In the United States, the tax laws pertaining to the buying and selling of real estate are applicable to all persons, whether domestic or foreign and these laws dictate that income tax must be paid on dispositions of interests in the United States real estate. A domestic person is liable to pay this tax and it is a part of their regular income tax, whereas a foreign person is subject to this tax on only particular elements of their income, which includes source income from the U.S. and certain connected forms of income. However a foreign person is not liable to pay taxes on most capital gains.
What is FIRPTA?
FIRPTA stands for ‘Foreign Investment in Real Property Tax Act’ and is a tax law of the United States which states that all foreign persons are subject to an income tax that are in the process of disposing of property interests in the U.S. The tax is implemented on a regular rate and it is based on the category of the taxpayer and the quantity of gain recognized. The FIRPTA was passed in 1980 and is the subtitle C of title XI of the Omnibus Reconciliation Act of 1980.
When buying real estate in the U.S., it is mandatory upon the purchaser to withhold the tax at a rate of 10% from the foreign seller on the gross sales price of the property. The deposit then must be paid to the IRS within 20 days of closing the transaction, provided that the sales price of the property is more than $300,000 but less than $1,000,000. The withholding rate might be lowered from 10% to a sum that covers the liability of tax, if an application is made to the IRS on the advance of a sale. FIRPTA tends to overshadow many of the non-recognition provisions along with those tax agreements that facilitate a tax break for these gains.
Sections 6039C and 897 of the Internal Revenue Code (IRC) were implemented in FIRPTA and the section 897 specifically states that the gain on the investment in the U.S. real estate is an effectively connected source of income that is subject to the income tax of the federal government. Foreign sellers must pay a 10% withholding tax on the sales price of a U.S. based property, although the seller can appeal to the IRS to lower the rate. The IRS is swift in approving valid applications from foreign sellers. However changes made to the Omnibus spending bill has majorly affected the FIRPTA and beginning from the 17th of February 2016, if the sales price of a U.S. real estate property exceeds $1,000,000, a 15% withholding tax is applicable on the foreign seller.
Generally, FIRPTA is compulsory on all foreign owners of U.S. real estate whenever they dispose of an interest. The provisions contained within the law that might prevent the gain from being recognized are mostly not applicable in this situation, unless the foreign seller is entitled to receive a U.S. real estate property interest in a certified non-exchange recognition. For the purpose of information, a foreign person is labeled under the FIRPTA as:
- A non-resident alien individual
- A partnership
- A foreign estate
- A foreign corporation or company
- A trust
Before 1981, all foreign persons such as non-U.S. citizens, non-residents, and corporations that weren’t U.S. based were not subject to paying tax on the sale of U.S. property. Later, the Congress passed the motion that all foreign individuals would be liable to pay a tax on the disposition of a U.S. real estate property interest. The law emphasized that its contents superseded any provisions of the tax agreements that declared otherwise.
What Type of Property is Subject to FIRPTA?
Generally, foreign persons and individuals are exempted from taxes on U.S. capital gains but under FIRTPA, foreigners are liable to pay taxes on the gains acquired through the disposition of U.S property interests. There are three types of property defined under FIRPTA:
- Interest: A property interest can be defined as any form of a direct equity in the property, like a simple fee ownership though there are more interests than just being a creditor. As a result, multiple owners of a certain property individually have a share in the particular property; however, this is not true for a bank that has provided a mortgage.
- Real Property: It includes buildings, land, and improvements in the land. Whether a property is real or not is actually decided by the concepts under the tax laws of the U.S. and not by the laws of the state. For example, gas station awnings and gas pumps are not considered real property under the U.S. federal tax law but they may fall under the category of ‘realty’ as defined by the state law. In FIRPTA, the laws are a bit different and real property includes personal property which is associated with the usage of real property and the natural resources contained in the land which are not severed, such as uncut timber, gas and oil underground, and crops which are not harvested.
- United States Real Property Interest (USRPI): The U.S. real estate holding corporation (USRPHC) has more than fifty percent of its assets as USRPIs at a given date. Disposing of USRPHC’s interest is liable to the FIRPTA as well as the withholding but an income tax of the state is not due on the corporation. On the flipside, the selling of a directly owned USRPI is liable to pay both the state income tax as well as the lower capital gains of the federal government.
The Recognition and Amount of Gain
On a general basis, a taxpayer should be able to recognize the potential gain from the disposition of a real estate property and in the case where the profit is obtained in a single year; the profit has to be recognized in a proportionate manner over the number of years it is acquired.
A taxpayer who is exchanging property might not be needed to identify the profit on certain transactions such as corporate formations, kind exchanges, corporate reorganizations, distribution from a partnership or a contribution to it, and some other forms of transactions. On the other hand, FIRPTA states that non-recognition provisions such as the ones mentioned earlier are not applicable to foreign persons and that they must recognize the gain. However there are two exceptions that are applicable here:
- The gain will not be recognized in case the acquired property in an exchange is a United States real property interest. However if it is disposed of shortly after the transference, FIRPTA will be applicable.
- The Internal Revenue Service may be able to furnish a few other conditions in its regulations concerning the avoidance of FIRPTA. It should be noted that certain regulations which were temporary and provided some extremely limited exceptions are no longer valid. But there are still some regulations that provide a few exceptions to partnership interests by considering them as a USRPI and hence, the gains from those partnerships need not be recognized.
According to the tax principles governed by the U.S. government that apply to FIRPTA, the profit equals the market value or an excess sum of money of the property which is obtained over the sum of the regulated criteria of the exchanged property. A contingency is imposed on the acquired sum of money and it is not accepted until the resolution of the contingency.
The Imposed Tax
The gain received through the disposition of U.S. property interests is liable to the FIRPTA tax as an effective income. Like U.S. residents, non-resident alien persons are liable to pay a tax on income, fixed on a regular rate. Certain aspects of the tax like adjustments to the gross income, deductions for personal exemptions, and many deductions aren’t permitted. Foreign companies and corporations are also subject to the tax on sources of income at a corporate tax rate that is regular. The section 884 of the IRC may subject the corporation to taxes on branch profits, unless the branch has terminated. Additionally, the supplemental income tax might also be applicable in such a situation.
How to Avoid FIRPTA?
As mentioned earlier, since February 17th 2016, any individual who purchases U.S. real estate interests from a foreign seller is required to collect fifteen percent of the total sales price of the property, if it is greater than $1,000,000. However the standard withholding rate of 10% is still in effect on properties that sell for more than $300,000 but less than $1,000,000. There are only two ways a seller can avoid FIRPTA.
The first case is where withholding is needed, the seller can appeal to the IRS to reduce the standard withholding rate of 10%, and if the appeal is accepted, they will provide a certification which will allow for a reduction in the withholding rate. The seller has to apply for the reduction by filling the IRS application 8288-B and submitting it before the transaction ends. The withholding certificate will mention particular details like the correct quantity of withholding, which is subjected to the declared closing price. After the certificate is received, remit the mentioned amount within twenty days after the date of the withholding certificate along with a copy of the certificate and the form 8688-B. Furthermore, the buyer must remit the balance of the withholding and interest to the seller with a copy of the IRS filing.
Sometimes if the withholding rate is not reduced, the seller might also receive the option of paying the tax in installments. A buyer might face penalties if they fail to withhold, pay the amount within 20 days, or file the IRS form 8688. It should be noted that it can take months to get a withholding certificate and there are three conditions when a withholding certificate will be granted:
- The transaction is tax free.
- There is a very small percentage of profit or loss in the transaction (less than 10%).
- If the seller is selling a recently inherited property.
The second case is where the buyer does not need to withhold FIRPTA and hence the seller can avoid paying FIRPTA tax. The exceptions that make this possible are:
- The buyer signs an affidavit stating that they will utilize the bought property to reside in and occupy it, along with their family members (if any), for at least half the time or the number of days the residence is occupied for each of the first 2 year-long periods immediately after the date of transfer. When you are counting the number of days, do not include those days when the residence was vacant. The buyer must also purchase the property for a price of not more than $300,000. This exception only holds true for individuals.
- The property being disposed of is an interest for a domestic company or corporation, if any category of stock of the company is traded on a daily basis in an established security market. However, this exception is not applicable to some dispositions of large amounts of non-public interests that are traded in public trading corporations.
- The property being disposed of holds an interest for a domestic corporation and that corporation supplies you with a certificate which states under the penalties of perjury that the property is not a U.S. real estate interest. The corporation can make this certification only if either of the following is true:
- In the last 5 years (if the time period is less, then this would apply to however long the current owner held the interest), the corporation or company wasn’t a USRPHC.
- On the date of the disposition, the interest held by the corporation is not a U.S. real estate interest according to the reason stated in section 897(c)(1)(B) of the code. The certificate should not be dated for more than 30 days before the transfer date.
- The transferor or the seller furnishes you with a certificate that states, under the penalties of perjury that the seller is not a foreign individual and the certificate contains the seller’s name, home or office address (in the case of a company), and the U.S. taxpayer identification number.
- The seller or the transferor provides you with a certification to a qualified substitute. The substitute supplies you with a statement, under the penalties of perjury, that the certification is held by the qualified substitute. A substitute can be the transferee’s agent or a person like an attorney or a title company.
- You obtain a withholding certificate from the IRS that exempts you from the withholding.
- The transferor or the seller gives you a written statement that there is no need for the recognition of any profit or loss to be identified on the transaction because there is a provision for non-recognition in the IRC or U.S. tax treaty. A copy of the notice has to be filed by the 20th day after the transfer date with the Ogden Service Center.
- The transferor or the seller realizes that the amount involved in the transaction of a U.S. real estate interest is zero.
- The property involved is obtained by the United States, a political subdivision, a U.S state or possession, or the District of Columbia.
- There is a realization on the amount of the grant by the grantor or there is a lapse of an option to purchase a U.S. real estate interest. Nevertheless, you are liable to withhold on the exchange, sale, or implementation of that option.
- The property being disposed of holds an interest in a trust or a publicly traded partnership. However, this exception is invalid in a situation where a disposition of a substantial amount of interests that are not traded publicly in trusts or publicly traded partnerships.
Previously, there were many U.S. tax treaties that allowed exemption from tax for making a profit on the disposition of U.S. based real property. With the arrival of FIRPTA, quite a many of these provisions became void after a specific date. Consequently, majority of the U.S. tax treaties have been changed to comply with the regulations set down by FIRPTA.