What You Need to Know About FIRPTABy Paul Bercovici | December 10, 2018
The Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”) was enacted to combat perceived abuses whereby foreign investors were able to avoid, with relative ease, otherwise applicable US taxes on the disposition of interests in US real property. FIRPTA imposes a tax on gains derived by foreign persons from the disposition of US real property interests. Collection of the tax imposed by FIRPTA is ensured by the operation of a tax withholding procedure. The withholding procedure is designed to prevent foreign sellers from removing proceeds derived from the sale of US situs real property without paying, at the very least, a significant portion of the US federal income taxes due in connection with such sale.
WHAT IS A “US REAL PROPERTY INTEREST”?
As noted above, foreign persons who dispose of a US real property interest are subject to US federal income tax on gains realized on such disposition. A United States Real Property Interest (“USRPI”) is defined to include any interest, other than an interest solely as a creditor, in:
. Real property located in the United States or the US Virgin Islands;
Certain personal property associated with the use of real property (e.g., farm machinery); and
An interest in a United States Real Property Holding Corporation (“USRPHC”).
The remainder of this article considers the FIRPTA implications associated with the sale of a parcel of US situs residential property by a nonresident alien of the US. For federal income tax purposes, the term “nonresident alien” means a natural person who is not a US citizen, is not a “lawful permanent resident” of the US (i.e., an individual who does not hold a “green-card”) and does not meet the “substantial presence” test for the year in which the sale of the US situs real property occurs. In general, the principles regarding the application of FIRPTA to the sale of a parcel of residential real property by a nonresident alien of theUS also apply in the context of any sale of a USRPI by a foreign person.
WITHHOLDING ON DISPOSITIONS OF USRPIS
As a general rule, a purchaser of a USRPI from a foreign person must withhold 15 percent of the total amount realized by the foreign person on the sale. There are certain exceptions to the 15 percent FIRPTA withholding requirement, including a reduction in the FIRPTA withholding tax rate from 15 percent to 10 percent for the purchase of a property for use by the purchaser as a residence and where the consideration paid is less than $1 million.
For the purposes of the FIRPTA withholding provisions, the amount realized includes cash, the fair market value of noncash consideration and liabilities assumed by the purchaser to which the USRPI was subject immediately before or after the transfer. It is crucial to note that the amount to be withheld by the transferee is 15 percent of the amount realized by the transferor, not 15 percent of the gain. This concept is illustrated in the following example.
Snowbird is a resident of Canada and is a nonresident alien of the US;
Snowbird owns the 100 percent fee simple interest in a Florida vacation property (the “Florida Property”);
The Florida Property meets the FIRPTA definition of a USRPI;
The Florida Property is sold to Purchaser for: $2 million in cash, noncash consideration with a fair market value of $1 million and the assumption by Purchaser of $2 million of liabilities to which The Florida Property was subject immediately before the sale; and
Snowbird’s adjusted basis in The Florida Property immediately before the sale was $4 million.
Total amount realized by Snowbird on the sale of The Florida Property $5,000,000 Snowbird’s adjusted basis in The Florida Property at the time of sale 4,000,000 Gain realized by Snowbird on the sale of The Florida Property $ 1,000,000 On the assumption that none of the available exceptions applies, Purchaser would be required to withhold and remit to the IRS $750,000 (i.e., 15% of the $5,000,000 realized by Snowbird on the sale of The Florida Property), not $150,000 (i.e., 15% of Snowbird’s gain on the sale of The Florida Property) from the proceeds otherwise payable to Snowbird.
As a general rule, where a USRPI is purchased from a foreign person, the purchaser is required to report and pay US federal income tax withheld under FIRPTA to the US Treasury by the 20th day after the date of sale. It is also crucial to note that the 15 percent withheld on the amount realized by a foreign seller of a USRPI is not the final amount ofUStax actually due from the seller in connection with the sale of the USRPI. The 15 percent amount withheld and remitted is merely an advance payment toward the foreign seller’s final US tax obligation in connection with the sale of the USRPI. Failure of a purchaser to withhold the required amount on the purchase of a USRPI from a foreign seller can result, in certain circumstances, in the purchaser becoming personally liable for the FIRPTA tax amount that should have been withheld and remitted.
CHARACTER OF GAIN OR LOSS REALIZED ON THE SALE OF A USRPI
In most cases, the gain or loss realized by a nonresident alien on the sale of US situs real property will be capital in nature. Whether the seller is required to report the gain or loss as a long-term or shortterm capital gain depends on how long the seller owned the asset. A capital asset is treated as generating a long-term capital gain if the seller owned the asset for more than one year. Capital assets that are owned for less than one year are treated as generating a short-term capital gain. Net long-term capital gains are taxed at a maximumrate of 20 percent. Short-term capital gains, on the other hand, are taxed at ordinary income tax rates. In those less common cases where the US situs real property that is sold does not qualify as a capital asset, the gain or loss realized on the sale will be treated as ordinary income. The property sold will not be treated as a capital asset if:
- It is an inventory item or it is property held primarily for sale to customers in the ordinary course of the taxpayer’s trade or business; or
- It is property used in the taxpayer’s trade or business.
Purchasers of USRPIs from foreign sellers are required to use IRS Forms 8288 (U.S. Withholding Tax Return for Dispositions by Foreign Persons of U.S. Real Property Interests) and 8288-A (Statement of Withholding on Dispositions by Foreign Persons of U.S. Real Property Interests) to report and remit to the IRS any federal income tax withheld on the acquisition of a USRPI. As a general rule, purchasers of USRPIs are required to file Form 8288 and pay over the withheld tax by the 20th day after the date of sale. In addition, purchasers must attach copies A and B of Form 8288-A to Form 8288. The IRS will stamp Copy B of Form 8288-A and send it to the foreign seller. The foreign seller must attach Copy B of Form 8288-A to his or her US income tax return in order to receive credit for the amount of tax withheld. As noted earlier, failure of a purchaser to withhold the required amount on the purchase of a USRPI from a foreign seller can result, in certain circumstances, in the purchaser becoming personally liable for the FIRPTA tax amount that should have been withheld and remitted.
In order for a nonresident alien seller of a USRPI to get credit for amounts withheld and remitted by the purchaser, it is imperative that the seller have some form of US Taxpayer Identification Number (“TIN”). A TIN is either a US Social Security Number (“SSN”) or an Individual Taxpayer Identification Number (“ITIN”). In most cases, a nonresident alien seller of a USRPI will not have a SSN.Where a foreign seller of a USRPI does not have a SSN, the seller can apply for an ITIN. FIRPTA documentation and tax amounts remitted by purchasers that do not include a US TIN are likely to disappear into the “black hole” of the IRS bureaucracy. In recent years, the process of obtaining an ITIN has become incredibly time consuming and cumbersome. In addition, applications for ITINs are routinely rejected by the IRS on spurious or questionable grounds. In some cases, foreign sellers of USRPIs are so reluctant to become involved in any way with the US tax system that they refuse to apply for an ITIN, knowing full well that failure to provide a valid ITIN will cause them to forsake a valid claim for excess FIRPTA tax withheld. In many cases, such reluctance is based on a desire to maintain secrecy and a fear of somehow becoming ensnared in the US tax system. Nonresident sellers of USRPIs who do choose to apply for an ITIN are well advised to submit their application as far in advance of the closing of their sale of US situs real property as possible.
The amount that must be withheld in connection with the disposition of a USRPI can be decreased (or entirely eliminated) pursuant to a withholding certificate issued by the IRS. Withholding certificates are generally issued where the 15% amount required to be withheld pursuant to FIRPTA would be more than the foreign seller’s maximum federal income tax liability in connection with the disposition of the USRPI or where there is an exemption fromUStax of all gain realized by the seller. Applications for withholding certificates are made on IRS Form 8288-B (Application for Withholding Certificate for Dispositions by Foreign Persons of U.S. RealProperty Interests).
Withholding certificates are most commonly issued where a foreign seller is able to demonstrate to the IRS that the income tax amount due in connection with the sale of a USRPI will be less than the amount required to be withheld under FIRPTA. A withholding certificate authorizes the purchaser to withhold (and remit) an amount less than the 15 percent FIRPTA withholding tax otherwise required to be withheld and remitted.
In order to enable the IRS to determine whether reduced withholding is appropriate, the seller is required to provide the IRS with certain information, including:
- Evidence of the amount to be realized by the seller, such as a copy of the signed contract of sale;
Evidence of the adjusted basis of the property, such as closing statements, invoices for improvements, and depreciation schedules, or if no depreciation schedules are submitted, a statement of the nature of the use of the property and why depreciation was not allowed;
Amounts to be recaptured for depreciation, investment credit, or other items subject to recapture;
The maximum capital gain and/or ordinary income tax rates applicable to the sale;
The tentative tax owed; and
Evidence showing the amount of any increase or reduction of tax to which the seller is subject, including any reduction to which the seller is entitled under a US income tax treaty.
According to the instructions for Form 8288-B, the IRS will normally act on an application for reduced withholding within 90 days of receipt of all information necessary to make a proper determination. As a result, applicants for withholding certificates are well advised to submit their application as far in advance of the scheduled closing date as possible.
FILING FOR REFUNDS OF FIRPTA TAX ALREADY PAID
In a perfect world, attorneys for purchasers who are provided with a valid withholding certificate will withhold the amount of tax as authorized by the IRS. However, in far too many cases, attorneys for purchasers who are buying US situs real property from a foreign person either do not understand the significance of a withholding certificate or refuse to withhold as directed by the withholding certificate. In many cases, attorneys for purchasers advise their clients not to honor the terms of a valid withholding certificate because they are concerned about the purchaser somehow being held personally liable for failure to withhold and remit the correct tax in the event the withholding certificate is somehow determined to be invalid. In such cases, the attorney adopts a “better safe than sorry” approach, advises their client to withhold at 15 percent and leaves it to the seller to seek a refund of the excess FIRPTA tax withheld.
In such cases, and in other cases where the amount of tax withheld and remitted under FIRPTA exceeds the seller’s ultimateUSfederal tax liability, the seller can apply for a refund of the excess FIRPTA tax withheld. There are generally two ways that the seller can seek a refund in such cases:
Apply for an “early refund”; or
File a US federal income tax return to claim a refund.
As noted above, in many cases the attorneys for the purchaser of US situs real property from a foreign person will not base the amount withheld and remitted on a valid withholding certificate and will withhold and remit at the 15 percent rate. Nonetheless, a valid withholding certificate can be used to apply for an early refund. In general, a seller will avail himself or herself of the “early refund” procedure where they are anxious to receive the refund of excess FIRPTA tax withheld and where the time for filing an income tax return to claim the refund amount is too far in the future. For example, a nonresident alien who sells a USRPI in January of 2019 and who is entitled to a refund of excess FIRPTA tax withheld cannot make a claim for refund by filing a 2019 income tax return until, at the earliest, February 2020. This is because the IRS will not start to process 2019 income tax returns until, at the earliest, February 2020. In the alternative, the nonresident seller could make a claim for “early refund” immediately after the January 2019 closing is completed and significantly expedite the issuance of the refund by many months.
A nonresident alien seller of a USRPI makes an application for early refund by providing the information required under certain Treasury regulations and submitting certain required documentation. The information required to be provided pursuant to the above-noted
Treasury regulations is:
The name, address, and identifying number of the transferor seeking the refund;
The amount required to be withheld pursuant to the withholding certificate issued by the IRS;
The amount withheld by the transferee; and
The amount to be refunded to the transferor.
The applicant is also required to include Copy B of Form 8288-A as stamped by the IRS and should submit a withholding certificate where one has been issued prior to the application for early refund being submitted. Where a withholding certificate has not been issued prior to the application for early refund being submitted, the applicant must submit an application for withholding certificate with his or her application for early refund.
Whether a foreign person applies for a refund of excess FIRPTA tax by making an application for early refund or by filing an income tax return, the IRS will not pay interest on the excess tax amount withheld.
EFFECTIVE ADVANCE PLANNING IS CRUCIAL
The FIRPTA withholding provisions can be quite complex. Failure to rigorously adhere to the FIRPTA provisions could, for example, result in foreign sellers failing to apply for refunds of FIRPTA tax to which they are entitled, to significant delays in the receipt of tax refunds to which foreign sellers are entitled and to the possible imposition of penalties on purchasers of US situs real property from foreign sellers for failure to timely remit FIRPTA taxes withheld and/or to timely submit required documentation to the IRS in connection with such sale.
Nonetheless, effective advance planning can yield one or more of the following positive results:
Reduction or complete elimination of the withholding tax imposed by FIRPTA through the use, where appropriate, of withholding certificates and/or other tax planning techniques;
Entitling a foreign seller of a USRPI to expeditiously receive a refund of tax paid where his or her ultimate tax liability in connection with the sale of the USRPI is less than the amount withheld under FIRPTA; and
Ensuring that all compliance and reporting requirements imposed by FIRPTA are met in a timely fashion.
This article originally appeared in the November 2018 issue of the Taxes & Wealth Management publication by Thompson Reuters.
About Paul Bercovici
Paul Bercovici, LL.B., is a Principal at Marks Paneth LLP. Mr. Bercovici specializes in international tax matters including advising US individuals on the income tax implications associated with working and living outside of the United States. He also advises foreign individuals on the income tax implications associated with working and living in the US. Further, he assists foreign and domestic corporations with structuring their US and offshore operations. Immediately prior to joining the firm in 2009,... READ MORE +