With this article, we hope to outline the core concepts of FIRPTA. These are difficult tax laws even if you’ve contracted an experienced real estate agent or title company to help with your pending real estate transaction.
The Basics of FIRPTA
Let’s get the fancy legal terminology out of the way. The United States Internal Revenue Service (IRS) states the following:
“The disposition of a U.S. real property interest by a foreign person (the transferor) is subject to the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) income tax withholding. FIRPTA authorized the United States to tax foreign persons on dispositions of U.S. real property interests.
A disposition means ‘disposition’ for any purpose of the Internal Revenue Code. This includes but is not limited to a sale or exchange, liquidation, redemption, gift, transfers, etc. Persons purchasing U.S. real property interests (transferees) from foreign persons, certain purchasers’ agents, and settlement officers are required to withhold 15% (10% for dispositions before February 17, 2016) of the amount realized on the disposition (special rules for foreign corporations).”
Let’s break down a few of those key concepts:
- Disposition means a sale, a transaction of real estate — whether commercial or residential.
- FIRPTA typically applies to situations where the seller is a foreign entity.
- “Foreign person” means a nonresident alien. This could be an individual (including a member of domestic LLC) or a foreign entity like a corporation, estate, trust, or partnership.
- A resident alien is NOT a foreign person since they have a green card. They often pass the “substantial presence” test (which we’ll describe below).
- The amount of tax you might have to pay depends upon a variety of factors, complete with a network of exemptions.
With that out of the way, let’s get into the meat of FIRPTA. Specifically, we want to help you can understand your obligations in a real estate transaction with a foreign seller. Because if they don’t pay the withholding tax, you as the U.S. citizen will definitely be responsible for ensuring the correct amount of this tax gets paid.
The Three Top Takeaways of FIRPTA
Anyone who wants to engage in regular real estate transactions should have more than a passing familiarity with how FIRPTA works. Hence, before you dig into the nuances of the tax, we want to discuss the three key elements of this legislation you need to understand best.
1. How to Calculate the 15% Tax
The amount realized in any transaction to which FIRPTA applies is the sum of:
- The cash paid or to be paid (principal only);
- The fair market value of other property transferred or to be transferred; and
- The amount of any liability assumed by the transferee or to which the property is subject immediately before and after the transfer.
You must additionally recognize the following:
- If the property being sold was owned jointly by U.S. and foreign persons, the amount realized is allocated between the sellers based on the capital contribution of each.
- A foreign corporation that distributes a U.S. real property interest must withhold a tax equal to 35% of the gain it recognizes on the distribution to its shareholders.
- A domestic corporation must withhold tax on the fair market value of the property distributed to a foreign shareholder if:
- The shareholder’s interest in the corporation is a U.S. real property interest, and
- The property distributed is either in the redemption of stock or in the liquidation of the corporation.
For any distribution that occurred before February 17, 2016, the corporation generally withheld 10% of the amount realized by a foreign person. After February 16, 2016, the distribution rate increased to 15%.
2. The Domestic Buyer is Responsible for FIRPTA Withholding
The IRS rules place the responsibility for withholding potential income tax due in the amount of 10% of the purchase price on the buyer of the real property from a foreign entity. The real property becomes the security for the IRS to ensure they receive the taxes due to them. If the payment is not made by the buyer, the IRS can seize the real property (or other assets of the buyer).
3. There are No Automatic Exemptions
We commonly hear the question: “If the cost of the transaction is under $300,000 and the buyer verbally agrees to live in it, isn’t that enough to earn the exemption?” Our answer is always “No.” Why? Because there are no automatic, set-in-stone exemptions to paying the withholding tax.
Sure, the scenario we described typically is eligible for an exemption, but the law is clear. The buyer must agree to sign an affidavit stating that the purchase price is under $300,000 and the buyer intends to occupy the house. If the buyer chooses not to sign the form, the parties involved must pay the withholding tax.
Getting into the FIRPTA Flow
We’re the first to admit that this entire arrangement seems convoluted even to the most experienced real estate professional. That’s why we’re happy to share this excellent flowchart from our friends at BeachFleischman. Here are the crucial highpoints you should understand in terms of who pays the withholding tax and when:
- Is the buyer a foreign person or entity according to the FIRPTA definition we shared before?
- Is the property a residence?
- Will the buyer personally live in this property for at least 50% of the time it’s occupied?
- Is the purchase price of the home under $300,000?
If you answered “Yes” to the first two questions and “No” to the last two questions, there is a very good chance you will have to pay either 10 or 15% withholding tax as part of the purchase of the property. Luckily, you have some options available.
The Primary Exceptions for FIRPTA
Typically, you won’t have to pay withholding taxes in the following situations. However, you must meet the necessary notification requirements, including filing the paperwork to confirm th