Classification of income into FDAP and ECI for Non Resident Alien
The IRS classifies income into two general categories:
- The Fixed,-Determinable,-Annual,-Periodical-(FDAP)-Income. This class of income is subject to a high flat tax rate. It does not allow for any netting of related expense, FDAP applies on stock dividends, bond coupons and US savings account interest.
- The Effectively-Connected-Income-(ECI)), meaning connected to some business or activity in the US. ECI is subject to gradual income tax on the basis of US based net income. The important difference it makes for investor is only taxed on Net Income.
The ECI treatment allows for deduction of all expenses related to the investment, including mortgage interests, local taxes, insurance, repairs, property management, etc. NRA who own real estate directly and supports these costs can and should elect for ECI treatment. Not doing so would result in the property expenses not being offset against income, and the gross income being taxed at a high flat rates of 30%. A consequence of opting for ECI treatment which is the same advantageous treatment that US investors get, is that the NRA must file US income taxes with the IRS every year.
The election of ECI treatment is done by submitting an election with the tax return (US tax code 871(d)). To avoid withholding of 30%, the alien needs to submit a W8ECI form to his a property manager. He will require this before he distributes any of the rents to the owner, as he is registered as a withholding agent with the IRS. The NRA will need to fill a W8ECI form and send it to his property manager, whereas a US resident is required to file a W9 form.