Foreign buyers purchased a record $153 billion of U.S. real estate during the 12 months ending in March 2017, according to the National Association of Realtors®. As these buyers secured their pieces of the American dream, they may not have realized that Uncle Sam will want his share when it comes time to sell.
The Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) changed the way the government taxes U.S. real property transactions involving a foreign person or organization. The Internal Revenue Service defines a U.S. real property interest as an interest in real property, including an interest in a mine, well or other natural deposit, located in the United States or the U.S. Virgin Islands, as well as certain personal property that is associated with the use of real property, such as farming machinery. In this article, we will focus solely on real estate.
FIRPTA applies to foreign corporations, partnerships and other entities selling U.S. real property. It also applies to individual sellers who are nonresident aliens — individuals who are not citizens, do not hold a green card at any time during the calendar year in which the sale occurs and do not have “substantial presence” in the United States. “Substantial presence,” for U.S. law, means 183 days or more in the country during a calendar year; partial days count as full days, and there are rules for partially counting time in the country for the two years preceding. Resident aliens are not governed by FIRPTA because they generally must file income tax returns as citizens do.
Before FIRPTA, foreign persons who did not meet the U.S. residency requirements were often exempt from tax on U.S. real estate sales, in the way they are generally exempt from U.S. capital gains tax. Because the IRS cannot easily force foreign investors to file U.S. tax returns, FIRPTA built in a mechanism to ensure that the government gets its due. The law requires the buyer of the property to withhold a set percentage of the gross proceeds from the transaction, and that sum goes to the IRS. If it is less than the tax owed, the seller still owes the difference, but in the more typical instance where it exceeds the tax owed, the seller must file a tax return (Form 1040NR, 1120-F, etc.) to get the difference as a refund. The seller should file regardless, but the law’s mechanism provides more motivation to do so.
The PATH Act of 2015 raised the amount of withholding required under FIRPTA to 15 percent for dispositions after February 16, 2016; it was formerly 10 percent. Failure to withhold can make the buyer liable for the tax due on the transaction. In most instances, the closing agent will forward the withheld amount to the IRS following the closing.
You may have already realized that this process can cause substantial inconvenience for the seller, especially since withholding is required regardless of whether there is a gain or loss on the sale of the property. If an individual or entity regularly buys and sells real property, cash flow is an essential part of the business. Having a substantial part of the gross proceeds handed over to the IRS is not ideal, especially when getting a refund from the IRS can take over a year, depending on the timing of the sale.
The IRS does provide exceptions to FIRPTA withholding on dispositions. The most common are:
- The buyer acquires the property for use as a residence and the sales price is not more than $300,000.
- The buyer or a family member must have definite plans to reside at the property for at least 50 percent of the number of days the property is used by any person during each of the first two 12-month periods following the date of transfer.
- The seller gives written notice that no recognition of any gain or loss on the transfer is required because of a nonrecognition provision in the Internal Revenue Code or a provision in a U.S. tax treaty.
- The property disposed of is an interest in a domestic corporation, if any class of stock of the corporation is regularly traded on an established securities market. However, this exception does not apply to certain dispositions of substantial amounts of nonpublicly traded interests in publicly traded corporations.
- The disposition is of an interest in a publicly traded partnership or trust. However, this exception does not apply to certain dispositions of substantial amounts of nonpublicly traded interests in publicly traded partnerships or trusts.
Foreign buyers can also create a business structure to mitigate FIRPTA withholding. To do this, a nonresident foreign individual would create a two-tiered structure involving a foreign corporation and a U.S. corporation that owns the U.S. real estate. If structured and implemented correctly, the foreign individual could avoid FIRPTA withholding on the disposition of U.S. real estate and enjoy other U.S. estate and gift tax benefits. However, many foreign buyers have already purchased properties or don’t want to deal with the complexity of forming entities. So how do nonresident aliens deal with FIRPTA when their sale is subject to withholding? Are they stuck letting the IRS take what amounts to an interest-free loan because of the excess withholding on the sale? No. While FIRPTA sets the required withholding amount at 15 percent, it also stipulates that the amount withheld should not exceed the seller’s maximum tax liability. However, this provision is not automatic. Taxpayers must apply for withholding certificates in order to prove that this is the case.
A seller will need to file IRS Form 8288-B by the time of the property transfer to request a withholding certificate. A withholding certificate may be issued due to a determination by the IRS that reduced withholding is appropriate because:
- The amount that must be withheld would be more than the transferor’s maximum tax liability.
- Withholding of the reduced amount would not jeopardize collection of the tax.
- All gain realized by the transferor is exempt from U.S. tax.
- An agreement for the payment of tax providing security for the tax liability is entered into by the transferee or transferor.
Many individual sellers will end up applying for withholding certificates because their maximum liabilities are less than the required withholding amount. The IRS requires that the withholding certificate be applied for on or before the date of transfer of the property. If that is done, the withholding need not be paid over immediately. Instead, that amount, or such other amount as is appropriate, must be reported and paid over by the 20th day following the day upon which a copy of the withholding certificate or notice of denial is issued. The IRS promises to issue a withholding certificate within 90 days of receiving an application, so it is recommended that a seller apply for a certificate as soon as an agreement to sell the property is reached.
In addition to filing Form 8288-B, the seller must also inform the buyer in writing that he has applied for the certificate no later than the transfer day. If the IRS agrees with the calculations, it will issue a certificate that confirms the new amount. Note that applying for a withholding certificate does not negate the responsibility to file an income tax return.
When applying for a certificate, a seller will need to provide support regarding the expected tax liability from the sale of the property. This means providing support for the cost basis of the property by enclosing original settlement statements and receipts for any improvements that were added to the property’s basis. In addition, if the property was used in a trade or business, a seller should provide depreciation schedules and support for the adjusted basis of the property. For most foreign individuals, it is wise to hire a U.S. tax professional with experience in FIRPTA transactions to assist with this process, since providing the IRS with an estimate of expected tax liability will require running a tax projection.
I recently worked on a withholding certificate application for a client who was selling a rental property for $865,000. Under FIRPTA, the required withholding was $129,750, or 15 percent of the gross proceeds, which completely ignored the client’s cost basis in the property or the ultimate tax liability. My client wanted to use the proceeds to service other investments, so having a large portion withheld for taxes was not ideal. Therefore, we applied for a withholding certificate, and the IRS agreed to reduce the withholding to $61,400.
While the process of applying for a withholding certificate should not be especially onerous, a seller may run into problems with the buyer, especially if the buyer has not engaged in a transaction subject to FIRPTA before. As noted above, the buyer is held responsible for withholding and remitting the taxes to the IRS. If, for some reason, the proceeds aren’t properly submitted, the IRS could come after him or her. Therefore, a buyer or buyer’s agent may not wish to hold the money while a decision on a withholding certificate is being made. From the buyer’s standpoint, sending the funds to the IRS immediately may seem easier, even though the IRS authorizes the buyer to wait until a determination is made before submitting the withholding.
If the buyer refuses to cooperate, a seller can still file for a withholding certificate. However, doing so takes more steps and additional paperwork, since the seller will now have to apply for an early refund from the IRS. If possible, it is better to avoid this situation. A nonresident foreign seller should try to work with a real estate agent and title company that have experience working on real estate transactions involving FIRPTA. A seller should also try to find out if the buyer’s real estate agent has experience with such transactions. Regardless of the buyer’s experience, or lack thereof, a knowledgeable real estate agent will be more likely to cooperate with the seller’s representative. This can massively simplify the process. I also recommend that a seller include a clause in the sales contract that the buyer will cooperate if the decision is made to apply for a withholding certificate, and will not submit withholding to the IRS until a final determination is made. Being upfront with the agent and potential buyers will ensure a smoother sales process.
Many foreign buyers have staked claim to real estate here in the United States over the last several years. Most of them were likely not acting with FIRPTA in mind. Taking these steps can ensure that when it’s time to sell, Uncle Sam does not get a bigger share of the sales proceeds than required.