US Cross-Border Tax Blog

Published by W.L. Dueck LLP

Catherine Shen-Weafer

Is the interest expense deductible for US non-resident aliens owning a US real property interest?

Loaning between business entities is a widely-adopted business strategy in the real estate industry. Multiple levels of entities are often chosen in a business structure.

U.S. limited liability companies (“LLC”) are commonly used to hold U.S. real property interests. When foreign investors are involved for various reasons (i.e., asset protection), foreign investors use a non-U.S. corporation that is treated as a disregarded entity for U.S. federal income tax purposes to be the sole owner of the U.S. LLC. When the LLC needs funding, the non-U.S. corporation makes the loan to the LLC.

Interest Expenses when Non-U.S. Corporations fund U.S. LLCs

An example would be a U.S. non-resident alien Al, has a wholly owned non-U.S. corporation Al Co. that solely owns a Washington LLC, Al LLC. Al LLC plans to purchase a commercial building in Seattle, Washington. Al intends to hold the building for appreciation of value in the future. During the holding period, he may lease the building for short-terms to tenants.

To purchase the building, Al LLC borrows from Al Co. for an amount with a prescribed interest rate and reasonable repayment arrangements. If Al Co. directly loans Al LLC for the purchase, and the building is leased out, it would be classified as a passive activity since rental activity is deemed to be a per se passive under the passive activity loss rules per IRC § 469(c)(2). No matter what level of Al’s participation in the rental activity may be, it will still be considered “passive.” Al plans not to actively participate in any rental activities, or engage in the rental activities for more than 750 hours in a year.

So, what about the interest expense? IRC § 163(d)(3)(A) defines the term “investment interest” being any interest allowable as a deduction which is paid or accrued on indebtedness properly allocable to property held for investment.

Since Al intends to hold the building for a few years, does it qualify as a property held for investment? Under IRC § 163(d)(5)(A), “property held for investment” includes:

(1) property which produces portfolio income of a type that is not treated as income from passive activity rule [1] (generally interest, dividends, annuities, or royalties, not derived in the ordinary course of business, or gain or loss on the disposition of property producing such income); and

(2) any interest in an activity involving the conduct of a trade or business which is not a passive activity, and with respect to which the taxpayer does not materially participate.[2]

Property subject to a net lease and investment income

Property subject to a net lease is not treated as property held for investment because rental is a passive activity. Therefore, the rental income would not be investment income. As a result, the interest accrued or paid on the loan to Al LLC from Al Co. would not be deductible against the rental income, but would be carried forward. If Al sells the building in the future, would the potential gain on the sale be investment income eligible to deduct the investment interest expense? To deduct the expense, further analysis and reorganization steps may be required to turn potential capital gain into investment income and deduct the investment interest expense.

Catherine Shen-Weafer, CPA/CGA, CPA (WA), MST

[1] Internal Revenue Code § 469(e)(1)

[2] Internal Revenue Code § 163(d)(5)(A)(i) and (ii)