US property owners ignore tax at a price

WITH property prices surging in Hong Kong, some people are discovering they can make better real-estate investments in the United States - but not all realise they must give at least a nod to the tax man.

Ignoring the US Internal Revenue Service (IRS) can be costly, even when a property is costing more than it brings in. Pre-emptive action is necessary to avoid paying 30 per cent withholding tax on gross receipts.

'They may be thinking, 'I'm not making any money on this, so I don't need to file a return',' Deloitte Touche Tohmatsu partner Anne Shih Mee-yee said. 'The danger is that if they don't file a return, then they'd have a liability.' In a recent US court decision, a non-resident alien (the rather-awkward legal term for a person who is neither a US citizen nor a US resident) found himself hit by a hefty sum for back taxes, plus interest and penalties, owed on two loss-making properties - all of which could have been avoided if he had been filing annual tax returns and electing net-basis taxation.

Got your attention? The filing deadline is June 15. That's right, today. Since this falls on a Sunday, the IRS is granting a one-day reprieve this year. Getting a two-month extension to file is fairly routine, but the application for the extension must be filed by tomorrow. Forms can be downloaded from the Internet or picked up at the US Consulate.

Non-resident aliens are taxable on two types of US-generated income: active income connected with a trade or business and passive income received in fixed, periodic payments. Rent falls into this latter category. Active income is taxed on a net basis at graduated rates from 15 per cent to 39.6 per cent, but passive income is taxed on a gross basis at a flat 30 per cent rate.

There is a simple way to avoid the withholding tax on gross rental receipts. Under section 871(d) of the US tax code, non-resident aliens can elect to treat rental income as active, thereby offsetting property-related expenses against gross rental income and paying graduated rates.

This net-basis election must be made on a statement attached to a timely filed tax return.

This is where Guillermo Baez Espinosa, the non-resident alien recently hit with a huge tax bill in court, went wrong. Mr Espinosa owned two US rental properties that were generating more expenses than rent, and he did not file US tax returns.

This did not go unnoticed by the IRS. After Mr Espinosa failed to respond to the tax authority's inquiries, the IRS prepared tax returns for him that did not take into account any deductions. He then filed his own returns taking the deductions, and the IRS responded with a notice of delinquency. Off everyone went to court, which ruled the deductions were allowable only on a timely filed return.

The same thing could easily happen to, say, Joe Wong. More and more Hong Kong people are buying properties in the US, where prices are lower than in the territory, down-payments are smaller and rates of return are often better.

Deloitte Touche Tohmatsu tax director Patrick Yip Wai-man said he used to get only about one call a year with questions about owning US property; now he averages one every other week.

Fortunately, our Mr Wong is in a position to learn from Mr Espinosa. Even if Mr Wong is in arrears - has not had 30 per cent withheld from his gross receipts and has not filed any tax returns - he would do well to clear the decks sooner rather than later. It is still possible to file returns and elect net-basis taxation for 1995 and 1996.

Prior years will mean tax liabilities, interest and penalties, but paying now is cheaper than letting them pile up.