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 these terms have been met. These exemptions are specifically defined by the IRS.
Substantial Presence Test
You must be physically present in the United States (U.S.) on at least:
- 31 days during the current year, and
- 183 days during the 3-year period that includes the current year and the 2 years immediately before that, counting:
- All the days present in the current year, and
- 1/3 of the days present in the first year before the current year, and
- 1/6 of the days present in the second year before the current year.
The Other 11 Exceptions
1. You (the transferee) acquire the property for use as a residence and the amount realized (sales price) is not more than $300,000. You or a member of your family must have definite plans to reside at the property for at least 50% of the number of days the property is used by any person during each of the first two 12-month periods following the date of transfer. When counting the number of days the property is used, do not count the days the property will be vacant. For this exception, the transferee must be an individual.
2. The property disposed of is an interest in a domestic corporation if any class of stock of the corporation is regularly traded on an established securities market. However, this exception does not apply to certain dispositions of substantial amounts of non-publicly traded interests in publicly traded corporations.
3. The disposition is of an interest in a domestic corporation and that corporation furnishes you a certification stating, under penalties of perjury, that the interest is not a U.S. real property interest. In most cases, the corporation can make this certification only if either of the following is true.
- During the previous 5 years (or, if shorter, the period the interest was held by its present owner), the corporation was not a USRPHC.
- As of the date of disposition, the interest in the corporation is not a U.S. real property interest by reason of section 897(c)(1)(B) of the Code. The certification must be dated not more than 30 days before the date of transfer.
4. The transferor gives you a certification stating, under penalties of perjury, that the transferor is not a foreign person and containing the transferor’s name, U.S. taxpayer identification number, and home address (or office address, in the case of an entity).
5. The transferor can give the certification to a qualified substitute. The qualified substitute gives you a statement, under penalties of perjury, that the certification is in the possession of the qualified substitute. For this purpose, a qualified substitute is (a) the person (including any attorney or title company) responsible for closing the transaction, other than the transferor’s agent, and (b) the transferee’s agent.
6. You receive a withholding certificate from the Internal Revenue Service that excuses withholding.
7. The transferor gives you written notice that no recognition of any gain or loss on the transfer is required because of a nonrecognition provision in the Internal Revenue Code or a provision in a U.S. tax treaty. You must file a copy of the notice by the 20th day after the date of transfer with the Ogden Service Center, P.O. Box 409101, Ogden, UT 84409.
8. The amount the transferor realizes on the transfer of a U.S. real property interest is zero.
9. The property is acquired by the United States, a U.S. state or possession, a political subdivision, or the District of Columbia.
10. The grantor realizes an amount on the grant or lapse of an option to acquire a U.S. real property interest. However, you must withhold on the sale, exchange, or exercise of that option.
11. The disposition is of an interest in a publicly-traded partnership or trust. However, this exception does not apply to certain dispositions of substantial amounts of non-publicly traded interests in publicly traded partnerships or trusts.
FIRPTA = Real Estate Protection
As we said before, no one really likes paying taxes, but we do want to pay what’s expected of us so we don’t break the law. This is the point of FIRPTA: by illustrating the situations and scenarios in which taxes need to be paid on real estate transactions with foreign persons and how much those taxes should be. Laws of these nature provide essential protection, especially in situations where the law can be slightly complex.
Please be advised that this article is designed to be informative. It should not be regarded as official legal or accounting advice. If you need more detailed information about FIRPTA taxes for your immediate transaction, you should speak with your title company, attorney, and/or accountant.