Hi,

I am on an H1B visa and have been working in the US for 4+ years. I purchased a condo (only property I own) in India 3 yrs ago (2006) and got a mortgage (through a bank in India). I make a monthly mortgage payment out of my salary here (I have no other income) to this bank in India.

On advice of my tax filers, I claimed the interest deduction on my US tax return (I don't file taxes in India as I don't have any income there). I did this for the first time for the 2008 tax year and the refund came through without any hassle. Now I am wondering whether to amend my previous two years (2006 and 2007) tax returns to claim the interest deduction since I didn't claim it for those tax years.

I am being now told by a different CPA that there is a possibility that I could be asked to withhold 30% of the interest payment since this bank that I make my mortgage payment to doesn't file taxes in the US and doesn't provide a 1098 either.

So my question is, is there a risk of the IRS asking me to withhold 30% which would then make this deduction not worth seeking? I have read various threads on many forums on the topic but I am not clear what happens in the case of the property as well as the mortgage provider being foreign based but being paid out of income in the US.

Thanks,

Yes, you need to withhold. For a discussion of this issue, see
https://www.askmehelpdesk.com/taxes/...st-323588.html

And

https://www.askmehelpdesk.com/taxes/...ry-181648.html

The risk IS definitely there that the IRS may ask you to withhold funds for interest paid to a foreign bank.

However, to date, it has NOT happened with any of my clients, and I have claimed the mortgage interest deduction for interest paid to a foreign bank for the past four tax seasons, on about 20 returns per year.

So you need to evaluate whether it is worth the risk or not.

ATE, there is clearly a requirement for a U.S. resident paying interest to a foreign person to file Form 1042 and to pay the withholding tax if no treaty applies.

You seem to be suggesting that taxpayers should consider whether the IRS will catch them if they don't file. How is this different than suggesting that self-employed individuals that don't receive 1099s consider the risks of getting caught if they don't file Form 1040?

IntlTax:

I did not intend nor counsel that they break the law. I merely pointed out that enforcement of this provision of the law is spotty at best.

However, I see your point, but I question as to how a foreign bank can be considered to be on the same level as a foreign person, and I suspect that is WHY there is no consistent enforcement by the IRS on this matter.

The term "person" means an individual, a trust, estate, partnership, association, company, or corporation. Code § 7701(a)(1). Thus, it is quite clear that a foreign bank would be considered a foreign person.

The IRS can't enforce withholding when it doesn't know about the payments. That is the purpose of Form 1042. From a professional responsibility perspective, how do you not prepare Form 1042 for your clients that make such payments?

Noted about the bank being considered a "person.

The client has to agree to the process, and to the associated fees for preparing the Form 1042.

I have to amend my previous posting.

Prior to the 2009 tax season, I was NOT aware of the withholding requirement, and last year, I did NOT include any deduction for mortgage interest from a foreign bank. Now that I am aware of it, I tell the clients about it in detail, and, to date, they have decided it is NOT worth the trouble, esepcially if the home is in Pakistan or India, where the interest deduction is so small that it has little effect on their overall deduction.

In your experience, have you had ANY luck getting a foreign bank to agree to have 30% of their monthly payment withheld and sent to the IRS?

In my mind, the negotiation of the fee is not relevant in the context of professional responsibility. If I have explained to a client that they have an obligation to file a form and they are unwilling to pay to have the form filed, I would feel compelled to terminate the relationship.

Note that the requirement to file Form 1042, and if necessary to withhold, is independent of whether a deduction is claimed on Form 1040. It is the payment of the interest, not the claiming of the deduction that triggers the obligation to file/withhold.

Although it may on the surface seem so, it is not relevant whether the foreign bank/person agrees to the withholding. The U.S. tax is due regardless of such agreement. If withholding is requried, one option would be to make full payment of the interest to the foreign person and also to make payment of the tax to the IRS.

IntlTax:

I have relied on your expertise in this matter without doing my own research. This case, however, caused me to call the IRS International Tax Hotline to discuss my legal and ethical requirements on this matter.

The IRS representative listened to my concerns and specifically noted that the property on which the mortgage interest was paid lay OUTSIDE of the United States and that the interest was paid to a foreign bank.

He stated that the interest portion of the payments was clearly tax deductible on the resident alien's Schedule A.

After doing a bit of research, he came back to state that, if the property was located OUTSIDE of the United States, there is NO withholding requirement. He cited IRS Pub 515, page 18. The relevant section is below. His contention is that withholding of interest is required only if the property is located WITHIN the U.S.

Interest on real property mortgages (Income Code 2). Certain treaties (see Table 1) permit a reduced rate or exemption for interest paid or credited on real property mortgages. This is interest paid on any type of debt instrument that is secred by a mortgage or deed of trust on real property located in the United States, regardless of whether the mortgagor (or grantor ) is a U.S. citizen or a U.S. business entity.

Further, in an earlier post, Five Rings noted that U.S. citizens who resided outside of the U.S. did NOT have a withholding requirement on mortgage interest paid to a foreign bank on real property that they owned outside of the U.S. I believe you conceded that fact. If so, why would the taxpayer's location (inside the U.S. versus outside the U.S.) change the requirement?

I am not relying solely on that IRS agent's interpretation of IRS Pub 515, and I have not finished doing the research, but my preliminary findings seem to indicate that the IRS does NOT require any withholding on interest paid to a foreign person if the property is loacted outside of the United States.

Can you provide a specific reference or citation, preferably with a URL link, that states that mortgage payments paid by a U.S. resident to a foreign person (in our case, a foreign bank) on a property located outside of the United States?

Even I had called the IRS int'l tax line and got the same answer as ATE.

Here is a link to another forum where a response by username "Lizzit" to a similar question was interesting:

TaxAlmanac - Discussion:Mortgage Interest Deductibility on a Vacation Home Outside the US

My original tax filers have the same experience as ATE that none of their clients have had an issue in getting this deduction without having to withhold. It seems to be adding up. Of course you all are the experts so I will have to go with whatever is deemed the right thing.

Thanks,

I don't disagree that the interest is deductible as mortgage interest. The 30% tax is independent of the interest deduction.

As you may know, the I.R.S. advice is notoriously inaccurate. In a 2005 test of the I.R.S. telephone help line, the Treasury Inspector General determined that 34% of the answers provided were incorrect. Customer Accuracy at Taxpayer Assistance Centers Showed Little Improvement During the 2005 Filing Season

Page 2 of Publication 515 states that:
Page 3 of Publication 515 states that:
Page 16 of Publication 515 states that:
To summarize, interest from U.S. sources paid to foreign persons is subject to a 30% withholding tax. The person making the payment must withhold. Treaties may reduce the tax or eliminate it.

So the next question is: What is the source of mortgage interest paid by a U.S. resident on a foreign located property? Section 861(a) provides that:
We have been discussing individuals paying interest to foreign banks. Individuals are “noncorporate” persons. If the individual resides in the U.S. then the interest income would be sourced in the U.S. As you indicated, I agreed with Five Rings that interest paid by individuals that reside outside the U.S. would not be subject to the withholding tax. This is because the sourcing rule is based on residence. If the person who owes the money (the “obligor”) resides in the U.S. the interest is U.S. source income. On the other hand, if the person who owes the money (the “obligor”) resides outside the U.S. the interest is not U.S. source income. Only U.S. source income is subject to the withholding tax. Thus, what Five Rings stated is correct.

This rule applies regardless of where the property is located. Sourcing for interest is not based on where the mortgaged property is located. Instead, source for interest is based on where the person who owes the money resides. The regulations under section 861 support this. Treas. Reg. § 1.861-2(a) provides in part:
Chart B on page 14 of Publication 515 is consistent. The chart is titled “Summary of Source Rules for FDAP Income.” The chart states that “IF you have.. . Interest.. . THEN the source of that income is determined by.. . The residence of the payer.. . ” On page 15 of Publication 515, it states that interest is one of the types of “FDAP income.”

The language you quote from Page 18 of Publication 515 indicates that certain treaties permit a reduced rate or exemption for interest paid on real property mortgages, and that the treaty reduction/exemption applies to interest paid on debt instruments secured by a mortgage on real property located in the United States. I agree that treaties may reduce or eliminate the withholding tax. The language in the publication is sloppy because it refers only to real property located in the United States. However, this does not mean that there is an exemption if a treaty doesn't apply.

If you report the interest payments on Form 1042 (as they should be reported because they are U.S. source interest payments) and you don't include the 30% tax, I think you will find the I.R.S. has a different opinion about whether tax would be due, even if you explain that the interest is related to a mortgage on a property located outside the U.S.

Attached is a copy of the Housden case, which holds that interest paid by a U.S. resident is subject to the withholding tax.

Attached Images

Housden.pdf (121.2 KB, 900 views)

This is a very interesting question and I did not pay enough attention to it when it first came up for discussion.

Withholding tax on nonresident alien corporations is spelled out in secs. 881 and 1442.

However, in a general sense, one must turn to the US Model Treaty to determine US doctrine concerning this issue. I direct your attention to the USMT tech explanation of Art. 11:

ARTICLE 11 (INTEREST)

Article 11 specifies the taxing jurisdictions over interest income of the States of source and residence and defines the terms necessary to apply the article.

Paragraph 1

Paragraph 1 generally grants to the State of residence the exclusive right to tax interest beneficially owned by its residents and arising in the other Contracting State.

The term "beneficial owner" is not defined in the Convention, and is, therefore, defined under the internal law of the State of source. The beneficial owner of the interest for purposes of Article 11 is the person to which the income is attributable under the laws of the source State. Thus, if interest arising in a Contracting State is received by a nominee or agent that is a resident of the other State on behalf of a person that is not a resident of that other State, the interest is not entitled to the benefits of Article 11. However, interest received by a nominee on behalf of a resident of that other State would be entitled to benefits. These limitations are confirmed by paragraph 8 of the OECD Commentary to Article 11. See also paragraph 24 of the OECD Commentary to Article 1.

Paragraph 3

The term "interest" as used in Article 11 is defined in paragraph 2 to include, inter alia, income from debt claims of every kind, whether secured by a mortgage.

Thus, it would appear to me that a foreign bank in a country having a tax treaty with the US is exempt from withholding from interest arising in the US.

Now, in reference to Pub. 515 the relevant passage seems to me to be this:
Interest on real property mortgages (Income Code 2). Certain treaties (see Table 1) permit a reduced rate or exemption for interest paid or credited on real property mortgages. This is interest paid on any type of debt instrument that is secured by a mortgage or deed of trust on real property located in the United States, regardless of whether the mortgagor (or grantor) is a U.S. citizen or a U.S. business entity.

Note that this describes real property located within the US. What about property located without the US? What does the relevant treaty perscribe?

Five Rings, a tax treaty would only be applicable if U.S. law would have caused the income to be subject to tax in the first place. Before we get too much into a discussion of the Model Tax Treaty, do you agree that if no treaty applies, the mortgage interest payments by a U.S. resident to a foreign bank would be subject to the 30% U.S. tax under section 881 and withholding would be required under section 1442?

Yes, I do agree with that. No treaty means no protection from withholding as far as I can determine.

I have sent a letter to some contacts I have at IRS international to get some clarification, with authority, on this issue. It is very interesting, no?

I agree with IntlTax. Under US law, the interest is subject to US tax. Treaties may alleviate the burden in part or full.

IntlTax, Five Rings and TTE:

Thank you all for your very detailed input.

IntlTax: Yes, I recognize that the advice issued by the Tax Hotlines are not always accurate. That is why I asked for your detailed rebuttal, which I find illuminating. I have read the Housden case you provided, plus reviewed other sources. Unless Five Rings clarification request from the IRS yields some relief, it seems likely that:

- I will have to ask each resident alien client if they are making mortgage or other interest payments to foreign banks.

- If so, then they will have to request the bank provide them a copy of a properly-executed Form 4224 (or like form or correspondence) for the tax year in question.

- If no Form 4224 is produced, then, under U.S. tax law, the resident alien client is OBLIGATED BY LAW to withhold 30% (or the percentage allowed for by tax treaty) of the total annual payment and file Form 1042 annually.

- For India, the home country of the bulk of my clientele, my reading of the tax treaty limits the tax at 10%, so, for resident aliens from India, the withholding would be 10% vice 30%.

Five Rings: Interesting is NOT the word that comes to mind; I am thinking more like "blanking nightmare scenario" for my clients who are here on H-1B visas who are making mortgage payments to banks in their home country.

I truly hope that you are successful in getting a definitive answer from the IRS. You may want to inquire as to what the monetary minimum will be to trigger the withholding requirement. In other words, what is the annual payment amount that the IRS considers the minimum to initiate wthholding action, similar to the $10K minimum that triggers the FBAR requirement?

Comments/suggestions?

Also, can anyone share how many Forms 1042/1042S they have filed over the past few years?

A couple of minor additions. Form 4224 is the old form. See Form W-8BEN. Treaty benefits must be claimed on the Form W-8BEN (see Part II, lines 9a, 9b, 9c, and 10).

Form 1042 is required regardless of whether withholding is required.

Corrections noted.

How many Forms 1042 have you submitted this past year?

Excuse me for saying so but no one will do this.
No foreign bank will tolerate this circumstance.

If the IRS rules require it is like whistling past a grave yard and hoping for the best.

Henry IV, Part II
Owen Glendower: I can call demons from the vasty deep.
Hotspur: So can I. So can any man. But do they come when you do call them?

Let's get really complicated. Suppose an Indian national, resident in the US on a HIA visa, has an Indian bank account which he holds in joint tenency with his brother (wife, father, mother, friend). The brother pays the mortgage to the Indian bank on the indebtedness of his brother in the US. What is the source of the payment?

I have no clients that are required to file Form 1042.

With regard to Five Rings' comment that "no one will do this," I am not sure exactly what "this" is. While I agree that a foreign bank would likely not accept anything less than the full payment of the principal and interest, there is still an actual U.S. tax due and the person paying the interest is liable for the tax if they do not withhold.

As we have discussed in other threads, it may be possible to get treaty benefits, although the foreign bank would need to get a U.S. EIN and sign a W-8BEN certifying that they qualify for treaty benefits. This process may not be feasible.

If the numbers are big enough, it may make sense to consider the use of entities to structure around the problem.

If I had a client that was required to file Form 1042 and/or that was required to withhold tax and the client refused to file or withhold, I would likely terminate the relationship.