Dispositions of U.S. Real Property Interest by Foreign Individuals Under FIRPTA
The past few years have seen a rise in the purchase of real property interest by foreign investors in the United States. A complex set of rules popularly known as FIRPTA (Foreign Investment in Real Property Interest Act of 1980) under Internal Revenue Code Section 1445 governs the disposition of U.S. real property interest by these foreign investors.
The FIRPTA regulations have many nuances and apply not only to dispositions of U.S. real property interest but also to distributions by certain partnerships, corporations, trusts, and estates to foreign persons. The U.S. real property interest definition under FIRPTA encompasses not only residential or commercial real estate but other types of interests, such as mineral interests, interest in U.S. real property holding corporations, and others. And the regulations apply to the sale of real property as well as other types of dispositions, e.g., redemptions, capital contributions, etc.
In this article we look at a simplified version of FIRPTA tax and compliance requirements through the lens of an individual who:
- Wishes to purchase residential or commercial real estate located in the U.S. that is owned by a foreign individual, or
- Is a foreign investor wanting to sell his/her direct ownership of residential or commercial real estate located in the U.S.
The FIRPTA regulations require that when the U.S. real property interest is sold by a foreign transferor/seller, the transferee or the buyer must, within 20 days of such sale, withhold, report, and pay over to the IRS 15% of the sale proceeds. The 15% rate is reduced to 10% if the U.S. real property interest acquired by the transferee from the foreign transferor is for use by the transferee as a residence, the amount realized for the property is at least $300,000but not more than $1,000,000. As we will see later in this article, if the sale proceeds are less than $300,000 and certain other conditions are met, there is no withholding, only a notification requirement.
The transferee/buyer files Forms 8288 and 8288-A and makes a payment of 15% of the sale proceeds to the IRS. The IRS next returns the stamped copy of Form 8288-A to the transferor/seller of the U.S. real property interest, acknowledging receipt of the withheld amounts.
Note that the amount the transferee withholds is 15% of the sale proceeds and not 15% of the realized gain. This can cause an over-withholding of the tax otherwise payable by the transferor because typically a gain — the difference between the cost basis and the sale proceeds — is taxable under the U.S. tax code. The foreign person/transferor must therefore (or otherwise) file a U.S. tax return showing actual gain upon sale of the U.S. real property interest, attach the stamped copy of Form 8288-A to this return, and claim credit against taxes actually payable upon sale.
There are exceptions to the 15% withholding rule. If the parameters of any of these exceptions are met, 15% withholding on sale proceeds can be reduced to a lesser amount or can even be zero. Only the exceptions as they apply to sales of residential or commercial real estate held by a foreign individual is discussed here. Additional exceptions apply, for example, to the sale of interest in U.S. real property holding corporation.
- First, the obvious exception: No withholding is required if prior to, or at the time of, the transfer the transferor provides a certification under penalties of perjury to the transferee that withholding is not required because the transferor is not a foreign person.
- Next, the most commonly used exception: Under this exception, the transferee or the transferor seeks certification from the IRS that eliminates or reduces the withholding. In this case, the transferee does not need to report and pay over to the Internal Revenue Service the withheld amount until the 20th day following the IRS’s final determination with respect to the application for a withholding certificate.
There are three circumstances under which this withholding certificate can be requested:
- A claim that the transferor is entitled to non-recognition treatment or is exempt from tax;
- A claim based solely on a calculation that shows that the transferor’s maximum tax liability is less than the tax otherwise required to be withheld; or
- A claim that the special installment sales rules described in section 7 of Rev. Proc. 2000-35 allow reduced withholding.
The circumstance described in (b) above is the most used exception to the 15% withholding.
The application for a withholding certificate in these three instances can be filed by the transferor or the transferee. Form 8288-B is used for this purpose. The Internal Revenue Service is generally required to act within 90 days after the completed application is received. A withholding certificate obtained prior to a transfer notifies the transferee that no withholding or reduced withholding is required. A withholding certificate obtained after a transfer may authorize a normal refund or an early refund.
Form 8288-B must be filled out completely and clearly set out the calculations that support the reasons for seeking a reduced or zero withholding. For example, (i) if the transferor claims a principal residence exclusion, the application must clearly include the facts, circumstances, and calculations that support this claim, or (ii) if the transferor claims that the 15% withholding is greater than the actual tax liability the transferor will have upon sale, Form 8288-B must be accompanied by all calculations including cost basis, sale price, any ordinary gain that may be recognized, etc. that support such a claim. Form 8288-B must include the taxpayer identification numbers (TIN) for all parties – transferor(s) and transferee(s) – to the transaction. If the applicant is a non-U.S. person who is not eligible to obtain an SSN, Form 8288-B should be accompanied by a Form W-7 – Application for IRS Individual Taxpayer Identification Number.
- The third exception relates to property where sale proceeds are not more than $300,000, and the transferee/purchaser acquires the U.S. real property interest with a definite plan to use it as a residence by her (or her family members) for at least 50% of the number of days that the property is used by any person during each of the first two 12-month periods following the date of transfer. The number of days that the property will be vacant is not taken into account in determining the number of days such property is used by any person. No form or other document is required to be filed with the Internal Revenue Service to support residency. The transferee who fails to reside in the property is liable for the failure to withhold, provided the transferor also did not pay the full U.S. tax due on any gain recognized upon the transfer, or the transferee established that the failure to reside the minimum number of days was caused by unanticipated circumstances.
- No withholding is required if the transferor gives transferee a written notice (and meets certain other conditions) that no recognition of any gain or loss on the transfer is required because of a non-recognition provision in the Internal Revenue Code, or a provision in a U.S. tax treaty. This notice must be filed with the IRS by the transferee within 20 days of the date of transfer.
- Additional not-so-often-used exceptions include:
- An appliction for reduced/modified certificate of withholding based on an agreement for the payment of tax. The application must be accompanied by a security instrument or other form of conforming security prescribed by the IRS.
- An application for a blanket withholding certificate accompanied by an irrevocable letter of credit or guarantee, and a tax payment and security agreement with the IRS. Generally, a blanket withholding certificate excuses withholding related to multiple dispositions by the foreign person within a 12-month period.
- An appliction for reduced/modified certificate of withholding based on an agreement for the payment of tax. The application may use a security instrument or other form of security not otherwise prescribed by the IRS but acceptable to the IRS. The application must explain why the non-conforming security is valid, enforceable, and adequately protects the interests of the U.S. government.
In summary, the transfer of U.S. real property interest by a foreign individual is subject to the FIRPTA withholding rules under IRC Code section 1445. A limited relief from this withholding obligation is available either by obtaining a certification from the transferee or because the sale price of the U.S. real property interest is below the threshold amount, or by applying to the IRS under certain specific circumstances. While these exceptions are not unsurmountable, nor is the application to the IRS a difficult process, a purchaser of the U.S. real property interest from a transferor who is a foreign person must ensure full compliance to avoid being subject to tax, penalties, and interest.