Nonresident Alien

A nonresident alien is an individual who is neither a citizen of the United States nor a resident of the United States for federal tax purposes. Internal Revenue Code section 7701(b)(1)(B) states it as a residual: "An individual is a nonresident alien if such individual is neither a citizen of the United States nor a resident of the United States (within the meaning of subparagraph (A))." Because it is defined by exclusion, the status is never determined directly. You test residency first, using the green card test, the substantial presence test and the first-year election in section 7701(b)(1)(A), and a non-citizen who fails all three is a nonresident alien.

The label is a tax classification, not an immigration one. Someone can hold a valid US visa, work in the United States for months, and still be a nonresident alien; someone can be outside the country all year and still be a resident alien because they hold a green card. Immigration status feeds into the tax tests but does not decide them.

The two tax regimes, and why the difference is so large. Section 872(a) limits a nonresident alien's gross income to two buckets: US-source income that is not effectively connected with a US trade or business, and income that is effectively connected. Section 871 then taxes them on completely different principles.

The first bucket is taxed under section 871(a)(1) at a flat 30 percent of the gross amount received, on a list that begins "interest, dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, and other fixed or determinable annual or periodical gains, profits, and income." Tax practice shortens that to FDAP. Gross is the operative word: section 873(a) allows deductions only against effectively connected income, so no expense, no loss and no basis reduces a FDAP amount. A $1,000 US dividend produces $300 of tax whether the recipient is wealthy or destitute.

The second bucket is taxed under section 871(b)(1) "as provided in section 1 or 55" on taxable income that is effectively connected with the conduct of a US trade or business. That means the ordinary graduated brackets, and it means deductions connected with that income are allowed. Section 873(b) adds three deductions allowed regardless of connection: casualty and theft losses on property located in the United States, charitable contributions, and the personal exemption allowed by section 151. The third is currently worth nothing to anyone: section 151(d)(5) sets the exemption amount at zero for tax years beginning after 2017, so in practice the exception carries the first two.

Withholding is the collection mechanism, and it is set at the statutory rate. Section 1441(a) requires any person with control or custody of a US-source FDAP payment to a nonresident alien to "deduct and withhold from such items a tax equal to 30 percent thereof." The payer, not the recipient, carries that duty, which is why a US broker withholds on dividends before they reach a foreign account. A recipient claiming a lower treaty rate has to certify foreign status and treaty eligibility to the payer, for an individual on Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding and Reporting. Without the certificate the payer withholds at the full rate.

Capital gains are the strange case, and the rule surprises people. A nonresident alien is generally not taxed by the United States on gains from selling US stock. But section 871(a)(2) imposes the 30 percent tax on net US-source capital gains for "a nonresident alien individual present in the United States for a period or periods aggregating 183 days or more during the taxable year." So the same trade is untaxed for someone who visited briefly and taxed at 30 percent for someone who spent most of the year in the country without becoming a resident. Gains on US real property interests are governed by a separate regime and are not covered by this rule.

The portfolio-interest exemption removes most US-source interest from the tax. Section 871(h) disapplies the section 871(a) tax for interest that meets its conditions. The interest must be paid on an obligation in registered form, and the payer must generally receive a statement that the beneficial owner is not a US person. The exemption does not reach interest received by a 10-percent shareholder of the issuer. This is the reason foreign investors can hold US bonds without a 30 percent haircut on the coupons while foreign investors in US stocks cannot avoid withholding on dividends the same way.

US rental income has an election attached to it. Rent is FDAP, so by default a nonresident alien landlord is taxed on 30 percent of the gross rent with no deduction for the mortgage, the property tax, repairs or depreciation. Section 871(d) lets the individual elect to treat income from US real property held for the production of income as effectively connected, in which case it "shall be taxable as provided in subsection (b)(1) whether or not such individual is engaged in trade or business within the United States." That moves the rent to the net-basis, graduated-rate regime with deductions. The election stays in effect for later years unless the Secretary consents to a revocation, and section 871(d)(2) then bars a new election before the fifth taxable year beginning after the first year for which the revocation took effect, absent the Secretary's consent.

The filing consequences are a short list of hard bars. Section 63(c)(6)(B) sets the standard deduction at zero for a nonresident alien. Section 6013(a)(1) provides that "no joint return shall be made if either the husband or wife at any time during the taxable year is a nonresident alien." Section 2(b)(3)(A) provides that a taxpayer is not head of household "if at any time during the taxable year he is a nonresident alien." The return itself is Form 1040-NR, US Nonresident Alien Income Tax Return. A treaty can override individual pieces of this, and there is a separate route for a couple in which one spouse is a nonresident alien to elect resident treatment for both, which belongs to the resident alien side of the line.

Status can change mid-year, and the two halves are taxed separately. Section 7701(b)(2) sets residency starting and ending dates, so a person who arrives or leaves partway through a year is a nonresident alien for part of it and a resident for the rest. That produces a dual-status year, in which the nonresident portion is taxed under section 871 and the resident portion under the ordinary rules.

The sequence is: test residency under section 7701(b); if the individual is a nonresident alien, sort each item of US-source income into effectively connected income or FDAP; apply graduated rates on the net for the first and 30 percent on the gross for the second; check whether a treaty reduces the FDAP rate; and file Form 1040-NR if a return is required, claiming credit for amounts already withheld.

A hypothetical example. Kenji lives in Osaka, is not a US citizen and holds no green card. He spends 40 days in the United States during the year and had no US presence in either of the two preceding years, so his weighted three-year count is 40 and he does not meet the substantial presence test. He is a nonresident alien. He has two US-source items.

US dividends of $8,000. These are FDAP, not connected to any US business, so section 871(a)(1)(A) taxes them at 30 percent of the gross: $8,000 × 0.30 = $2,400. His broker withholds that under section 1441 and remits it. No expenses reduce it. If Kenji files a valid Form W-8BEN and a treaty reduced the dividend rate to 15 percent, the withholding would instead be $8,000 × 0.15 = $1,200, a saving of $1,200. The 15 percent here is illustrative; the rate depends on the specific treaty.

A US rental property producing $30,000 of gross rent, against $22,000 of mortgage interest, property tax, insurance, repairs and depreciation. By default rent is FDAP too, so the tax would be $30,000 × 0.30 = $9,000, with none of the $22,000 deductible. If Kenji makes the section 871(d) election, the rent becomes effectively connected income taxed on the net: $30,000 − $22,000 = $8,000 of taxable income at graduated rates. At a 12 percent marginal rate that is $960, against $9,000 without the election.

The comparison is why the election exists, and why a nonresident alien who buys US rental property and never makes it can pay several times the tax a US owner would on the same building.

Pros

• The US tax base is narrow. Foreign-source income of a nonresident alien is outside the US system entirely, which is the opposite of the worldwide taxation a US citizen faces.
• Gains on US securities are generally not taxed by the United States for a nonresident alien who is not present 183 days or more in the year.
• The portfolio-interest exemption removes US tax on most US-source interest paid on registered obligations to foreign individual investors.
• Withholding at the source means most nonresident aliens with only investment income have no US return to file.

Cons

• The 30 percent FDAP tax is on the gross. No deduction, no basis, no loss offset, and it applies at the same rate regardless of the recipient's circumstances.
• The standard deduction is zero, and most personal deductions are unavailable because section 873(a) limits deductions to those connected with effectively connected income.
• A joint return is barred where either spouse was a nonresident alien at any time in the year, and head of household is barred outright.
• Default treatment of US rental income on the gross is punitive, and the section 871(d) election that fixes it is easy to overlook and hard to revoke.
• Treaty benefits are not automatic. Miss the certification to the payer and the full statutory rate is withheld, leaving a refund claim as the only remedy.