The Net Election on U.S. Rental Income for Foreign Owners

A foreign owner renting out a U.S. property is, by default, taxed on the wrong number. IRC §871(a) treats U.S.-source rent as fixed, determinable, annual or periodical income, taxed at a flat 30% of the gross amount received, with no deduction for the mortgage interest, the property taxes, the insurance, the management fee, or a single dollar of repairs. IRC §871(d) offers a different path: an election to treat that same rental activity as if it were a U.S. trade or business, taxed on net profit at graduated rates instead. Most owners never learn the election exists until a withholding statement arrives showing tax withheld on money the property never actually made.

The default rule and why it is so punishing

Under IRC §871(a)(1)(A), a nonresident alien individual is subject to a flat 30% tax on U.S.-source FDAP income that is not effectively connected with a U.S. trade or business, and rent from real property falls squarely in that category unless the owner has done something affirmative to change its treatment. IRC §1441(a) puts the mechanical burden on whoever pays the rent, generally the tenant or, more commonly in practice, the property manager or leasing agent, who is required to withhold 30% at the point of payment and remit it to the Treasury. The withholding agent does not ask what the mortgage payment is or what the roof repair cost. The statute gives them one number to apply the rate to, and that number is the gross rent collected.

The result is a tax that does not track the economics of the property at all. A highly leveraged rental, the kind with meaningful mortgage interest and real operating costs, can generate a 30% gross withholding bill that exceeds the entire economic profit the property produced for the year. That is not an edge case. It is the ordinary outcome for financed U.S. rental property held by a nonresident who has not made the election.

What the election under §871(d) actually does

IRC §871(d) lets a nonresident individual (and, under the corporate parallel at IRC §882(d), a foreign corporation) elect to treat income from U.S. real property as if it were effectively connected with the conduct of a U.S. trade or business. The regulatory mechanics sit in Treas. Reg. §1.871-10, which describes the manner, timing, and scope of the election.

Once in effect, the rental activity is taxed the way a domestic landlord's rental activity is taxed: on net income, after the ordinary deductions allowed under IRC §162 and IRC §212, including mortgage interest, real estate taxes, insurance, management fees, repairs and maintenance, and depreciation under IRC §168. The tax is computed under the graduated rate schedule in IRC §1 that applies to any individual, rather than at a flat 30% on the top-line rent. For a property with genuine operating costs, this is frequently the difference between a real, if unwelcome, tax bill and a bill that consumes the entire return on the investment.

A worked example

Take a single-family rental in Florida, purchased for $400,000, with $300,000 allocated to the depreciable building. It rents for $3,000 a month, or $36,000 a year. Annual operating costs, mortgage interest, property taxes, insurance, a management fee, and routine repairs, run $22,000. Depreciation on the building, computed on a 27.5-year straight-line schedule under IRC §168(c) for residential rental property, adds roughly $10,900 a year.

Item	Default rule (gross, §871(a))	Net election (§871(d))
Gross rent	$36,000	$36,000
Operating expenses	Not deductible	$22,000
Depreciation	Not deductible	$10,900
Taxable amount	$36,000	$3,100
Tax basis	Flat 30% of gross	Graduated rates on net
Approximate tax	$10,800	A few hundred dollars, depending on the owner's other U.S. income

The property in this example is genuinely profitable in cash-flow terms, and the default rule taxes it as though it were not. The election, applied to the identical property with identical income, produces a tax that tracks the actual economics. This gap widens as leverage increases and narrows for an unleveraged property with few carrying costs, which is worth modeling before assuming the election is automatically worthwhile in every case.

Making the election

The election is made by attaching a statement to a timely filed U.S. nonresident income tax return, Form 1040-NR for an individual, for the first year the election is to apply. The statement identifies the taxpayer, describes the real property and the income involved, and states that the election is being made under IRC §871(d). Once made, the rental activity is reported on the return the way a domestic rental would be, generally on Schedule E attached to Form 1040-NR, rather than on Schedule NEC, which is where FDAP income taxed under the default gross rule is reported.

A critical feature of the election is its scope. It generally applies to all of the taxpayer's income from real property held for the production of income in the United States, not to a single building chosen because it happens to be leveraged. An owner with several U.S. properties cannot elect net-basis treatment for the financed one and leave an unleveraged property on the gross regime; the election, once made, reaches the whole category.

Revocation is not casual

Treas. Reg. §1.871-10 treats the election as binding for the year it is made and for all later years unless it is revoked, and revocation generally requires the consent of the Commissioner, obtained through a written request that explains the circumstances. This is a deliberate design choice. The election exists to let a taxpayer choose a consistent regime for reporting real property income, not to let a taxpayer switch back and forth year to year depending on which computation produces the smaller number for that particular year. An owner should treat the decision as a long-term one, made with the full ownership period in view, rather than as an annual toggle.

Form W-8ECI: telling the withholding agent what changed

Making the election on a tax return does not, by itself, stop a tenant, leasing agent, or property manager from withholding 30% of the gross rent at the point of payment. The withholding agent has no visibility into what a taxpayer has elected on a return filed months or a year later, and IRC §1441 obligates that agent to keep applying the default rule until it is given documentation that says otherwise.

The document that changes the withholding agent's behavior is Form W-8ECI, Certificate of Foreign Person's Claim That Income Is Effectively Connected With the Conduct of a Trade or Business in the United States. Once a valid Form W-8ECI is on file with the payer, the payer stops withholding 30% on the rent, because the income is now treated at the point of payment as ECI rather than FDAP. Form W-8ECI generally needs to be renewed periodically and re-provided if circumstances change, and it should be delivered before the first payment the owner wants exempted from withholding, since withholding already taken is only recovered later, by filing a return and claiming a refund or credit.

The most common way this process fails is not the election itself. It is the gap between the two documents. An owner makes the §871(d) election on a return and never gives the property manager a Form W-8ECI, so withholding continues regardless of what the return says. Or an owner gives a property manager a Form W-8ECI without ever having made the underlying election, which creates a mismatch between what the withholding agent is doing and what the return ultimately reports. Both halves need to be in place, and the W-8ECI needs to reach the specific party actually disbursing the rent, which for a property using a management company is usually the management company rather than the individual tenant.

Depreciation now, recapture later

Depreciation is typically the largest deduction available once the election is in force, and it is frequently what pushes a modestly profitable property to a small or zero taxable amount. It is not a free deduction, though. Depreciation claimed while the property is held reduces the property's basis under IRC §1016(a)(2), and that reduced basis is what the gain is measured against when the property is eventually sold.

The mechanics of that later step, including the fact that depreciation reduces basis whether or not it was actually claimed, and the special rate that applies to the portion of gain attributable to depreciation, are covered in detail in the firm's material on selling U.S. rental property. The short version worth carrying forward from this page: making the §871(d) election and claiming depreciation is very often the right call during the holding period, but the sale-year consequence should be understood from the start, not discovered at closing.

Multiple owners and different holding vehicles

Where U.S. rental property is held through a partnership or a multi-member LLC treated as a partnership for U.S. tax purposes, the §871(d) election generally operates at the level of the foreign partner making the election on their own share of the income, reported on their own Form 1040-NR, rather than as a single election made once for the entity. Where the property is held through a single-member LLC that is disregarded for U.S. tax purposes, the election is made by the individual owner directly, since the disregarded entity is not itself the taxpayer.

A foreign corporation that owns U.S. rental property has its own version of this choice under IRC §882(d), made on Form 1120-F rather than Form 1040-NR, with the same basic trade-off between flat withholding on gross FDAP rent and graduated corporate-rate tax on net income once the election is in effect. The corporate context adds its own layer, since a foreign corporation earning ECI can also become subject to the branch profits tax under IRC §884 on the after-tax earnings, a separate charge from the underlying income tax and one worth modeling before choosing a foreign corporation as the holding structure for U.S. rental real estate.

The ongoing filing obligation this creates

Electing net-basis treatment is not free of cost even where it produces a smaller tax bill. Once income is being reported on a net basis, a U.S. nonresident return is required every year the election remains in force, with records adequate to substantiate every deduction claimed, particularly the split between capital improvements and deductible repairs and the depreciation schedule itself. An owner who was previously outside the U.S. filing system, perhaps because a property manager was simply withholding 30% and nothing further was ever filed, becomes a return-filer going forward.

For most leveraged properties, this ongoing filing obligation is a small price relative to the withholding avoided. For a small, unleveraged property with modest carrying costs, the comparison is closer, and it is worth running the actual numbers, gross withholding against net tax plus the cost of annual compliance, rather than assuming the election is automatically the better outcome.

What to do next

Start by working out the property's actual annual numbers: gross rent, genuine operating costs, and a reasonable depreciation estimate based on the building's allocated basis. If costs and depreciation together are a large fraction of gross rent, which is the normal case for a financed property, the default 30% gross rule is very likely producing a result well out of proportion to the property's real profitability, and the §871(d) election is worth examining seriously.

If the property is already owned, rent has already been collected for prior years, and nothing has been filed, that is a common starting position with established routes back into compliance, but the specific route depends on the facts and should be worked out before anything is submitted to the IRS. This is general information about how the election and the withholding rules operate as of the date written, not advice on a specific property or ownership structure.