Residential Rental real estate includes rental housing (including mobile homes) where at least 80% of the rental income comes from people using the units as homes.

Renting such real estate is generally considered passive, even if a foreigner who can be the owner materially participates in it. The IRS considers rental activity to be passive if real estate is used by tenants and rental income (or expected rental income) is received mainly for the use of the real estate property.

In other words, owning a real estate rental property and collecting rental income is considered passive and not active in most cases. However, there are exceptions to this rule that one should be aware of.

Exceptions to the Passive Rental Income Rule

While rental income is almost always considered passive, there are possible exceptions to the rule. The IRS may treat income from rental property as active in the following cases:

• • The Real Estate Professional ExceptionA real estate professional spends the majority of his/her time in the real estate business by materially participating in it. To materially participate, a real estate professional should meet the following two requirements:
    • • He/she should spend more than 50 percent of his/her time working in real property businesses. And,
    • • He/she should spend more than 750 hours of service during the year.

    A real estate professional who meets the above two requirements materially participates in the real estate business. In such a scenario, rental activities from the real estate business may not constitute passive activity.

    Remember that the IRS real estate professional (REP) status differs from obtaining a license. As a real estate professional, you can only get tax benefits, but you are not licensed to practice legally.

    Foreigners may apply for a real estate license in the U.S. However, it may be difficult since most states require foreigners to be legally authorized to work in the country. Therefore, it is important to check individual state laws, as each state has its requirements for obtaining a real estate license.

  • Short-Term Rentals (STRs)Short-term rentals are properties with an average rental period of seven days or less. These generally include many condos, vacation cottages, time-shares, hotels, motels, and bed and breakfasts.

    As a result, these activities are not defined as rental activities but instead treated as businesses.

    Also, if significant services are provided to occupants, the activity may not be treated as a rental activity. These significant activities go beyond basic maintenance. This includes things like:

    • Daily cleaning
    • Concierge services
    • Meals or room service
    • Other hotel-like amenities

    Income from such short-term rentals may be classified as active business income. A foreigner planning to invest in short-term rentals in the U.S. should carefully analyze the related U.S. tax consequences.

  • Significant Personal Use of the Property

There are special rules for rental activities involving the owner’s dwelling. A dwelling is a residence if the owner used it for personal purposes during the tax year for several days, that’s more than the greater of:

• • • 14 days, or
    • 10% of the total days you rent it to others at a fair rental price.

This means homeowners who use their residence for more than 14 days or 10% of the total days rented at a fair rental price must report the rental income. They must allocate expenses proportionately between rental and personal use days based on the number of days.

Example: Let’s say Mike from Brazil has a vacation home in Florida. He uses a vacation home for three months out of the year. During the other nine months, the property is rented to unrelated individuals. Mike can deduct expenses associated with the nine rental months as rental expenses, but not expenses associated with the three months of personal use. However, they may be able to deduct the expenses associated with the three months of personal use as itemized deductions.

• Renting Property to Your Own BusinessAs a foreign individual, if you rent property to a partnership, LLC, S-Corp, or C-Corp in which you materially participate, the net rental income may be reclassified from passive to nonpassive (active).

  This is called the self-rental rules provided under the Regs. Sec. 1.469-2(f)(6). It may apply when you own real estate via a separate entity. Assuming you materially participate in the operating company’s activities, any rental income the entity produces is deemed active rather than passive.

  Example:

  A German investor, Sam, owned a C corporation in US and materially participated in its trade or business. Sam also owned an LLC in US that rented real estate to the C corporation. Here, Sam did not materially participate in the LLC’s rental activity. The rental activity generated a certain income, which Sam might think is passive income.

  However, the self-rental rule may be applied to the LLC’s rental of real property. Here, Sam, the LLC owner, materially participated in the business of the C corporation that rented the property. As a result, the income generated by the rental activity had to be recharacterized as nonpassive income under the self-rental rule.