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Withholding is money withheld from the positive income generated from a US based investment. This is mandatory if it involves a non US resident. It basically means you receive only a portion directly from your investment whereas the amount withheld is paid to the US Tax office in your name where it is a credit in your name. This means that investment companies label the payment to the US Tax office in general as a distribution directly to you.

The amount withheld can be determined in a few different ways. It can be a percentage over the total sales price (10%) or a higher percentage over the profit and/or gain realized (35%) in that year. The gain is based upon the sales price minus the equity at the beginning of that fiscal year. Therefore this is not the actual gain because the equity is most likely reduced by depreciations and/or expenses made.

When the tax return is prepared there are elements that did not play a part in the determination of the amount withheld but can have an important impact on calculating the tax due. The main “new” elements are losses such as the Net Operating Loss (NOL) and the Passive Activity Loss Adjustment (PALA).

PALA consists of losses booked but not yet realized such as depreciation, renovation cost and/or management fees. They are registered in the tax return by investment every year as unallowed until the termination at which point the losses are actually realized. The equity paid in has been reduced with these losses and therefore create a gain that is not really made.

An example:

Paid in capital
Losses prior years
Equity beginning year of sale
Sales price
Equity beginning year of sale
Gain for that year and basis for withholding
Gain for that year
Correction for unused losses prior years
Realized gain

NOL consists of losses actually realized. Any deductions are added to this on a yearly basis. Also PALA that is remaining after an investment ends with a loss, as that loss is now unfortunately realized, is added to the NOL.

In the tax return we correct the gain, as listed for that one year, with these losses and because the actual tax rate is a lower percentage, than the one used to determine the amount withheld, there is most likely too much withheld. In the return the actual tax due is calculated and any overpayment asked to be refunded. Some of this can be done well before a return can be filed by filing a form 8804-C in which these losses are reported to the manager of your investment so they can preemptively lower the gain as the base for the withholding.

Refunds are in principal paid by the issuing of a paper check. If you have a bankaccount in America the refund can also be directly deposited. This will be faster and most likely cheaper than cashing a check.