Introduction
Foreign investors actively invest in United States real estate by speculating on land and developing homes, condominiums, shopping centers, and commercial buildings. Many foreign investors also own recreational property in popular U.S. vacation destinations. This article attempts to summarize the Foreign Investment in Real Property Tax Act of 1980 (hereinafter “FIRPTA”) consequences surrounding a foreign investor’s acquisition of U.S. real property interests. FIRPTA is designed to ensure that a foreign investor is taxed on the disposition of a U.S. real property interest. Under FIRPTA, gains or losses realized by foreign corporations or nonresident alien individuals from any sale, exchange, or other disposition of a U.S. real estate interest are taxed in the same manner as other income effectively connected with the conduct of a U.S. trade or business. See (All reference made to the Internal Revenue Code (hereinafter “IRC”) shall mean that of 1986 as amended) IRC Section 897(a)(1). This means that gains from the disposition of U.S. real property interests are taxed at the regular graduated rates, whereas losses are deductible from effectively connected income.
To ensure collection of the FIRPTA tax, a withholding mechanism was eventually established by the Tax Reform Act of 1984. Internal Revenue Code Section 1445 requires that, when a foreign person disposes of a U.S. real property interest, the “transferee” must withhold 15 percent of the amount realized by the transferor on the disposition and pay it to the United States Treasury. A transferee includes “any person, foreign or domestic, that acquires a U.S. real property interest by purchase, exchange, gift, or any other transfer.” See Treas. Reg. Section 1.445-1(g)(4). Since it applies to the proceeds of the disposition and not to the income realized on the sale of the property, the imposition of the withholding obligation could be for an amount not necessarily equal to the income tax liability. In fact, the withholding obligation is imposed on gross receipts rather than gross income. Any tax imposed on a foreign person in excess of the amounts withheld remains the liability of the foreign investor. The foreign person is entitled to recover any portion of the tax withheld that exceeds the actual tax liability, but must file a refund claim with the IRS.
The amount to be withheld on the sale by the foreign investor of a U.S. real property interest generally is the lesser of 15 percent of the “amount realized” or the transferor’s “maximum tax liability.” The amount realized equals the cash and fair market value of other property received and any liability assumed by the transferee or to which the property was subject. Thus, the withholding obligation may exceed the cash paid by the transferee. The maximum tax liability tax alternative would come into play when the seller’s maximum tax is less than ten percent of the proceeds of the sale. Generally, the rate of the FIRPTA tax withholding is equal to 15 percent of the sales price.
Although the FIRPTA rules apply to the seller of real estate. If the seller does not comply with the FIRPTA withholding requirements, the IRS may place the responsibility for collecting the FIRPTA withholding on the buyer of the real estate purchased from the foreign seller. The property which withholding did not take place may be liened or seized by the IRS in order to satisfy the required withholding. Given what is at stake under the FIRPTA, purchasers of real estate should familiarize themselves with the FIRPTA withholding rules.
Exceptions to FIRPTA Withholding Requirements
Even though FIRPTA withholding rules have a broad reach, there are a series of exceptions to the FIRPTA withholding rules. Withholding is not required in the following circumstances:
- By the transferee of property if the transferor furnishes an affidavit 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” from the Internal Revenue Service (hereinafter “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.
- If the transferee is going to use the property as a residence and the amount realized by the transferor on the disposition does not exceed $300,000.
The Entities that Can Be Classified as a Seller for FIRPTA Purposes
FIRPTA requires a determination to be made if the seller of property is a U.S. person or a foreign person. This is because FIRPTA imposes a withholding obligation on the seller of real estate. If the seller of real property is a foreign person and not a “U.S. person” (as defined by the Internal Revenue Code), FIRPTA withholding may be required. A “U.S. person” has been defined under the Internal Revenue Code to include:
- U.S. citizen or resident alien;
- Domestic corporations, as defined by Internal Revenue Code Section 7701(a)(4);
- Domestic partnerships, as defined by Internal Revenue Code Section 761(a);
- Domestic trusts and estates, as defined by Internal Revenue Code Section 7701.
The Rules to Determine if an Individual Can be Classified as a U.S. Person for FIRPTA Purposes
One of the keys to minimizing FIRPTA exposure is to understand when the individual selling real property can be classified as a U.S. person for federal tax purposes. Under Internal Revenue Code Section 7701(a)(30)(A), an individual is a U.S. person if he or she is either a citizen or resident of the United States. Under Internal Revenue Code Section 7701(b), an individual who is not a U.S. citizen (i.e., an “alien”) may be a U.S. resident for U.S. income tax purposes (i.e., a “resident alien”) under the “permanent residence” test (hereinafter referred to as the “green card” test) or the “substantial presence” test. Additionally, an alien may, in certain circumstances, elect to be treated as a U.S. resident (known as a “First Year Election”).
Under the green card test, an alien is treated as a resident alien if he is a “lawful permanent resident of the United States” at any time during the calendar year. Under Internal Revenue Code Section 7701(b)(6), an alien is a lawful permanent resident of the United States at any time if: 1) the individual has been lawfully accorded the privilege of residing permanently in the United States as an immigrant in accordance with the immigration laws (i.e., the individual holds a green card); and 2) such status has not been revoked (and has not been administratively or judicially determined to have been abandoned). For an alien who qualifies as a resident alien under the green card test, residency for U.S. income tax purposes generally begins on the first day in the calendar year on which the alien is physically present in the United States while holding the green card.
Under the substantial presence test of Internal Revenue Code Section 7701(b)(3), an alien is treated as a U.S. person if he is physically present in the United States for at least 31 days in the current calendar year and 183 days during the 3-year period that includes the current calendar year and the previous 2 calendar years. In calculating an individual’s total day count for the relevant 3 year period, the number of days present in the United States in the current calendar year is multiplied by 1, the number of days present in the United States in the immediately preceding calendar year is multiplied by ⅓, and the number of days present in the 2nd preceding calendar year is multiplied by ⅙. As a general matter, an alien present in the United States 183 days or more in a taxable year, including partial days, is a U.S. resident for that year.
For purposes of FIRPTA, if the seller of real property is a U.S. citizen, green card holder, or meets the substantial presence test, withholding is not required. Determining whether a seller satisfies the green card test can be determined by viewing a seller’s alien registration card, or Form 551, more commonly referred to as a “green card.” Establishing whether or not a seller satisfies the substantial presence test can be done by viewing the Department of Homeland Security Official Site for Travelers Visiting the United States at https://i94.cbp.dhs.gov/I94/#/home.
If it is determined that the seller of real estate is a U.S. person by either satisfying the green card test or the substantial presence test, FIRPTA withholding is not required. Sometimes multiple sellers are selling real property. In cases where there are more than one seller, it must be determined if each seller is a U.S. person for FIRPTA purposes. In cases where one or more sellers does not satisfy the FIRPTA test, withholding will be necessary. The amount of withholding necessary is determined by making an allocation to the foreign investor. An allocation is made to the foreign investor based on the capital contribution of each seller. The capital contribution percentage formula is calculated as follows: [individual foreign seller’s amount of contribution to the real property at the time of purchase] divided by [total price paid for real property at time of purchase] = percent capital contribution, unless the sellers previously agreed to a different formula. Based on this formula, the capital contribution is then used to allocate the share of the sales price to each seller. See To Withhold, or Not to Withhold, That is the Question, A Step-by-Step Approach to the FIRPTA Income Tax Withholding, by Gil Acevedo, The Florida Bar Journal, Volume 92, No. 4 April 2018. In cases where the sellers are married, in general, each individual will be deemed to have made a capital contribution of 50 percent. See Treas. Reg. Section 1.1445-1(b)(3).
The Test to Determine if a Corporation can be Classified as a U.S. Person for FIRPTA Purposes
The definition of a “U.S. person” for FIRPTA purposes includes domestic corporations. For corporations, the test for FIRPTA purposes is whether or not it was established in the United States. If the a corporation is established under the laws of the United States, FIRPTA withholding is not required in connection with the sale of real estate. The application of this principle can bring about surprising results. Suppose a group of individuals that are citizens of the United Kingdom own a corporation that has property in California. If the incorporation papers were filed in Delaware, the corporation would be a U.S. corporation for FIRPTA purposes. By contrast, suppose that a corporation whose stock is traded on the New York stock exchange and owned by investors from a number of different countries is organized under the laws of the Cayman Islands. The corporation’s head office and place of management is located in New York. Under current law, this corporation is a foreign corporation for FIRPTA purposes.
Even if a corporation is classified as a foreign corporation for U.S. tax purposes, the corporation may avoid the harsh FIRPTA withholding requirements if it elected to be taxed as a domestic corporation under Internal Revenue Code Section 897(i). In this case, if the foreign corporation previously elected to be treated as such, then it simply has to provide a copy of the acknowledgment from the IRS as evidence confirming the domestic election. See Treas. Reg. Section Treas. Reg. Section 1.1445-2(b)(2)(ii). If the corporate seller provides supporting evidence at closing, FIRPTA withholding will not be likely be required.
The Test to Determine if a Partnership can be Characterized as a U.S. Person for FIRPTA Purposes
As with corporations, the definition of a “U.S. person” includes domestic partnerships. For federal tax purposes, a partnership includes a syndicate, group, pool, joint venture or other unincorporated organizations through or by means of which any business, financial operation, or venture is carried on. See IRC Section 761(a). For FIRPTA purposes, if a partnership was created or organized in the United States, it is a domestic partnership. In which case, FIRPTA withholding does not apply in connection with the sale of the partnership’s real property.
The Test to Determine if a Trust or Estate is Classified as a U.S. Person for FIRPTA Purposes
The rules become more complex if a trust or estate that is selling real property is subject to backup withholding. U.S. trusts are not subject to the FIRPTA withholding rules. Foreign trusts on the other hand are subject to the FIRPTA withholding rules in connection with the sale of the trust’s real property. Internal Revenue Code Section 7701(a)(30)(E) contains a two-part test for determining whether a trust is a U.S. or foreign trust. If both parts of the test are met, the trust is a U.S. trust. If either part of the test is not met, the trust is a foreign trust. See IRC Section 7701(a)(31)(B). Under the first part of the test, a U.S. court must exercise primary supervision over administration of the trust. Under the second part of the test, one or more U.S. fiduciaries must have the authority to control all substantial decisions of the trust.
In regards to estates, foreign estates are subject to FIRPTA withholding rules. Internal Revenue Code Section 7701(a)(31)(A) defines a foreign estate as one that is not subject to taxation on its worldwide income. Under this rather circular definition, an estate is a foreign estate if it is taxable by the United States in a manner similar to a nonresident alien individual. Any other estate is treated as a U.S. estate. See IRC Section 7701(a)(30)(D). Under revenue rulings and judicial decisions, a number of rules have been promulgated to determine if an estate is comparable to that of a nonresident alien individual. These factors include the location of the estate assets, the country under whose laws the estate is administered and the nationality and residence of the executor, the decedent and the beneficiaries. See Rev. Rul. 81-112, 1981-1 C.B. 598.
Determining the residency of a trust or estate for FIRPTA purposes could be a very difficult analysis. Such an analysis may require an analysis regarding the residency of any relevant trustee or fiduciary. It may also require a determination of which country the trust or estate had a closer connection.
FIRPTA Withholding and the Potential Liability to the Unsuspecting Buyer of Real Property
If it is determined that the seller of real property is a foreign person, whether or not withholding must take place requires a multi-step separate analysis. If the seller is a foreign person, the initial step is to determine whether the real property being sold is residential property. If the real property that is being sold by the foreign person is commercial property, then no exception applies and the foreign seller is subject to the 15 percent FIRPTA withholding rate. Provided the real property is residential property, the next question is whether the buyer, not the seller, is an individual. If the buyer is an individual person, the next question is whether the buyer will acquire the real property for personal use as a residence.
The Income Tax Regulations state that real property is acquired as a “residence” if on the date of the transfer the buyer has plans to reside at the property for at least 50 percent of the 24 months following the sale. In this case, the sale is not subject to withholding and no form or other document needs to be filed with the IRS to establish a transferee’s entitlement to rely upon the exception. In this case, it is only recommended that the buyer sign an affidavit acknowledging the residence requirement timeline previously mentioned. If such affidavit is provided, subject to certain qualifications, the seller may be exempt from the withholding. The seller may also qualify for a reduction on withholding depending on the sales price to be discussed below. With that said, if it is known that the real property is to serve as a rental property or other commercial investment, then no exception or reduction applies, and tax withholding is required.
A buyer must tread carefully in this area because if withholding does not take place and the buyer elects to use the property for commercial purposes or decides to sell the property before the time allotted by the Income Tax Regulations, he or she could be stuck paying the withholdings that should have taken place.
The second step in the FIRPTA analysis is to determine the sales price of the real estate. If the sales price of the real estate is $300,000 or less, then the tax withholding is not required. See IRC Section 1445(b)(5). If the sales price is equal to or more than $300,001, but the amount realized is equal to or less than $1 million, then the seller would qualify for a reduced withholding of 10 percent (instead of 15 percent). See IRC Section1445(c)(4).
The above rules demonstrate the complexities of the FIRPTA withholding rules. The FIRPTA rules could place the responsibility of withholding on the buyer of real estate from a foreign person or entity. Given these hazards facing buyers, when in doubt as to FIRPTA withholding, a buyer should always play it safe and withhold.
Anthony Diosdi is one of the founding partners of Diosdi Ching & Liu, LLP, a law firm with offices located in San Francisco, California; Pleasanton, California; and Fort Lauderdale, Florida. Anthony Diosdi concentrates his practice on tax controversies and tax planning. Diosdi Ching & Liu, LLP represents clients in federal tax disputes and provides tax advice throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: Anthony Diosdi – adiosdi@sftaxcounsel.com
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.