By Anthony Diosdi
U.S. real estate has become a popular investment with foreigners. However, few foreign investors fail to consider the U.S. tax implications of holding U.S. real property. There are significant income, gift and estate tax consequences that may result when U.S. real property is sold or transferred. This article discusses the withholding requirements of the Foreign Investment in Real Property Tax Act of 1980 (or “FIRPTA”) and how the FIRPTA withholdings may be reduced or eliminated.
Under FIRPTA, gains or losses realized by foreign corporations or nonresident alien individuals from any sale, exchange, or other dispositions of a U.S. real property interest are taxed in the same manner as income effectively connected with the conduct of a U.S. trade or business. This means that gains from dispositions of U.S. real property interests are taxed at the regular graduated rates, whereas losses are deductible from effectively connected income.
A U.S. real property interest includes interests in any of the following types of property located within the United States:
1) Land;
2) Buildings, including a personal residence;
3) Inherently permanent structures other than buildings;
4) Mines, wells, and other natural deposits;
5) Growing crops and timber; and
6) Personal property associated with the use of the real property.
For this purpose, an “interest” in real property means any interest (other than an interest solely as a creditor), including fee ownership, co-ownership, a leasehold, an option to purchase or lease property, a time-sharing interest, a life estate, remainer, or reversion interest, and any other direct or indirect right to share in the appreciation in value or proceeds from the sale of real property.
A U.S. property interest also includes interest (other than an interest solely as a creditor) in a domestic corporation that was a U.S. real property holding corporation at any time during the five-year period ending on the date of the disposition of such interest or, if shorter, the period the nonresident held the interest. This prevents foreign persons from avoiding the FIRPTA tax by incorporating their U.S. real estate investment and then realizing the resulting gains through stock sales which may be exempt from U.S. tax.
FIRPTA imposes a tax on capital gains derived by foreign persons from the dispositions of U.S. property interests. Withholding of the funds is required at the time of sale, and payment must be remitted to the Internal Revenue Service (“IRS”) within 20 days following closing. Internal Revenue Code Section 1445 requires a buyer to withhold 15 percent of the total amount realized by the foreign seller, unless an exemption or limitation applies, such as when the seller furnishes a certificate of non-foreign status, when the property transferred is U.S. stock that is regularly traded on an established securities market or when “withholding certificate” is obtained from the IRS that reduces or excuses withholding or establishes the seller’s maximum tax liability upon the disposition to a lesser amount. The amount realized is the sum of the cash paid or to be paid, the market value of other property transferred or to be transferred, the amount of liabilities assumed by the transferred, and the amount of liabilities to which the transferred property was subject.
The 15 percent rate is reduced to ten percent for purchases of real property which is acquired by the purchaser for use as a residence and the amount realized for such property does not exceed $1,000,000. To qualify under this exception, the buyer or certain members of the buyer’s family (i.e., brothers, sisters, spouse, or lineal descendants) must intend to reside at the property for more than 50 percent of the number of days for two years following the acquisition of the property. In addition, a buyer who intends to use the purchased property principally as a residence can elect to forego FIRPTA withholding so long as its cost is $300,000 or less. As with withholding taxes in general, a buyer that fails to withhold is liable for any uncollected taxes.
Along with withholding, a buyer has an obligation to file with the IRS Form 8288, U.S. Withholding Tax Return for Dispositions by Foreign Persons of U.S. Real Property Interests and IRS Form 8288-A, Statement of Withholding on Dispositions by Foreign Persons of U.S. Real Property Interests. These forms must be filed with the IRS no later than the 20th day after the date of closing.
Ways the Foreign Seller Can Reduce It’s FIRPTA Liability
From the foreign seller’s perspective, the withholding amount is usually greater than its U.S. federal income tax liability. The foreign seller has two options. First, the seller can have the buyer withhold the 15 percent. The seller can then file a U.S. federal tax return and request a refund for any overpayment of taxes. The seller’s other option is to file a Form 8288-B with the IRS on or before the date of the transfer. Although the transferee or buyer will still need to withhold 15 percent of the amount realized in escrow, the buyer does not need to report or pay over these monies to the IRS until the 20th day following the sale or transfer of the real property. In the meantime, the transferor or seller of the property can file a Form 8288-B and request a withholding certificate to reduce or eliminate withholding on the disposition of the real property. A transferor or seller can request a reduction in the FIRPTA withholding based on:
1) a claim is made that the transferor is entitled to nonrecognition treatment or is exempt from tax (i.e. a tax treaty reduces or eliminates the U.S. tax on the disposition of the real property);
2) A claim is made solely on a calculation that shows the transferor’s maximum tax liability is less than the tax otherwise required to be withheld; or
3) A claim is made that special installment sales rules which are described in Section 7 of Rev. Proc. 2000-35 are permitted in the disposition of the real property to reduce withholding.
The IRS will normally act on a Form 8288-B submission within 90 days of receipt of all information. In order to avoid unnecessary withholdings, the Form 8288-B should be submitted to the IRS as early as practically possible. The Form 8288-B must be accurately completed in order to avoid a rejection of the application. At a minimum, the following information will be necessary to properly complete the Form 8288-B:
1. The name of the transferor of the property and the identification number of the transferor.
2. The name or names of the party or parties transferring the property and the identification number.
3. A full description of the property being transferred (for example, “10-story, 100 unit apartment building).
4. The sales price of the property being transferred and the adjusted basis in the property.
5. It is necessary to tell the IRS whether or not tax returns for the three preceding tax years were filed. The definition of U.S. income tax returns includes Form 1120-F that is required to be filed by foreign corporations that have a direct or indirect interest in the U.S. property.
6. It is necessary to state on the Form 8288-B the maximum U.S. tax liability for the sale of the property. The maximum U.S. tax liability can be determined through the contract for the sale of the property, invoices for improvements to the property, and depreciation schedules on previously filed tax returns. Special rules apply under Rev. Proc. 2000-35, Section 4.06 for net operating losses. Documents used to determine the maximum U.S. tax liability may also need to be submitted to the IRS with the Form 8288-B.
7. If a reduction in the withholding is requested under a U.S. income tax treaty, the provision and an explanation must be submitted with the Form 8288-B.
The Form 8288-B must be signed under penalties of perjury by the nonresident transferor or a responsible corporate officer. The Form 8288-B may also be signed by an authorized agent such as an attorney admitted to practice before the IRS.
1031 Exchanges and FIRPTA
A 1031 exchange allows investors to swap real estate investment property for another without recognizing capital gains taxes at the time of exchange. For certain limited types of transactions, such as exchanges qualifying in their entirety for tax-free treatment such as a 1031 exchange, Internal Revenue Code Section 1445 allows the closing to proceed based on the seller notifying the buyer and the seller notifying the IRS that the transaction is entitled to nonrecognition treatment. The FIRPTA regulations specifically provide that, to avoid withholding in a 1031 exchange, the foreign seller must timely apply for a withholding certificate from the IRS.
In order to potentially avoid FIRPTA withholding, the foreign seller, the Form 8288-B and a contract for the purchase of the replacement property, must be submitted to the IRS on or before the replacement property’s closing following the procedures discussed in Rev. Rroc. 2000-35. The IRS will ordinarily act upon Form 8288-B no later than 90 days after all information necessary for the IRS to make a determination is received. However, it is possible that the IRS will not issue a certificate of withholding before the close of the property being relinquished. In order to avoid issues caused by a late determination, the foreign seller should submit the Form 8288-B to the IRS as soon as possible. The seller may also consider depositing an amount equal to the required withholding with the settlement agent.
Conclusion
The filing of Form 8288-B requires careful and detailed attention to details. Failure to submit an accurate Form 8288-B will result in either a rejection of the application or a delay in the processing of the Form 8288-B. Foreign sellers should also be aware that some states such as California also have withholding requirements similar to FIRPTA. These withholding requirements should also be considered when transferring through a 1031 exchange or selling U.S. real property.
Anthony Diosdi is one of several international tax attorneys at Diosdi Ching & Liu, LLP. As an international tax attorney, Anthony Diosdi advises foreign and domestic clients on U.S. federal income, gift, and estate tax matters, including cross-border investments, U.S. real estate investments, and business activities. Anthony Diosdi also routinely counsels clients with respect to pre-immigration planning, FIRPTA, expatriation planning, and tax treaties. Anthony Diosdi is a frequent speaker at international tax seminars. Anthony is a member of the California and Florida bars.
Diosdi Ching & Liu, LLP has offices in San Francisco California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: 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.