What Income Is Taxable for Nonresident Aliens in the US?

Understanding the U.S. tax system as a nonresident alien (NRA) can be complicated when determining taxable income. Generally, nonresident aliens are only subject to taxation on income connected to the U.S. However, the tax treatment varies based on the type of income earned. Employment income, rental income, dividends, capital gains, and interest are taxed differently, and tax treaties can further influence your responsibilities.

It's important to understand these tax rules to prevent overpayment or missing vital filing responsibilities. In this blog, we will discuss the taxable income for nonresident aliens in the US, understand the exempt types of income, explore the impact of the India-US DTAA on taxation, and also explain how to report US source income accurately.

Who Is Considered a Nonresident Alien?

A nonresident alien (NRA) is a foreign citizen who does not hold a U.S. Green Card and does not satisfy the Substantial Presence Test. It is the test that the IRS uses to determine whether an individual has spent enough time in the U.S. to be treated as a tax resident.

For many Indian nationals, including certain NRIs, F-1 students, visitors, and some H-1B visa holders who have not yet met the substantial presence test, this classification may apply. If you lack a Green Card and haven’t reached the requisite number of days in the U.S. over three years, you are classified as a nonresident alien for U.S. tax purposes.

You are taxed only on the US source income as a nonresident alien. It means you don't need to report worldwide income. This differs fundamentally from the taxation of citizens, green card holders, and resident aliens, who must declare their global earnings.

What Income is Taxable for Nonresident Aliens in the US?

For nonresident aliens, US source income falls into two broad categories:

• Effectively Connected Income (ECI): It is the income that is directly associated with a U.S. trade or business that you are actively involved in. This income is taxed at the same graduated rates as those applicable to U.S. residents, after allowable deductions.
• Fixed, Determinable, Annual, or Periodic (FDAP) income: This is passive income from U.S. sources, such as dividends, interest, royalties, and rents. It is typically subject to a flat 30% withholding rate unless a tax treaty provides for a reduction.

Here is a breakdown of how various types of income are treated:

Employment Income

Wages earned for services performed within the U.S. are taxable, regardless of whether the employer is a U.S. or foreign entity. Hence, if you work in the US and recieve a salary for the same, it is categorized as U.S.-source income and is liable to federal income tax.

Employers will withhold federal income tax from paychecks and issue a W-2 at year-end. You'll report this income on Form 1040-NR and may incur taxes ranging from 10% to 37% depending on your income level.

Important for NRIs on an H-1B visa: If you work remotely from India for a U.S. company, the taxability depends on the location where services are performed. Also, the income earned for work executed entirely outside the U.S. is typically not subject to U.S. income tax, even if the employer is American.

Self-Employment Income

If you provide services for US clients while being physically present in the US, this income is considered ECI and must be reported on Form 1040-NR, subject to graduated rates. This includes consulting, freelancing, or contracting.

Self-employment tax (Social Security and Medicare) has special considerations. Generally, nonresident aliens are not subject to self-employment tax, although exceptions exist, especially for those on visas that do not exempt them. It’s advisable to consult a tax advisor regarding your specific case.

Interest Income

One area often misunderstood by NRIs is interest income.

• US Bank Account Interest: Interest earned on deposits with qualifying U.S. banks is generally exempt from U.S. tax for nonresident aliens under separate statutory rules. The portfolio interest exemption applies to certain qualifying debt obligations that satisfy specific IRS requirements.
• US Bond Interest: Interest from specific US government and corporate bonds may also qualify for the portfolio interest exemption, provided certain criteria are satisfied (the bonds must be in registered form, and you must certify your nonresident status).
• Taxable interest: Some US source income does not qualify for exemption, such as interest from a US business you own or interest linked to a US trade or business, which is taxed as ECI.

Dividend Income

For nonresident aliens, dividends from US corporations are generally subject to a 30% withholding tax. This withholding occurs automatically by the paying institution before you receive the funds.

According to the India-US DTAA, this rate is reduced to 25% or even 15% if the beneficial owner is a company with at least 10% of the voting stock of the paying entity. Most individual NRI investors generally qualify for the 25% treaty rate.

You must submit a valid W-8BEN to your broker or financial institution with the treaty claim correctly filled out in Part II to claim the reduced rate.

Rental and Capital Gains Income

• Rental Income from US Property: If you own a property in the US and rent it out, the rental income is US source income, which is taxable for nonresident aliens. You get two options:
• Either pay a 30% withholding tax on the gross rental income (no deductions), or
• Elect to classify the rental activity as ECI, allowing you to deduct mortgage interest, property taxes, depreciation, maintenance costs, and other expenses. This is taxed only on the net profit at graduated rates.

This election must be made using Form 1040-NR and is usually the more favorable option when you have significant expenses.

• Capital Gains from US Property: Selling US real estate is subject to taxation under the Foreign Investment in Real Property Tax Act (FIRPTA). It requires the buyer to withhold 15% of the gross sale price upfront and not just the gain. You will then report the actual gain on Form 1040-NR and reconcile the withholding with your actual tax liability.
• Capital Gains from US Securities: Generally, for nonresident aliens, capital gains from selling US stocks and other securities are not taxable, provided the gains are not related to a US trade or business. This exemption is particularly beneficial for NRIs investing in US markets via Indian brokerage platforms.

What Income is Not Taxable?

The following types of income are generally not subject to US tax for nonresident aliens:

• Capital gains from selling US stocks and securities
• Portfolio interest from US bank accounts and qualifying bonds
• Income from services provided entirely outside the U.S.
• Foreign-source income such as salary, rental income, dividends, and bank interest from India.
• Certain scholarships and fellowships for students on F-1 and J-1 visas (up to the amount covering tuition and necessary fees).

How Do Tax Treaties Affect Taxable Income?

Under the India-US DTAA (Double Taxation Avoidance Agreement), NRIs get significant relief on several types of income. The key provisions include:

Submitting Form W-8BEN before payment generally allows the withholding agent to apply the correct treaty rate immediately. If excess tax is withheld, you may generally claim the applicable treaty benefit on your Form 1040-NR, subject to IRS requirements.

How Do Nonresident Aliens Report Taxable Income?

Nonresident aliens use Form 1040-NR, which is the US nonresident alien income tax return. This form differs from the standard Form 1040 used by US residents. On Form 1040-NR:

• ECI (such as wages, rental income elected as ECI, and self-employment income) is reported with deductions and taxed at graduated rates.
• FDAP income (such as dividends after treaty reductions and withholding on royalties) is summarized separately.
• Claims for treaty exemptions and reduced rates are made in specified sections.
• If applicable, Form 8843 (exempt individual statement) is attached.

Common Tax Filing Mistakes

Here are some common tax filing mistakes to avoid:

• Not filing Form 1040-NR when necessary: Some NRIs think that tax withholding at the source eliminates the need to file a return. However, this is wrong. Filing allows for the reconciliation of withholding, claiming refunds for excess payments, and claiming any treaty exemptions not applied at the source.
• Failing to claim treaty benefits upfront: Not submitting W-8BEN ahead of receiving dividends means that the payer might withhold at a higher rate (30% instead of 25%). Although one can reclaim the overpayment through Form 1040-NR, it is wiser to get it right from the start.
• Not tracking US vs. non-U.S. days for residency purposes: If you spend considerable time in the U.S. across years, your day count may approach the threshold for the Substantial Presence Test. This will potentially change your status from nonresident to resident, with significant tax implications. So, it's crucial to track your days actively.
• Reporting worldwide income on 1040-NR: Nonresident aliens should only report US source income on Form 1040-NR. Including Indian or foreign income is wrong and can create unnecessary tax liability.

To Conclude

As a nonresident alien, your U.S. tax responsibilities focus only on U.S.-source income, but understanding the complex details is important. ECI is taxed at graduated rates following deductions, while FDAP income faces a 30% withholding tax, unless reduced by a treaty. Capital gains from U.S. securities typically enjoy an exemption, and income earned from work outside the U.S. is not taxed at all.

The most common confusion arises not from the complexity but from the lack of clarity regarding which categories your income falls into. Nonesident US tax compliance can become manageable by having the appropriate W-8BEN on hand, a correctly completed Form 1040-NR, and a solid knowledge of what qualifies for treaty relief.

Moreover, if you have various types of US source income, US property, or complex treaty claims, contact an expert at Savetaxs. Our experts can help you ensure you neither overpay taxes nor miss any important filing obligations. Contact us right away, as we are actively working 24/7 across all time zones and can help with complex issues of US tax for NRIs.