The Five Critical Aspects of the Rule and When They Apply
The Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) establishes that persons purchasing U.S. real property interests from foreign individuals must withhold 10% of the gross amount realized on the transaction. This rate will be increased 50% effective February 17, 2016 from the previous 10% to 15%.
The Five Critical Aspects of the Rule:
- This withholding only applies to cases involving a foreign seller (a person whose primary residence for tax purposes is outside of the United States).
- This is not an actual tax. Rather, it is a measure taken by the IRS in order to ensure the collection of any applicable income taxes from the foreign seller resulting from the sale.
- As of February 17, 2016, the FIRPTA withholding rate provided for under the law will increase from 10% of the gross sale price to 15%. This 50% rate increase may indicate that property values are again on the rise as that the amount of tax owed generally exceeds 10%.
- Under U.S. Law, it is the buyer’s responsibility to withhold the proper funds from a foreign seller when purchasing U.S. real estate. If the buyer fails to do so, they can then be held liable for the amount of the withholding. Typically, the buyer’s closing agent will act on their behalf to meet these obligations.
- FIRPTA protects the buyer. Although the purpose of the law is to ensure that the IRS is able to collect the applicable income tax on a transaction, it has the secondary benefit of protecting the buyer by covering the projected amount for which they will be held liable.
Because the rules for withholding can be cumbersome to understand, it is advisable as always, to take legal or accountancy advice to make sure you comply. It is always better to spend the money upfront to make clear what you need to do, rather than deal with any unintended consequences from simply not knowing how it works.
That said, we think it is important to present the information here as clearly as possible in order to familiarize you with the rules and how they apply.
Buyer meets foreign seller: knowing the rules can help you seal the deal
Like many countries, one of the ways the U.S. Government generates its income is by taxing the profits on the sale of real estate investments made within the country. This is a type of capital gains tax, which applies to citizens and non-citizens alike, who sell investment property (the sale of a primary residence is handled differently).
U.S. citizens are subject to this tax as part of their regular income tax. For global buyers, The Foreign Investment in Real Property Tax Act (FIRPTA) is the mechanism that sets the parameters for handling the payment of taxes for foreign persons who sell U.S. real estate interests.
FIRPTA: What It Is and How It Works
Essentially, when an individual sells a property in the United States, they are required to file a U.S. income tax return to report the sale. This is where the actual tax on the sale is calculated.
FIRPTA requires that any individual who is selling a property in the U.S. that is not a U.S. citizen will have 15% of the gross sales price withheld at closing. This 15% withholding must then be remitted to the Internal Revenue Service (IRS) within 20 days after closing.
This 15% withholding is considered a deposit that will be applied to the actual tax which is calculated when filing a U.S. income tax return. Upon comparing the deposit and the actual tax, if the tax is less than the 15% withholding, the remainder is refunded to the seller. If the difference is greater than the 15% withholding, the seller must then remit the balance to the IRS.
The Exception You Need to Know About
No withholding is required provided that the sale price is $300,000 or less and the buyer (including family members) intends to use the property as a personal residence for at least 50% of the time it is in use for a period of 24 months after closing. Days that the property is not in use are excluded from this 50% calculation.
For this to apply, the buyer must be an individual as opposed to a corporation, estate, trust, or partnership. Vacant land is not eligible for this exemption even if the buyer intends to build a residence on the property.
As an example, let’s consider that a foreign citizen sells a U.S. property for $285,000. In this example, the buyer intends to use the property as a personal residence for five months out of the year on an ongoing basis. The buyer also intends to rent the property for three months out of each year. During the remaining four months of each year, the property will remain vacant.
Because the buyer intends to use the property as a residence for five out of the eight months that the property is in use during a twelve-month period and the buyer intends to continue this pattern for more than the required two years, the 50% calculation will be met and the seller qualifies for the exemption.
In this example, however, the buyer must be willing to sign an affidavit as to their intentions under penalties of perjury. The seller must still file a U.S. income tax return reporting the sale and pay all applicable income taxes.
Sales exceeding $300,000, whether at a profit or at a loss, do not qualify for an exemption.
When The New 2016 Rules Provide for the Reduction of the 15% Back Down to 10%
The 15% withholding rate may be reduced back down to the prior 10% rate provided that the sale price does not exceed $1,000,000 and, as with the exception above, the buyer intends to use the property as a personal residence as described. In this case, as well, the buyer must sign an affidavit under penalty of perjury expressing their intentions.
Applying for a Withholding Certificate When Selling at a Loss
Another important piece of information to keep in mind is that, when the actual tax on the sale is significantly less than the 15% withholding, the seller can apply for a withholding certificate from the IRS. This, then, allows for a reduction in the amount withheld at closing from 15% down to 10% of the gross sales price.
To clarify why this is crucial, let’s look at another example. An individual bought a property for $700,000. He is later only able to sell the same property for $600,000. In this case, because the seller is incurring a significant loss on the sale of the property, no income tax is payable on the sale. Still, the 15% withholding is applicable and $90,000 will be withheld on the transaction.
However, in this situation, the seller may submit an application to the IRS documenting that the sale will result in a loss. Provided that the application is made no later than the date of closing, no withholding is required.
Because it generally takes the IRS 90 days to issue the withholding certificate, the closing may take place before the certificate is issued. If this is the case, the 15% is deducted at closing. However, instead of remitting the withholding to the IRS, the closing agent is able to hold the money in escrow until the withholding certificate is issued. Upon receipt of the certificate, the agent is then able to remit the reduced withholding amount, if any is applicable, and return the balance to the seller.
Things to Consider When Applying for a Withholding Certificate
Things to consider in deciding to apply for a withholding certificate are how the actual tax compares the withholding amount and the time of year that the transaction takes place. Individual income taxes are reported based on the calendar year.
There is less reason to file for the withholding certificate if the sale takes place in December and the tax return may be filed in the near future. In this case, the funds would be refunded a few months after the sale.
However, if the sale takes place in January, it could be 14 months or more after the sale before the refund is issued. In this case, depending on the amount due, it may be advisable to apply for a withholding certificate.
In considering the terms of a short sale, where the amount due on the existing mortgage will not be met from the proceeds of the sale, the 15% rule still applies on a property with a sale price over $300,000. In this case, it would be advisable to apply for the withholding certificate as any withholding would reduce the amount paid to the lender at closing. Without it, it is unlikely that the lender would approve the sale.
In order to apply for a withholding certificate, all parties involved in the transaction must have a Tax Identification Number (TIN) or a U.S. Social Security Number. This is extremely relevant for the Foreign Investor because it provides for the opportunity to obtain a U.S. TIN. The only other way for a Foreign National to get a TIN is by renting their property.
Helpful resources mentioned in this article:
To find out more about FIRPTA visit:
https://www.irs.gov/Individuals/International-Taxpayers/FIRPTA-Withholding
To find out more about Tax Identification Numbers visit:
https://www.irs.gov/Individuals/International-Taxpayers/Taxpayer-Identification-Numbers-TIN
