You can learn more about Brent at RimonLaw.com, WealthAndLaw.com, Twitter, Facebook and LinkedIn.

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Our Guests

George Grombacher

Brent Nelson

Episode Transcript

nknown Speaker 0:00

Unknown Speaker 0:15
my name is George G. And the time is right welcome today’s guest strong and powerful Brett Nelson. Brett. You ready to do this? I am ready. All right, man, welcome back is estate planning and tax partner with Ramon law. He’s the host of the wealth and law podcast.

Unknown Speaker 0:33
That’s number two and number three, Brent that kind of runs together. I think this is number two for us. So number two, well refresh your memory. Tell us a little about your personal lives more about your work, why you do what you do? Yeah, well, thank you for having me back. And you came on my podcast too. So that was very kind of you. You’re You’re a giving person Jordan,

Unknown Speaker 0:54
or a tolerant person to have me back.

Unknown Speaker 0:58
family, the family life, married four kids. Oldest is 16. So we’re getting into the about to go to college sort of years sort of trying to navigate all those normal issues that normal people deal with for getting to be older teenagers. I was born and raised in a city called Yuma, which is on the border, the US Mexico border, it’s as far southwest as you can go in the state of Arizona before you’re in Mexico,

Unknown Speaker 1:28
to date farmers. And I knew enough after working on the date farm in the summer in Yuma, which is also about the hottest place on the planet.

Unknown Speaker 1:37
That that was not for me. And so I always liked philosophy and politics and writing and reading. I thought that maybe that’s law. So I went to law school. And at the law school that I was at, in in the list of required courses, they had a basic federal income tax class at which I was a political science, undergrad and English undergrad, and I wasn’t really at it. And I had no interest in tax. And so I was like, you know, I’m gonna take that as soon as humanly possible just to get out of the way. And I did that for a bunch of courses. And the first time that I could take it, where I had to control my schedule was the first semester of my second year of law school was three years of law school. And I took it and I loved it. So two, big surprise to me. Actually, it was very quickly, you know, a few weeks into the course I was thinking like, wow, this is actually super interesting and incredibly practical. And it’s like a topic for all topics, because tax touches everything. And so I took after that I took every tax class I could get. I did some sort of tax related work, clerking during law school. And I decided, yeah, I think I want to do that for a living, or something related to that for living. And it turns out if you want to do that, as a lawyer, couple of things need to be true. Were one of a few things need to be true, could be a combination. Number one, you were an accountant, your CPA before you went to law school, I was not, as I have established. Number two, you’re going to go work for the IRS, I was not going to do that. Number three, you are going to somehow luck into an entry level position in a tax department at a law firm, which most law firms big law firms are not hiring,

Unknown Speaker 3:22
just basic JD candidates to come work in their tax departments. I wasn’t going to do that. And then the final thing was you go get a master’s in law in tax, which is another law degree. So I thought, Great, I’ll do that.

Unknown Speaker 3:35
Long story short, moved to DC did that in DC and then moved

Unknown Speaker 3:40
back to Arizona after some very strong grammar lobbying, and have done that every day of my professional career. And basically, almost every day of my academic legal career. I know nothing else. I’m barely a lawyer.

Unknown Speaker 3:57
This is the only thing that I know how to do. This is the only thing anybody would ever pay me to do.

Unknown Speaker 4:03
That’s it that’s me. That’s that’s what I do. And that’s why I do it. Because I have no other gainful skills. George.

Unknown Speaker 4:09
I’ve been myself into a corner. There’s there’s there’s always date farm and you can fall back on it sounds like Brent. I could I could You’re right. You’re right. So there’s there’s at least one out. So these these these kids, are they aware that you grew up date farming and for perspective, do you ever forced them to do that in August? I have not. No. They are aware. They are aware they’ve seen the farm. They know about the farm. We go down. My parents still live in Yuma and my oldest brother also lives in Yuma. So we go down there quite a bit. So we visit they see it. They don’t fully appreciate what it means staff to work out there in the summer, but coincidentally my sister who lives in Philadelphia, sent her two boys out there last summer to work. Probably I don’t know

Unknown Speaker 5:00
Have like they did something really bad and she wanted to straighten them out or what but she sent them out. They’re like these kids are wonderful human beings, but could use a dose of what it’s like to work hard. And throw the date farm. Yeah, it’s like the equivalent of sending your kid to boot camp, you know, these, like Scarem straight boot camp type. Thanks. It’s that. Yeah, come back and very well mannered and grateful for the things that they have.

Unknown Speaker 5:26
I feel like a lot of people listening are going to be emailing about how they can get a second internship for their children at the day farm. Yes, sadly, the price for child labor on the date farm just went way up, sadly to say for all your listeners.

Unknown Speaker 5:42
So we were talking, before we get started here, and we could spend a lot of time talking about date farming, but what is on your mind right now? Or is always on your mind? Something that is top of mind, right? Yeah, a big I mean, a big chunk of what I do is, is cross border International. So, you know, think foreign families, my clients are basically just wealthy families.

Unknown Speaker 6:07
You know, like, when you might remember a few years ago, there was the 99%, protests, the people that were protesting, were basically all my clients.

Unknown Speaker 6:18
And that’s I, I do not mean that as a commentary at all on, on what they’re protesting just the point 1% or less, are basically my clients. And so you think about that group of people from other countries, especially countries that maybe aren’t as stable as ours, there is an extremely strong desire for them to invest in the US market. And really, with with those clients, there’s a really strong desire to invest in us real estate in particular,

Unknown Speaker 6:50
it’s a bit of a surprise, sometimes, if you actually, if you actually look it up the the National Association of Realtors,

Unknown Speaker 6:58
they do a survey, if you remember, if it’s every year, every other year, it’s anyways, with some frequency, they do a survey of kind of the the amount of money that is being invested in real estate, I believe it’s focused mostly on residential real estate,

Unknown Speaker 7:13
and where that money is coming from. And so you look at the list and the top three or four on the list is like China. So that kind of makes sense. Canada, that makes sense. Mexico, and actually the in the in the top five is Colombia. And, and then you know, other places, places in Europe, etc. So, and it’s big, big money, you’re talking billions of dollars of investment just in residential real estate. So there’s a tremendous amount of money coming into the US, we don’t tend to have controls on who can buy real estate here. And so it’s a pretty open market. And and that’s a policy reason that we there. It’s a policy choice that we’ve made, where we want to encourage investment in us real estate and the development of us real estate, under the theory that Americans need places to live, and you need peace people to build the places that people live in. And so you have to encourage people to build the places where people will live, etc, etc, etc.

Unknown Speaker 8:11
And so there’s a lot of that money that ends up here. But it turns out,

Unknown Speaker 8:15
maybe not as a surprise to anybody that when those folks, non Americans invest in us real estate, there’s a whole litany of tax issues that apply to them that are very special just to them, not so much to Americans, but really just for those people.

Unknown Speaker 8:32
And if you think about it, the idea is we want people to invest here, we want to be able to tax them.

Unknown Speaker 8:39
As long as the money is tied up in real estate, no problem. It’s not going anywhere. They’re not gonna pick the dirt up and move it. As soon as they start getting cash out of the real estate. The cash could flee without us getting our money. And that’s where we intervene. And so there are a bunch of rules structured to prevent the cash from leaving before we get our money.

Unknown Speaker 8:59
So should I as a Canadian citizen buy a house in Scottsdale, Arizona at 400,000 that appreciates to a million dollars. There’s rules around me doing a cash out refinance.

Unknown Speaker 9:14
Taking the money. Yeah, the refinance the refinance are not so much the issue, the bigger the bigger issues are. And Canadians are a good example because there’s so many of them around where we live in the sunnier climes of this country.

Unknown Speaker 9:30
So let’s say you’re you’re a Canadian, you bought that place in Scottsdale for $100,000. You know, congratulations, you hit the jackpot that was great investing. Hopefully you did it while the exchange rate was favorable, etc, etc. Now, you decide because you’ve been having a few drinks with your buddies that you want to turn it into an Airbnb because you’re not not down here all the time. You’re only down here in the nice, nice months of the year. So now you’re renting it out. Well, when

Unknown Speaker 9:59

Unknown Speaker 10:00
renter is renting that property, and they’re paying the rent to somebody who is not a resident of the US or citizen of the US, they are supposed to withhold tax. And that tax rate is 30% of the gross number, the gross amount of the rent, so friend is $100, that they’re supposed to be withholding $30 and paying it to the IRS. And that’s on the renter. And in fact, it’s the renters obligation to pay not the landlord’s obligation, the the sort of quid pro quo there is that the landlord, unlike a normal landlord, is not permitted in that situation, to take deductions for renting the property. So if you think like typical residential real estate rentals, quote, unquote, passive investments, the whole scheme is you get paid your rental income, but you get to depreciate the property. And so you’re not paying tax on the rental income for much of the life of the building. Well, that doesn’t apply. If somebody has to withhold 30% flat tax on the rental income and pay to the government and you the Canadian cannot get that money back.

Unknown Speaker 11:07
It is gone.

Unknown Speaker 11:10
And you didn’t get to take any deduction. So it becomes it can be very, very expensive to do it that way. There are it turns out exceptions, of course. So let’s say you’re that Canadian, and we have a few Milsons. And you asked me in my eyeballs, how do I do this, right? Brent? I would say, Well look, George, great idea, you’re gonna rent this property out, I hope you make a lot of money on it, that sounds like a great deal. Here’s what you’re gonna do, you’re gonna give your renter a W eight, e ci, that’s an IRS Form W eight e ci. And what it does is it tells the renter, I am electing to treat this income as business income that I’m earning in the US. And because of that, I will be filing a tax return with the IRS paying tax just like a normal American landlord would reporting the tax just like a normal American landlord would, but I’m filing a return with IRS, I’m gonna report it on myself. So therefore you rent or do not have to withhold the tax, you can just pay me the rent. And then the renter is off the hook, they do not have to withhold and pay this tax. And just by virtue of giving the renter that form, the renters tax liability for this 30% withholding tax vanishes. And now the tax liability shifts to the landlord who, because they’re filing a tax return the rules, say can take depreciation deductions. So like any normal landlord, they’re not going to probably not going to pay tax in the US, they may have to pay tax in Canada, but they don’t have to pay tax in the US because they’re going to be depreciating the property. So it’s like this really strange little quirky thing that you can do that makes a big difference. And it’s almost like a dumb trap for people who don’t know any better. But those are the rules. And that’s how they that’s how they create things in Washington DC traps for the unwary.

Unknown Speaker 13:02

Unknown Speaker 13:05
if I, as a United States citizen, am renting an Airbnb and my favorite vacation place? Am I responsible for that? 30% tax? Technically, yes. Interesting. Technically, yes.

Unknown Speaker 13:18
And is that typically handled through

Unknown Speaker 13:22
the common platforms like Airbnb or VRBO? Or no, not that I’ve seen? Nope. I’ve never been provided with any W with a number form from the the owner of the property when I have rented through verbo, or Airbnb. So the technical answer is the renter is obligated to pay the tax whether they do whether they know to do it is completely separate question.

Unknown Speaker 13:49
But that is the technical answer. Got it. Fascinating. Yeah. Do you think that it’s a function of the laws just haven’t caught up with this phenomenon? Oh,

Unknown Speaker 14:01
yeah, very much. So. very antiquated laws.

Unknown Speaker 14:07
I mean, antiquated relative to do the current laws. You know, we’re talking about 30 years old, maybe.

Unknown Speaker 14:14
But, you know, in 30 years, a lot has changed and a lot has changed him in the residential rent rental markets. And yeah, we certainly have not caught up to that. So there’s, so let’s say in your hypothetical,

Unknown Speaker 14:27
you then want to sell the property, it’s appreciated to a million dollars, it’s, it’s in a great area, it’s it’s, you know, the silver leaf leaf area of Scottsdale, so you’re just rubbing your hands together, you’re gonna make a tremendous amount of money.

Unknown Speaker 14:41
Assuming that property still sell you, because you’re not a US citizen, and you’re not a resident here. You are subject to what’s called FERPA and FERPA is another one of these withholding taxes. So, let me give you just a little bit of background

Unknown Speaker 15:00
So you can kind of understand where this fits into the puzzle slightly. So we talked about this 30% withholding tax. So obviously, if you’re a foreigner, you have to pay tax on on rental income, that same tax applies to things like periodic payments of like dividends, royalties, any sort of periodic income stream, for the most part, you’re going to have to pay this, somebody’s gonna have to pay this 30% tax for you in the US when you receive it. But you are generally not subject to capital gains tax. So easy example is you buy Apple stock, and you sell it for a game. You don’t pay capital gains tax on that. So that’s nice. And again, we’re trying to encourage people to park their money in the US markets, because that’s good for us. And we don’t care that they’re not paying tax, we just want them to invest here, and to prop up the markets. But that doesn’t apply to real estate.

Unknown Speaker 15:53
With real estate, the US government has drawn a pretty firm, hard line, and they’ve said no, no, with real estate, two things are going to be true. Number one, when you sell it, we’re going to treat that as business income here, you have to file a tax return and report it as if it was a capital gain event for you and pay capital gains tax in the US foreigner person.

Unknown Speaker 16:13
You know, tough luck, you got to pick no capital gains on all the other capital gain investments, but not this one. And there is a flat tax as a 15% withholding tax on the proceeds. For the purchase price. For the residents. It doesn’t matter whether it’s paid in cash or not. There’s a 15% withholding tax that again is on the buyer, the buyer withholds the tax, they’re obligated to pay it to the IRS, there are a few exceptions, but that’s the general rule. And then the 15% tax sort of it approximates what the capital gains tax is supposed to be. So the capital gains tax was more, then the seller has to file a tax return and pay the balance whatever is do, they pay that when they’re supposed to pay, they’re supposed to file their tax return, which for them would be due June 15. Without any accent extensions, then, if the withholding taxes too much, they have to file a return to request a refund. And so it’s a straight flat tax straight off the top, that’s the buyer has to pay it and you the seller, even if you wouldn’t have had any capital gains tax, you might not see that money for many months. And it’s just just gone gets paid to the to the IRS and then you have to go beg and plead with the refunds claim later, and try and get your money back.

Unknown Speaker 17:33
And this is not a thing that normal American buyers of real estate think about. And certainly normal American sellers of real estate, don’t think about it.

Unknown Speaker 17:43
So I sell I’m the Canadian citizen, I own the property.

Unknown Speaker 17:50
And I sell an American, the home, the flat tax, the 15% flat tax is paid by the American. Correct. And if I want that money as the Canadian, I need to then file an additional return asking the federal government for that money. Correct? Do I pay additional taxes? If it’s owed, if it’s out, so let’s say they withheld 50. Now it’s 15% on the total amount paid, it’s not 50% on the capital gains, because you invested. You invested $100,000 You sold familiar capital gains, it’s $900,000. But the 15% is on the million. So it could be that 15% On a million is more than the actual capital gains tax. And in that case, you would have to file a return just like a normal American would have to file a return and ask for a refund. report that the tax was paid. There’s certain forms to get filed so you can prove that it was paid, and report the capital gain event and then ask for a refund just like a normal like you would you and I would file our normal tax return and request a refund if we overpaid and tax Same thing for this hypothetical Canadian salary. But they have to do that there’s no there’s no other way. They have to ask for this refund claim. There’s a few ways to kind of speed up the process. They’re all very cumbersome and expensive. So this is the normal course of events. I can tell you that it comes as a bit of a shock for foreigners who usually want nothing to do with the IRS. IRS does not have the world’s greatest reputation beyond our borders, let alone here right. So they want nothing to do with the IRS and the idea that they’re going to have to file returns with the IRS scares a lot of people. But that’s the system if they want any of that cash back because it got over withheld. They have to ask for a refund and have to file a return

Unknown Speaker 19:42
in the eye as an American citizen want very little to do with the IRS so I can’t begrudge a

Unknown Speaker 19:50
so me you will just consume it. We’ll just use the example that you’re the buyer that you’re the American, the million dollar property so you have to write a check to the IRS

Unknown Speaker 20:00
asked for $150,000? Well, I mean, I’m writing a million dollar check. So really in practice, the way it works is

Unknown Speaker 20:08
I’m writing a million dollar check that goes to the escrow officer at the title company, the escrow officer writes the $150,000, check and mails it in with the appropriate forum to the IRS. That’s that’s the normal course of events the way it’s supposed to work. Now, the way, the way that that gets enforced is that if the escrow officer doesn’t do it, they’re liable for the tax. And everybody who advised on the transaction is liable for the tax if they didn’t tell the parties that they were supposed to withhold and pay the tax. So the stick that’s involved is on all the Americans, and all the Americans involved are supposed to make sure this tax gets withheld and paid otherwise, they have to pay it.

Unknown Speaker 20:50
More work for you guys. That’s right, exactly.

Unknown Speaker 20:56
Under goodness, yeah, the other element to it is that with FERPA, it’s very difficult to get around it.

Unknown Speaker 21:06
Unlike this, the rental income thing where you just give somebody a specific form, and then that magically eliminates the problem aside from having to file a tax return.

Unknown Speaker 21:15
There isn’t an easy way around FERPA, there is an exception, if if you’re selling the property for somewhere between 300 and a million dollars, and the buyer is going to use it as their personal residence, they have to sort of swear up and down. If that’s the case, then you can get out from underneath the withholding tax as a few other exceptions to withholding tax. So beyond those situations, you’re almost always going to have to do the withholding tax. And again, if somebody doesn’t know any better, and they don’t know about the exceptions, so they don’t claim the exceptions, then they’re obligated to withhold and pay the tax.

Unknown Speaker 21:52
Got it. Fascinating.

Unknown Speaker 21:55
Well, Brett, thank you so much for coming back on where can people learn more about you? How can they engage and what’s what’s the best time to be talking with you when we’re dealing with with international real estate early before you buy it? If you’re you know you’re you’re down here you’re enjoying the sunshine. You’re thinking man it would be great to own real estate that’s the moment

Unknown Speaker 22:19
that then you call me don’t do it after you close on the transaction. But people can find me You mentioned I host a podcast called wealth and law all spelled out just the words wealth and law. If you if you search that handle on social media pretty much everywhere you’ll find me on LinkedIn brands Nelson, lawyer, Arizona, you’ll find me the Google’s will find me if you search Brent Nelson lawyer, but I’m at a law firm called Ramon R I N O N. It has a website you can find me there. Yeah, that’s that’s the easiest way I’m in the interwebs all over the interwebs. Well, if you enjoy as much as I did show Brent, your appreciation and share today’s show with a friend who also appreciates good ideas if you are potentially terrified what your tax liability might be for a transaction or these transactions.

Unknown Speaker 23:10
It’s better to reach reach out now but obviously better is Brent’s been talking about to reach out as early as possible in this process. Find the wealth and law podcast. We listen to your podcasts and all over the internet again. And the name of the firm is Ramon. It’s ri mo N law. And again, it’s Mr. Brent Nelson. Thanks, guys. Appreciate it. Thanks a lot. And until next time, remember, do your part by doing your best

Transcribed by https://otter.ai

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