06 January 2015

Buying Real Estate from a Foreigner? FIRPTA Imposes a Withholding

After years of charting a choppy recovery, the U.S. real estate market—both residential and commercial—has improved with impressive speed, with many markets recovering to their pre-bubble norms. While the markets are attractive to domestic buyers, they have equally appealed to foreign buyers over the years. Moreover, we are seeing foreign buyers who have held on to real estate holdings through the market crash now beginning to unload their investments. With all of this activity in the real estate market, along with increased business deals involving real estate, many domestic buyers need to be aware of an overlooked tax regime known as “FIRPTA” and consider its potential application. Failing to do so may result in unanticipated and problematic tax consequences.

What is FIRPTA?
The sale of a U.S. real property interest by a foreign person is subject to the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA). FIRPTA was signed into law to address the potential risk of income tax not being collected when the foreign person sells or disposes of U.S. real property and returns to his/her home country without paying the tax liability. In general, FIRPTA requires 10 percent of the total amount realized from the sale (generally the sales price) to be remitted to the IRS to satisfy the foreign seller’s income tax liability. In other words, FIRPTA imposes a withholding mechanism to ensure that the government gets its tax.

Who is a Foreign Person?
A foreign person is a nonresident alien individual, foreign corporation, foreign partnership, foreign trust or foreign estate.

What is a Disposition?
A disposition is not just limited to a sale. The definition under FIRPTA is quite broad and includes “any transfer that would constitute a disposition by the transferor for any purpose of the Internal Revenue Code and regulations thereunder”. Consequently, this definition could include transfers involving a like-kind exchange gift; corporate liquidation, redemption or reorganization; certain changes in a partnership, trust, or estate interest; foreclosure, inventory conversion, and similar transfers.

What is a Real Property Interest?
A U.S. real property interest is any direct interest, other than solely as a creditor, in real property (i.e., land, buildings, mines, wells, crops, or timber) located in the U.S. and an interest in any domestic corporation that constitutes a U.S. real property holding corporation (USRPHC). Subject to certain limitations and exceptions, a USRPHC is a corporation where the U.S. real property interest makes up at least 50 percent of the total value of its real property interests and business assets. In certain circumstances, an interest in an entity taxed as a partnership may also be considered to be a U.S. real property interest to the extent the partnership owns a U.S. real property interest.

What is the Withholding Requirement?
FIRPTA imposes a withholding mechanism to ensure that the government collects income tax due from the disposition of the U.S. real property interest. Any one U.S. person who purchases U.S. real property interests from a foreign person is required to withhold 10 percent of the amount realized on the disposition (there are special rules that apply for foreign corporations) and remit it to the IRS within 20 days of the closing. This withholding event is in lieu of paying the full amount to the foreign seller. Certain IRS forms are used for purposes of reporting and remitting the tax.

The 10 percent withholding applies to the amount realized from the sale, regardless of the foreign seller’s gain, and is effectively an advance payment against the actual U.S. income tax liability of the foreign seller attributed from the transaction. If the amount withheld is greater than the foreign seller’s actual tax liability, then the foreign seller can claim a refund when filing the applicable U.S. income tax return.

Who is Required To Withhold?
In general, the FIRPTA withholding requirement falls on the buyer; however, it can also fall on the buyer’s agent. The tax rules say that a buyer’s agent is any person who represents the buyer in any negotiation with the foreign seller or foreign seller’s agent or in settling the transaction. This is a very broad definition and can include professionals such as a real estate agent, broker, title company, settlement office, fiduciary, or similar real estate professional or entity involved.

What Are the Consequences For Failing To Withhold?
If the buyer, as the withholding agent, fails to withhold and file the necessary forms, the buyer may be held liable for the income tax due. Additionally, the buyer may be subject to penalties and interest, with an open statute of limitations on IRS assessment.

Are There Any Exemptions to Withholding Requirements?
Yes. There are many situations that will eliminate the withholding requirement. However, the IRS must be given notice of the applicable exemption in many of these instances, typically through an IRS prescribed form. The more common exemptions seen in practice can be summarized as follows:

  • The foreign seller gives the buyer a certification stating, under penalties of perjury, that the foreign seller is not a foreign person.
  • The foreign seller or buyer obtains a withholding certificate from the IRS in advance of the closing stating that the foreign seller is entitled to a reduced or zero withholding amount, or has provided adequate security or made other arrangements for the payment of tax with the IRS.
  • The buyer acquires the property for use as a residence (must be for at least half the number of days that the property is to be used during each of the first two 12-month periods following the sale) and the amount realized doesn’t exceed $300,000 USD.
  • With certain exceptions, the property interest sold or transferred consists of shares of a USRPHC that are regularly traded on an established stock exchange.
  • With certain exceptions, the property interest sold or transferred consists of publicly traded partnerships or trusts.
  • A foreign seller that is a foreign corporation elects to be treated as a domestic corporation for tax purposes.

FIRPTA encompasses a complicated and penetrating set of rules that can be easily overlooked when purchasing a U.S. real property interest from a foreign seller. This regime is also injected into many business transactions since it is common for companies to have real estate holdings or interests in real property.

Without a doubt, FIRPTA should be carefully considered well in advance of a planned transaction in order to determine its application, the effects of the withholding and whether any exemptions to withholding apply. Taking a proactive approach will not only eliminate surprises and problematic tax consequences, but may also allow for tax planning for both parties to help improve the terms of the deal.

If you have any questions about FIRPTA or this article in general, please contact any one of the authors. Miller Johnson has experienced real estate, business and tax attorneys who can assist with these transactions.