U.S. residents with foreign vacation homes and foreign rental properties may unwittingly be subject to U.S. tax on interest paid to foreign banks. A 30% tax is imposed on U.S. source interest received by foreign corporations. Code § 881(a)(1). Interest is sourced in the U.S. if the obligor is resident in the U.S. Code § 861(a) provides:
The following items . . . shall be treated as income from sources within the United States . . . . (1) Interest from . . . obligations of noncorporate residents . . . .
Although the tax is technically imposed on the foreign lender, the person making the payment is required to withhold the 30% tax and can also be held liable for the tax. Code §§ 1441, 1442, and 1461. U.S. citizens and aliens residing in the U.S. that have borrowed to purchase real estate outside the U.S. are typically astonished to learn that this tax exists, and that they can be held liable for the tax.
- This is not a purely theoretical matter. In Housden v. Commissioner, 63 TCM 2063 (1992), a U.S. resident individual had existing loans from a Canadian bank prior to moving to the U.S. After he moved to the U.S., he continued to make payments on the loans from the Canadian bank. The Tax Court held that he was liable for the withholding tax. For a chart of this case, see Housden.
Income tax treaties between the U.S. and foreign countries typically reduce the withholding tax rate. However, if you want to rely on the treaty, you need to obtain a Form W-8BEN, Certification of Foreign Status of Beneficial Owner for United States Tax Withholding, from the foreign bank where the bank certifies that it qualifies for treaty benefits. Regardless of whether a lower treaty rate applies, Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons (and Form 1042-S) must be filed to report the interest payments to foreign persons.
For U.S. citizens residing outside the U.S., this tax does not apply. As indicated above, sourcing is based on the residence of the obligor. Thus, if a U.S. citizen resides outside the U.S., the interest will be foreign source income and there will be no withholding tax.
If the foreign lender is not a bank, it may be possible to structure the loan in a way that avoids the tax under the "portfolio interest exception." Code §§ 871(h) and 881(c). However, banks acting in the ordinary course of business cannot qualify for the portfolio interest exception. Code § 881(c)(3)(A).