Withholding Requirements When a Foreign Person is Selling U.S. Real Estate
Whether you are a foreign owner of U.S. real estate, a buyer purchasing from a foreign owner of U.S. real estate, or a real estate professional advising the parties, you should be aware of each party’s tax and withholding obligations. In 1980, Congress enacted the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”), which imposes obligations on the parties involved in a transaction with a foreign seller. Foreign owners of U.S. real estate are required to pay a tax on the gain derived from the disposition of a U.S. real property interest. To ensure the collection of the tax, FIRPTA made the income from the sale of real estate subject to a withholding mechanism. This withholding mechanism is a withholding tax obligation that is legally imposed on the buyer purchasing from a foreign owner of U.S. real estate. FIRPTA also imposes certain affirmative obligations on the real estate agent involved in a transaction with a foreign seller. This article will focus specifically on the withholding issues involved and will point out other factors that are important for all involved parties to consider.
As a buyer, when are you obligated to withhold and remit at closing a portion of the gross sales price? According to the Internal Revenue Code (the “Code”), the disposition of a U.S. real property interest by a foreign person is subject to income tax withholding. The first step is to determine what exactly this means. What is a U.S. real property interest? The term U.S. real property interest is defined as an interest in real property located in the U.S. or the Virgin Islands, as well as certain personal property that is associated with the use of real property. It also includes an interest in certain domestic corporations as further discussed in the Code. What is a foreign person? A foreign person is a nonresident alien individual, foreign corporation that has not made an election under the Code to be treated as a domestic corporation, foreign partnership, foreign trust, or a foreign estate.
For any real estate transaction, it must be determined whether the buyer is relieved from the obligation to withhold by meeting the requirements of a FIRPTA withholding exception. The most common FIRPTA withholding exceptions can be separated into four types of exemptions: (a) a nonforeign affidavit is provided by the seller, (b) a non-U.S. real property interest affidavit is provided by the seller, (c) the purchase price and intended use of the property qualify the transaction as exempt, or (d) a withholding certificate is provided by the I.R.S. There are a few additional exceptions specifically outlined in the Code.
If a buyer determines that an exemption is not applicable, the buyer is required to withhold and remit at closing ten percent of the gross sales price of the property. Failure to withhold and remit the applicable tax within 20 days after the closing can result in the buyer being liable for the tax, and possibly for interest and penalties. This amount is not the tax, but is held by the I.R.S. as a tax deposit to be applied by the seller against the actual tax due. Remittance of the withholding tax must be accompanied by Form 8288 and 8288A. The seller is responsible to file a U.S. income tax return and may receive a refund if the tax deposit is in excess of the actual tax due.
The first type of exemption is applicable only if the seller does not fall within the above definition of a foreign person. Under FIRPTA, it is presumed that every seller is a foreign person. To overcome this presumption, the seller must furnish a nonforeign affidavit. The affidavit must state, under penalty of perjury, that the seller is not a foreign person. The affidavit must also include the seller’s U.S. taxpayer identification number and home address (if an individual) or office address (if an entity). A resident alien individual is not a foreign person, whereas a nonresident alien is considered to be a foreign person. The definitions of resident alien and nonresident alien are technical and should be determined by a tax professional.
The second type of exemption is applicable only when the interest in a domestic corporation does not fall within the Code’s definition of a U.S. real property interest. The corporation must furnish an affidavit stating, under penalty of perjury, that the interest is not a U.S. real property interest. Generally, the corporation can make this affidavit only if: (a) the corporation was not a U.S. real property holding corporation during the previous five years, or (b) as of the date of the disposition, the interest in the corporation is not a U.S. real property interest by reason of section 897(c)(1)(B) of the Code. The determination of whether a corporation is a U.S. real property holding company is technical and should be considered by a tax professional. The date of the affidavit must be on or within 30 days from the closing date.
If either of the first two exemptions apply, it is important for the buyer to retain the affidavit to confirm, if necessary, to the I.R.S. that the buyer did not have a withholding obligation in connection with the transaction. The affidavit will not serve as proof to the I.R.S. of no withholding tax obligation if the buyer has actual knowledge that the affidavit is false. Additionally, a real estate agent in the transaction with any knowledge that the affidavit is false has an obligation to notify the buyer. The real estate agent may be held personally liable for a portion of the withholding amount, to the extent of the agent’s compensation, for failing to notify the buyer.
The third type of exemption applies in a residential transaction where: (a) the amount realized is $300,000 or less, and (b) the buyer or the buyer’s family plan to reside at the property 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 immediately following the transfer. The number of days the property will be vacant does not count towards the number of days the property will be used. For this exception to apply, the buyer must be one or more individuals and not a corporation or other legal entity.
A taxpayer may qualify for the fourth type of exemption by obtaining a withholding certificate from the I.R.S. The withholding certificate can adjust the amount that must be withheld from the disposition of a U.S. real property interest or may recognize that a transaction is of a kind that does not generate tax. The buyer, the seller, or an authorized person may request a withholding certificate by filing a Form 8288B. The application for a withholding certificate must be filed on or before the date of closing. The applicant must provide to the I.R.S. within the required time period all requested documentation. The purpose of the withholding certificate is to show that the maximum possible tax on the sale of the property would be an amount less than the ten percent withholding amount. The application for a withholding certificate cannot be filed until the parties have entered into a binding contract because the applicant must include the amount realized from the sale. It is in the parties’ best interest to consult an attorney or accountant who understands the FIRPTA withholding tax system before completing an application.
This exemption does not relieve the buyer from the responsibility to withhold a portion of the gross sales price at closing. Instead of sending the withholding amount to the I.R.S. within 20 days from the date of closing, the money may be held in escrow until the withholding certificate is received. The I.R.S. will generally respond within 90 to 120 days after receipt of a complete application, which must include the taxpayer identification number of all the parties involved in the transaction. Following receipt of the withholding certificate, the buyer must then disburse the maximum tax liability indicated on the certificate to the I.R.S. within 20 days after the issue date of the withholding certificate. Form 8288 and 8288A must accompany the tax payment. Any remaining balance in the escrow account is then disbursed to the seller.
It is important to remember that the exemptions determine only whether the buyer is obligated to withhold a portion of the gross sales price and have no effect on the seller’s responsibility to file a U.S. income tax return. A foreign person investing real property in the U.S. will want to consider the FIRPTA withholding requirements, as well as other U.S. income tax and estate tax issues before taking title to the property. In order to make a fully informed decision, it is critical to consult an estate planning and tax attorney well versed in this area early in the process.