Noncitizens and nonresidents of the United States that own, and are planning to sell, real estate located in the U.S. need to be aware that there are complicated tax rules that may apply to that sale. Oftentimes this is not considered when a foreigner invests in U.S. real estate, and the potential penalties for noncompliance may catch them off guard. The following article provides an overview of the withholding rules that apply under the Foreign Investment in Real Property Tax Act (FIRPTA).
If a foreign person who is not a tax resident of the U.S. sells U.S. real estate, up to fifteen (15) percent of the sales price will need to be remitted to the Internal Revenue Service (IRS) under the FIRPTA withholding rules. The U.S. requires the payment of this withholding tax to ensure that foreigners pay taxes owed on the recognition of gain on the sale of U.S. real estate.
U.S. Income Tax Rate vs. Withholding Rate
The withholding tax is, in most cases, higher than the actual income tax that is owed on the sale. When a U.S. tax return is filed to report the sale of real estate, the taxpayer usually receives a sizeable tax refund because the withholding is based on the selling price, but taxable gain is calculated by subtracting the taxpayer’s basis (generally the amount paid to purchase the real estate) from the selling price. If the real estate (a capital asset) is held for longer than one year, then the highest U.S. tax rate is the long term capital gain rate of twenty (20) percent, with a large portion of the gain generally taxed at fifteen (15) percent.
As an example, if a foreign person sells U.S. real estate for $500,000 and the basis of the real estate is $300,000, then the gain on the sale is $200,000. The withholding required under FIRPTA is generally equal to fifteen (15) percent of $500,000, or $75,000. When that foreign person files their tax return, they would report the gain of $300,000. If we assume that the fifteen (15) percent tax rate applies to the entire gain, then the tax owed would only be $45,000. The foreign person would then be entitled to a refund of $30,000.
Unfortunately, the tax return claiming the refund cannot be filed until January or February, at the earliest, of the year following the year of sale. For example, if the sale takes place in January 2020, the earliest the tax return can be filed would be January or February of 2021. Given the current practice of the IRS, the refund would likely be paid as late as June of 2021.
Personal Use Exception to Withholding
In certain cases, the FIRPTA withholding does not apply. One exception from the FIRPTA withholding is if the sales price is $300,000 or less, and the buyer is willing to sign an affidavit that, for the next two twelve-month periods, at least fifty (50) percent of the time the real estate will be used personally. If the sales price is between $300,000 and $1,000,000, and the buyer fulfills the personal use requirements and is willing to sign the affidavit, the FIRPTA withholding rate can be reduced to ten (10) percent. Going back to our example earlier, this means that the withholding would only be $50,000 instead of $75,000, and the expected refund would then only be $5,000 instead of $30,000.
Reduced Withholding Certificate
Another option to reduce the required withholding is to apply for a reduced withholding certificate. An application is made that computes the estimated gain and tax, and requests that the withholding be equal to the tax calculated. This application needs to be submitted, with support for the calculation, on or before the day of the closing. While the application is being processed, the regular rate of FIRPTA withholding has to remain in an escrow account. It usually takes approximately three (3) months for the IRS to process a reduced withholding certificate application. Once processed and approved, the withholding will be paid from the escrow account and the balance of the escrow account can be paid to the seller.
If a foreign person wishes to apply for a reduced withholding certificate, or even to receive a refund of excess withholding, the taxpayer must have a taxpayer identification number (TIN) or employer identification number (EIN). The IRS does not issue tax refunds without a valid tax identification number. Individual foreign persons should apply for an Individual Taxpayer Identification Number (ITIN) by filing Form W-7 with the required attachments.
Complying with the FIRPTA withholding requirements can be challenging, which is why it is so important to have a tax professional involved who is knowledgeable about the rules and has experience in these filings. Please consult with an HBK tax advisor to find out more information and how HBK can help taxpayers comply with the FIRPTA withholding rules.