Scenario
Nonresident alien who is a citizen of Singapore wishes to make $400,000 loan to resident of the United States for the purchase of U.S. real property.
Non-Technical Analysis
With the current tight loan market for those without perfect credit, I have been seeing an increase in personal loans between family members. Even at historically low interest rates, family members often try to help out by offering a below-market or even zero-interest loan. However, this opens up an imputed interest problem wherein the lender's taxable income is calculated by adding the amount of interest the IRS thinks should have been charged to the lender's income.
I've also been seeing an increase in below-market family loans from foreigners to relatives in the U.S. Interest paid on a loan made to a person in the U.S. is U.S. income for the lender, and the lender would typically owe U.S. tax and the borrower would be liable for this tax through an onerous and relatively complicated withholding regime.
However, when the lender is a foreign relative who is not in the business of making loans, there is a good chance that you can avoid imputed income for the lender and avoid onerous withholding requirements. Additionally, if your foreign relative wishes to charge you interest, then there is a good chance that they won't be subject to any tax and you can still take advantage of the home mortgage interest deduction.
Technical Analysis
Applicable Tax Law
Singapore and the U.S. do not have an applicable tax treaty. Therefore the appropriate tax law for U.S. income tax purposes is Title 26 of the U.S. Code, hereafter referred to as the I.R.C. Additionally, the California Revenue and Taxation Code applies to all transactions in the exact same way as under the IRC, except as noted.
Analysis in Absence of Any Exemptions
Mortgage Tax Issues
It is crucial for you that the loan is a properly registered non-recourse mortgage so that you may take advantage of the home mortgage interest deduction, assuming that this is your principal residence or second home. (I.R.C. 163; Cal. Rev. & Tax. Code, 17201.)
Additionally, the interest rates on the mortgage must be fair market rates. If the interest rates are not fair market rates, then the lender is liable for imputed income based on fair market rates. For example, if the interest rate results in interest paid of $10,000, but a fair market interest rate would have resulted in interest paid of $20,000, then the lender's annual income would be increased by $10,000 for the purpose of calculating income.
Your Mother-in-Law's U.S. Tax Issues and the Consequences for You
The interest paid to your mother-in-law is U.S. source income for U.S. tax purposes and is subject to a 30% U.S. tax rate. (I.R.C. 871(a)(1)(A).) That means that your mother must pay 30% U.S. tax on her interest income.
Furthermore, as the payor on the mortgage you are responsible for withholding, reporting, and paying the 30% tax on the interest payments to your mother-in-law. (I.R.C. 1441.) You are required to withhold 30% of the interest payment at the time of payment, submit this payment to the IRS, and report this information to the IRS on form 1042-S and 1042. You are required to deposit with the IRS electronically, and the frequency with which you deposit the withheld taxes is determined by how much tax tax you have withheld. (See Treas. Regs. 1.1461-1(a), 1.6302-2(a).)
For example, if $1,000 of your monthly mortgage payment was for interest, then you are required to withhold 30% or $300. (I.R.C. 871(a), 1441.) Since that number is greater than $200 and less than $2,000, then you are required to electronically deposit $300 by the 15th day of the next month after the tax was withheld.
Analysis with Exemptions
If the loan is interest-free and your mother-in-law is not in the regular business of making loans, then there is actually a specific regulation that exempts your mother from imputed income for a below market loan. (Treas. Reg., 1.7872-5T(b)(10), (c)(2).) This means that you can receive a below market loan from your mother-in-law and not subject her to any tax.
Additionally, if your mother-in-law wishes to charge you interest and you want to take advantage of the home mortgage interest deduction, then you do not need to do any withholding on the interest payments so long as several technical requirements are met which result in the interest being qualified as "portfolio interest." (IRC 871(h); Treas. Reg. 1.871-14.) One of the requirements is that the mortgage must be registered. Another requires you to file a W-8 form with the IRS declaring that your mother-in-law is not a US person. If it's not registered, then the portfolio interest exception does not apply, and the withholding requirements do apply. You would, however, still need to file withholding documents with the IRS. Although this sounds complicated, it's not in practice. You just need to let your tax preparer know all of the facts, and make sure that they file all of the proper tax forms.
And you could combine the lack of imputed income with the portfolio interest deduction to receive a below market loan, and deduct the interest payments actually made.
