Determining Taxable Income
Check Out Our Other Tax Guides!
Get all the information you need for your next tax season, all in one place
Determining What Income Is Taxable and How to Report It
If you are a nonresident alien, you are subject to U.S. income tax only on certain income from sources within the United States and on certain income connected with the conduct of a trade or business in the United States. Generally, you do not report income from sources outside the United States on your U.S. tax return. Your U.S. source income is divided into two general categories - income that is effectively connected with a U.S. trade or business and income that is not effectively connected with a U.S. trade or business.
Effectively Connected Income
Income that is effectively connected with a U.S. trade or business is reported on the first page of Form 1040NR. It is subject to tax at the same graduated rates that apply to residents and can be offset by allowable deductions. Effectively connected income can also be partially or fully excluded from your income by treaty provisions between the United States and your home country. See "Where to Find Treaty Information" under Tax Treaties below.
If you are in the United States as an F, J, M, or Q visa holder, you are considered engaged in business in the United States. That means any U.S. source income that is taxable to you in connection with your scholarly activities, such as wages or scholarship and fellowship grants, is included in this category. Also, any other income from personal services performed in the United States is generally considered effectively connected income.
Form 1040NR Graduated Tax Rates on Effectively Connected Ordinary Income for 2022:
- 10% on your taxable income from 0 - $10,275 (You pay 10% of taxable income)
- 12% on your taxable income from $10,275 - $41,775
- 22% on your taxable income from $41,775 - $89,075
- 24% on your taxable income from $89,075 - $170,050
- 32% on your taxable income from $170,050 - $215,950
- 35% on your taxable income from $215,950 - $539,900
- 37% on your taxable income over $539,900
Rates for Effectively Connected Capital Gains for 2022:
Net gains from capital assets owned by you for one year or less are called net short-term capital gains. On these gains, you pay the same rates as effectively connected ordinary income, shown above. The tax rate on net long-term gains (on capital assets held for more than one year), is 0% for most taxpayers, but the rate increases with your income to a maximum of 20% for most capital assets.
We have left out quite a bit regarding the computation of net long-term capital gains, and how these gains are computed. If you would like to read more, go to IRS Publication 544 (Sales and Other Dispositions of Assets), and IRS Publication 550 (Investment Income and Expenses).
Not Effectively Connected Income
If your U.S. source income is not effectively connected with a U.S. trade or business, it is reported on Schedule NEC on page four of Form 1040NR. It is generally taxed at a flat 30% rate and cannot be reduced by deductions and exemptions.
Treaty provisions between your home country and the United States might provide for a lower rate of tax. Common sources of income from this category include corporate interest, dividends, capital gains in excess of capital losses, prizes, awards, and certain gambling winnings.
If you are a nonresident alien, capital gains on stocks, securities, and other personal property are taxable only if you are present in the United States for at least 183 days during the tax year. A nonresident alien can be present in the U.S. for more than 183 days if they are an "exempt individual." (See the discussion under Residency Status, above.)
Generally, you cannot offset gambling winnings with gambling losses. However, if you happen to be a resident of Canada, you can claim gambling losses to the extent of gambling winnings under the U.S./Canada tax treaty. Bank interest received by nonresident aliens is statutorily excluded from taxation.
Effective or Not Effective?
Wages
Nonresident aliens are generally subject to tax on wages for services performed in the United States as effectively connected income. The general rules on personal service income are in Chapter Two of IRS Publication 519. However, there are exceptions to this general rule.
First, nonresident visitors with F, J, M, and Q visas can exclude pay received from a foreign employer, other than a foreign government. Second, any wages you receive might be exempt from U.S. tax under a treaty between your country of residence and the United States.
If you received taxable wages during the year, you should receive a Form W-2 from your employer within 30 days after the end of the year. If any of your wages are exempt from income tax under a tax treaty, you should receive a Form 1042-S (Foreign Person's U.S. Source Income Subject to Withholding) rather than a W-2 form. Record your taxable wages on page one of Form 1040NR on the line for wages.
Include any amount exempt by treaty ONLY on the line for income exempt by treaty (line 1k for 2023). Treaty-exempt wages are also reported on page 5, Item L. Attach one copy of any Form W-2 or Form 1042-S you received from your employer to the front of the return if paper filed. We e-file these forms, and for e-filed forms, this is not necessary.
Scholarships and Fellowships
Any scholarship or fellowship grant that is taxable to you is considered effectively connected income and is subject to graduated rates. It is reported on a separate line from wages on Form 1040NR. There are three ways, described below, in which part or all of your scholarship or fellowship grant can be excluded from income.
Foreign Source
If you receive a grant from a foreign payer, it is considered foreign source income and is not taxable. Generally, the source of a scholarship or fellowship grant is the source of the payer, regardless of who disburses the funds. Foreign source payments should not be reported on your tax return.
Qualified Scholarship
If you are a candidate for a degree, you can exclude amounts received as a scholarship or fellowship grant that you use for:
- Tuition and other fees you pay to the university to attend classes, and
- Fees, books, supplies, and equipment purchased due to course requirements. The amounts you used for expenses other than tuition and course-related expenses (such as room, board, and travel) are generally taxable
Also, any part of a scholarship or grant that is compensation for services cannot be excluded as a qualified scholarship. Attach one copy of any Form W-2 or Form 1042-S you received from the payor to the front of the return if paper-filed.
Schools are no longer required to report qualified scholarships you receive in the form of tuition benefits, so Form 1042-S will no longer show these amounts and they need not be reported on your federal tax return. You are supposed to attach a statement to your return if you exclude qualified scholarship payments that are reported on Form 1042-S (See Form 1040NR instructions). The statement should show:
- The amount of the grant
- The dates it covers
- The grantor's name
- Expenses the grant covers and conditions of the grant, and
- The amount that is taxable and tax-exempt
Here is a fill-in scholarship statement form that you can fill and print out for this purpose.
Treaty Exempt Scholarships
If there is a tax treaty between the United States and your home country, it might contain a provision that excludes scholarship payments from U.S. income. On Form 1040NR, put the excluded amount on the line reserved for treaty-exempt income and complete Item L on page 5. Attach one copy of any Form W-2 or Form 1042-S you received to the front of the return, if paper-filed.
See IRS Publication 901 and Tax Treaties, below, to learn about treaty benefits.
Investment Income
Reporting interest, dividend, and capital gain income is a little confusing. There are spaces provided to show it on page 1 and Schedule NEC page 4 as income that is not effectively connected with a U.S. trade or business. Reporting it on page 1 means it is effectively connected to a U.S. trade or business.
To be effectively connected, the investment income MUST have a direct economic relationship to your United States trade or business. For example, investment income reported on a K-1 of a partnership in which you have an interest could be classified as effectively connected income.
On the other hand, if you are a student or scholar with investment income, your trade or business in the United States is studying, teaching, or doing research. Therefore, your investment income would not be considered effectively connected income.
The tax rate on income not effectively connected with a U.S. trade or business is a flat 30% unless a treaty provision between the United States and your home country reduces the rate. Show the income on Schedule NEC page 4 and any U.S. tax withheld on the income, and compute the tax. The computed tax and related withholding are shown on page 2 of Form 1040NR.
Exempt Interest
Interest paid on deposits with banks, accounts or deposits with certain financial institutions, or certain amounts held by insurance companies are exempt from U.S. tax even though they are U.S. source income. If you file Form 1040NR, do not report this interest anywhere on the return.
Capital Gains
You do not pay tax on capital gains from the sale of stock or securities if you are a nonresident who has not been present in the United States for 183 days or more during the tax year UNLESS it is effectively connected income. In that case, tax applies at the lower capital gains rates for effectively connected income. However, if you are an "exempt individual" who resides in the United States longer than 183 days, you pay tax on not effectively connected capital gains. Unless a lower tax treaty rate applies, you pay the normal 30%.
Income from Rental Real Estate
You are given a choice regarding income from real property in the US. This income is generally considered not effectively connected with a U.S. trade or business and is taxed at a flat rate of 30% of gross income. A nonresident individual is not required to file a U.S. return if a tax of 30% is withheld by the payor (usually the property manager).
Alternatively, you can file a tax return and include an election (under IRC Section 871(d)) to have the net income (after expenses) taxed as income effectively connected with a trade or business in the US. Any net income is taxed at graduated rates beginning at 10%. Under Section 897 of the Code, gain on the disposition of real property by a nonresident alien is always treated as income effectively connected with a U.S. trade or business, and is therefore taxable, but at the generous capital gains rates.