Annual Income Tax Return Requirements for Nonresident Aliens Invested in U.S. Closed-End Real Estate Funds

Ashley Erwin, CPA

In the second part of this series, we discuss the U.S. tax filing requirements of a nonresident alien investor, and the various steps an investor needs to take in order to have a complete tax return. We also discuss the process of authorizing a CPA firm to handle an investor's tax return, and an overview of the various other forms associated with the U.S. Nonresident Alien Income Tax Return.

Form 1040NR, U.S. Nonresident Alien Income Tax Return, calculates the annual taxable income and the resulting income tax owed to the United States Treasury by a nonresident alien individual.  The United States income tax code requires nonresident aliens who are partners in U.S. closed-end funds to file Form 1040NR for all years where the closed end fund is engaged in a U.S. trade or business.   A foreign individual who does not have a green card and does not meet the substantial presence test is considered a nonresident alien for U.S. tax purposes.  See Part I for a discussion of the substantial presence test.

If a nonresident alien received no wages subject to U.S. income tax, Form 1040NR must be filed by the 15th day of the 6th month after the last day of the preceding tax year. This due date is June 15th for most foreign individuals.  An automatic six month extension may be granted giving the individual until December 15 th to file his return. 

Annually, each partner of a fund will receive Schedule K-1, which reports his annual share of income and loss from the fund.  There are several computations necessary to determine the amount of income from Schedule K-1 which is taxable and reportable on Form 1040NR.   For example, certain income and loss items reflected on Schedule K-1 may be considered passive to the partner, as he is not actively engaged in managing the business, but is only an investor. Passive losses can only be utilized up to the amount of any passive income.  For example, a nonresident alien’s portion of passive rental loss does not reduce his portion of interest income when determining the amount of taxable income to be reported on Form 1040NR.  However, any excess passive loss is able to be carried forward to reduce passive income in future years.   These passive losses carried forward can be very beneficial in the year in which the fund is liquidated or sold by the partner.  Part III of this series will discuss tax issues arising upon the exit of a partner from a closed-end fund.   Other factors need to be considered when calculating taxable income and income tax, such as: filing status, exemptions, itemized deductions and the different tax rates for different categories of income.  Because of the complicated nature of the U.S. income tax code, it is advised that nonresident alien individuals hire the services of a tax professional.  These services are relatively low cost and save the foreign investor time and effort involved with preparation of Form 1040NR and the subsequent issues which may arise with the Internal Revenue Service. 

Working with a Tax Professional or CPA, Certified Public Accountant

To meet the Form 1040NR annual filing requirement, individuals can either hire a Certified Public Accountant (CPA) through the closed-end fund or hire the services of a CPA or other tax professional (not all tax professionals are Certified Public Accountants) directly.  The real estate fund will typically offer tax preparation services using their own selected certified public accounting firm, such as Wilson LLP; however, the partner must give consent or authorization before a tax professional can file Form 1040NR on his behalf.  

Questionnaire or Authorization Form

Several months before the Schedule K-1 is distributed to the partners, real estate funds, who are clients of Wilson LLP, will distribute to their investors a package of information consisting of a questionnaire and a power of attorney (See Form 2848 or a durable power of attorney below).  The questionnaire requests that the investor authorize Wilson LLP or indicate if another tax professional has already been authorized to prepare the return.   If another tax professional, then generally the questionnaire authorizes the real estate fund to send the Schedule K-1 to that tax professional.   There are usually additional questions related to the current tax year such as marital status and a section for the foreign partner to list all investments funds owned in that particular tax year. 

Form 2848 or Durable Power of Attorney

Form 2848, Power of Attorney and Declaration of Representative, is an official IRS form which authorizes the tax professional, among other things, to represent the partner before the IRS.   Form 2848 streamlines the tax preparation process by allowing the tax professional to sign and file Form 1040NR on behalf of the partner.  This form is required to be signed by the tax professional and the nonresident alien partner, and only covers the tax years which are specified on it.   To further streamline the process, the partner may be asked to sign a durable power of attorney which specifically states that the tax professional may also sign Form 2848 on the partner’s behalf.    This way, the tax professional may file Form 2848 as needed for each year the partner consents on the questionnaire.  This is common practice for Wilson LLP.

Schedule K-1

As discussed above, the partnership reflects the partner’s share of income and loss on Schedule K-1, which is distributed to the partner.  The Schedule K-1 is then used to prepare the nonresident alien partner’s Form 1040NR.  Because the due date of the partnership filings may be extended until September 15th, the distribution of Schedule K-1 to the partners may occur any time from late spring to early fall of the year following the tax year.  This is why several nonresident aliens extend the filing of Form 1040NR from June 15th, to December, 15th.  Sometimes the CPA of the real estate fund will distribute the K-1s on behalf of the real estate fund.  This is the case with most real estate funds engaging Wilson LLP.   The fund or CPA will distribute the K-1 directly to the partner’s tax professional if instructed to do so by the partner. 

State Tax Returns

Form 1040NR satisfies the U.S. Federal filing requirement.  However, each partner may also have a state withholding or filing requirement.  Usually Schedule K-1 will include any applicable state income, losses and withholding paid on the partner’s behalf by the fund.  The CPA filing the Federal return will generally determine which, if any, state returns should be filed.  

Nonresident Alien Individuals in Multiple U.S. Closed End Funds

Some foreign investors are partners in different U.S. partnerships which are managed by different real estate funds.   A partner should expect to receive Schedule K-1 from each partnership.   This may also result in the partner receiving authorization documents from different real estate funds to use the tax preparation services of their preferred CPA.  A nonresident alien investor who is a partner in more than one U.S. partnership should be careful to 1) only authorize one tax professional to file Form 1040NR on his behalf, 2) inform his tax professional of all investments he has in the United States and 3) provide the name, address and phone number of his CPA to the real estate fund(s) of each partnership.  It is helpful when the partner consents for his CPA to communicate directly with the real estate fund.

Issues Arising After Form 1040NR Is Filed

The partner should receive a copy of Form 1040NR from the tax professional.  Wilson LLP is able to provide a summary copy of the return in the nonresident alien’s native language, in place of a complete copy of Form 1040NR.  Our summary is a shortened version highlighting certain details of Form 1040NR, such as a list of the U.S. investments owned by the partner, the overall income or loss, payments, amounts due or refunds and any information to be carried forward to the next tax year.  If Form 1040NR indicates an amount due, Wilson LLP will usually wait to file the return until we have received the tax due from the partner.   If the return reflects a refund of withholding, Wilson LLP will typically file the return with the IRS before sending a copy to the partner.  The refund will usually be issued within 45 days after the return has been filed with the IRS.  It is common for us to show the address of the partner as “in care of Wilson LLP,” so that any refunds or notices from the IRS are first mailed to us.  We then address any issues on notices, confirm the refund is correct and forward the refund to the partner via the real estate fund.  If a partner receives any documentation or refund checks mailed directly from the IRS or state departments, he should inform his CPA or the real estate fund as soon as possible.

Although it is a relatively easy process, there are several steps to be completed throughout the year to ensure Form 1040NR is filed in the appropriate manner for each year a nonresident alien is a partner in a closed-end fund.  The documentation and filing requirements become slightly more complicated in the year partners disposes of his investments in closed-end funds.  Part III of this article will discuss the disposition of closed-end funds in more detail.