Many foreigners have found great investment opportunities in the U.S. Though IRS rules for these clients are more restrictive, they still contain exceptions that offer relief.
Before 1980, foreign persons (non-residents, non-citizen individuals and non-U.S. corporations) were often exempt from tax on the disposition of U.S. real estate or any U.S. real property interest (USRPI), such as shares of a U.S. corporation holding U.S. real estate. Foreigners were only taxed in a few circumstances, including when they had Effectively Connected Income (ECI).
ECI is taxed at graduated tax rates, while non-effective income is taxed at a rate of 30% or lower, depending on treaties. In 1980, Congress enacted the Foreign Investment in Real Property Tax Act (FIRPTA) under section 1445 & ss. of the Internal Revenue Code (IRC). It came into effect the following year. FIRPTA meant major changes. IRC section 897 now viewed the disposition of U.S. real estate or any USRPI, including shares of U.S. corporations holding U.S. real estate, to be ECI and therefore taxable.
IRC section 1445(a) requires real estate agents to withhold 10% of the gross realized from the sale or other disposition by a foreign person of U.S. real estate. The agent must remit that amount to the IRS within 20 days of the date of disposition. FIRPTA’s withholding rules guarantee the client’s tax liability will be met. The precise amount of that liability is determined by the client’s subsequent filing of IRS Form 1040NR (for individuals) or Form 1120F (foreign corporations). Partnerships typically flow through to the individual partner; Forms 1065 and K1 need to be prepared, with the latter attached to the individual partner’s Form 1040NR.
FIRPTA adds significant costs to foreigners investing in the U.S. Consider a case where a disposition by a foreigner or foreign corporation is either tax neutral or results in a loss. In these cases, the filing will show no tax liability, but the 10% withholding is still required, preventing the seller from having access to his or her funds for a significant period of time following the disposition.
Fortunately, the IRC provides for several exceptions to the 10% withholding rule. Withholding isn’t required when:
- the property is purchased for $300,000 or less;
- the buyer, or a member of buyer’s family, has plans to reside at the property for at least 50% of the number of days the property will be in use by any person during each of the first two 12-month periods following the transfer date; and
- the buyer signs an affidavit confirming plans for personal use of the property.
With respect to disposition of a USRPI, the only way to avoid FIRPTA is to prove the disposition doesn’t fall under rules for United States Real Property Holding Corporations (USRPHC).
A USRPHC is taxable when its assets are held by a corporation with foreign ownership that holds at least 50% of its assets as USRPI at any given time, and for a period of five years ending with the disposition date. As for partnerships with foreign partners (defined as non-U.S.-based or non-U.S. taxpayers or partners), there may be withholding liability at the partnership level, as well as Non-
Resident Alien (NRA) withholding. The IRS bulletin on partnership withholding states: “If a partnership has income effectively connected with a trade or business in the United States, it must withhold on the income allocable to its foreign partners. A partnership may have to withhold tax on a foreign partner’s distributive share of fixed or determinable annual or periodical gains and income (FDAP income) not effectively connected with a U.S. trade or business, as well as withhold on any other FDAP income paid to a foreign person regardless of whether he is a partner or not.”
A domestic partnership won’t have to withhold 10%; instead, it will have partnership withholding of 39.6%. The partnership is required to withhold 39.6% on the nonresident alien partners’ shares of net income passed through on their K-1s. Again, that puts considerable strain on the partnership’s cash flow.
Rules allow IRS to issue a withholding certificate that reduces or eliminates withholding when the 10% to be withheld exceeds expected capital gains tax liability, or where the disposition is made at a capital loss. The seller has to petition the IRS and file Form 8288B, along with evidence for loss or a tax-neutral transaction, no later than the closing date. (Note this only applies to capital gains, and not other withholding such as partnership or passive income, currently at 30%.)
The IRS typically takes about 90 days to make a decision and issue a certificate. The agent has 20 days from receipt of the certificate to remit the requested amount, if any, to the IRS; otherwise, there will be penalties and interest.
If exceptions don’t apply, the agent has to withhold. An agent is any person who represents the seller or the buyer (single actions like receiving or transferring money, issuing title and settling the transaction are not considered to be actions of an agent), but it is typically the buyer who will be held personally responsible for the full amount of FIRPTA withholding, plus any additional penalties and interest.
Withholding amounts the agent remits to the IRS are associated with the Seller’s Individual Tax Identification Number (ITIN) on Form W-7. Any amount owed to the IRS will be deducted from the withheld amount and a balance will either be owed to the IRS or returned to
Originally published in Advisor's Edge Report
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