By Kerrin N.T. Liu
Despite the terrible toll COVID-19 has taken in the United States, the real estate market has perhaps surprisingly been booming amid historically low interest rates and an unprecedented exodus from cities into the suburbs. Houses located in the suburbs, especially near and around Northern California’s east and south bay, have been selling well above asking, all leading to a so-called “seller’s market”. Among the many homeowners who may be thinking of selling their home at this time are foreign investors who own recreational property in the United States. But U.S. persons buying homes from the foreign individuals need now, more so than ever, to be apprised of the rules and regulations governing the Foreign Investment in Real Property Tax Act of 1980 (hereinafter “FIRPTA”).
What is FIRPTA?
FIRPTA is a federal tax law that was enacted to ensure that foreign sellers pay income tax upon the sale of their U.S. real property. Foreign persons are defined under FIRPTA as nonresident alien individuals, foreign corporations, foreign partnership, foreign trust, or foreign estate. Although FIRPTA was enacted to collect income tax from foreign sellers, it is the U.S. buyer on which FIRPTA imposes the liability to collect and pay the FIRPTA tax itself. In what is often a shocking realization to unwitting homebuyers, buyers are regarded as “withholding agents” under FIRPTA and are generally required to withhold 10% or 15% of the sales price (and not the income realized) paid to the seller unless an exemption applies. See I.R.C. Section 1445. This FIRPTA tax is required to be reported and paid over by the 20th day after the date of closing on behalf of the buyer. Often this is done through the title company who collects the funds from the seller’s proceeds at closing and are remitted by the closing company on behalf of the parties. If proper withholding by the buyer does not take place in accordance with Internal Revenue Code Section 1445, the purchased property may be liened or even seized by the Internal Revenue Service. Although title companies often facilitate the withholding process, it does not ultimately unburden the buyer from their duty to withhold under FIRPTA.
One of the main questions that needs to be answered when investigating whether FIRPTA applies to a transaction is whether or not the seller is a so-called “foreign person”. Unfortunately, what seems like a straight-forward question has a complicated answer under FIRPTA. The IRS defines foreign persons as nonresident alien individuals, foreign corporation, foreign partnership, trust, or estate. Seller’s may not be considered a foreign person under FIRPTA if they pass the substantial presence test for the calendar year. The substantial presence test analyzes where the seller spends most of their time, regardless of their citizenship status
Under the substantial presence test, a seller is considered substantially present o the United States for that year if they are physically present in the United States for at least 31 days during the current year and 183 days during the three-year period that includes the current year and two years immediately before that. Under the substantial presence test, days present is calculated as all the days present in the current year, one-third of the days present in the first year before the current year, and one-sixth of the days present in the second year before the current year.
Should the calculation indicate that the seller was substantially present in the U.S. for that year, the buyer does not have a withholding obligation under FIRPTA and should obtain from the seller and file a FIRPTA affidavit attesting to the seller’s nonforeign status
For example, Brad (seller) was physically present in the U.S. on 120 days in each of the years 2018, 2019, and 2020. In order to determine whether Brad is considered a U.S. or foreign person, the buyer would count the full 120 days of presence in 2020, 40 days of presence in 2019 (⅓ of 120), and 20 days in 2018 (⅙ of 120). Since the total over 3 years is 180, Brad is not considered a resident under the substantial presence test for 2020 and buyer will need to do FIRPTA withholding on their transaction.
Given the harsh consequences which could occur should FIRPTA withholding not take place, it is of great benefit to buyers to understand the various main exemptions to FIRPTA withholding based in large part on the status of the seller, purchase price of the property and the eventual use of the buyer of the property as a residence. The following is, however, by no means an exhaustive list of FIRPTA exemptions as there have been numerous amendments to FIRPTA over the past 40 years, making the application of I.R.C Section 1445 anything but straightforward.
- If the transferor furnishes an affidavit as discussed above stating the transferor is not a foreign person and setting forth the transferor’s taxpayer identification number.
- On the disposition of an interest in a U.S. corporation if the corporation furnishes an affidavit stating that it is not and has not been a U.S. real property holding corporation during the last five years.
- If the transferee receives a “qualifying statement” or “withholding certificate” from the IRS that the transferor is exempt from tax or that adequate arrangements to secure payment of the tax or acceptable arrangements to pay the tax have been made. The transferee, the transferee’s agent or the transferor may request a withholding certificate. The IRS will generally grant or deny an application for a Withholding Certificate within 90 days after its receipt of a completed form 8288-B application.
- If the transferee is going to use the property as a personal residence for at least 50% 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, and the amount realized by the transferor on the disposition does not exceed $300,000. See Treas. Reg. 1.1445-2(d)(1).
- If the
seller declares non-recognition of gain or loss, generally found in instances
of the simultaneous 1031 exchange. In such cases, the transferee is not
required to withhold if “[t]he transferor gives written notice that no
recognition of any gain or loss on the transfer is required because of a
non-recognition provision in the Internal Revenue Code or a provision in a U.S.
tax treaty.” Such notice is called a “Declaration and Notice to Complete an
Exchange” (1031 Declaration and Notice). A transferee can rely on a 1031
Declaration and Notice only if: (1) the foreign person completes a simultaneous
exchange (i.e., the same day); and (2) the foreign person receives no cash or
Consequences of Noncompliance or Late Submission
Late submission may result in penalties and interest on the tax payable. Noncompliance could also result in a lien being placed on the property in question or even seized to the buyer’s detriment.
Given the often unforeseen consequences of failing to comply with FIRPTA withholding, it behooves buyers to be especially aware in cases where the seller indicates that they are a foreign person for purposes of the FIRPTA tax. The code governing FIRPTA exemptions is complicated and it is generally advised that FIRPTA-affected deals should involve competent tax professionals who are experienced in FIRPTA.
Kerrin N.T. Liu is a partner and attorney at Diosdi Ching & Liu, LLP. The tax attorneys at Diosdi Ching & Liu, LLP understand the rules and regulations governing FIRPTA and have represented clients who have been affected by FIRPTA. Kerrin Liu also represents clients in federal tax controversy and collection matters. Kerrin N.T. Liu may be reached at (415) 318-3990 or by email: firstname.lastname@example.org.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.