The purpose of this article is to increase awareness of FIRPTA and to highlight certain problems which may arise for a foreign investor selling U.S. real property. The Foreign Investment in Real Property Tax Act (FIRPTA) of 1980, 26 U.S.C. §1445, was enacted to encourage tax compliance when a foreign investor sells real estate.  Prior to FIRPTA, it was possible for non-residents to buy U.S. real estate, sell it at a profit, repatriate their profits back to their native country and pay no tax.  FIRPTA essentially has closed this loophole.  Unfortunately, in its operation, FIRPTA may result in delayed property sales as well as the withholding of tax that is not owed. 

by Andrew J. Pal*[i]

The U.S. generally welcomes the influx of foreign capital.  Not surprisingly, there are fewer legal issues to navigate when purchasing U.S. real property as a foreign investor than in divesting the same property.  The sale of U.S. real property by foreign investors can often involve difficult issues which require sophisticated expertise and advance planning.  The Foreign Investment in Real Property Tax Act (FIRPTA) of 1980, 26 U.S.C. §1445, was enacted to encourage tax compliance when a foreign investor sells real estate.  Prior to FIRPTA, it was possible for non-residents to buy U.S. real estate, sell it at a profit, repatriate their profits back to their native country and pay no tax.  FIRPTA essentially has closed this loophole.  Unfortunately, in its operation, FIRPTA may result in delayed property sales as well as the withholding of tax that is not owed. 

FIRPTA Generally

Under FIRPTA, foreign investors in U.S. real property must pay U.S. federal income tax on any gain recognized upon a sale or other disposition of “U.S. real property interests” (USRPI).  Tax is imposed, at the rates applicable to U.S. taxpayers, regardless of the actual extent of the investor’s activities in the U.S.  Collection of tax under FIRPTA is enforced through a system of withholding rules as well as a requirement that the foreign investor file a U.S. income tax return for the year in which the disposition occurred.  FIRPTA requires the withholding of ten percent (10%) of the gross sales price of the real property sold (even if sold at a loss) unless certain exemptions apply.  Any tax so withheld is then credited against any tax shown as due on a subsequently filed tax return, with any excess withholding being refundable to the foreign seller.  It is important to note that in addition to FIRPTA, some states have similar withholding rules (albeit at a lower rate).

Definition of Foreigner under FIRPTA

FIRPTA defines a foreigner as a non-resident alien individual, a foreign corporation not treated as a domestic corporation or a foreign partnership, trust or estate.  Under FIRPTA, a non-resident alien individual is defined as a person who is neither a U.S. citizen nor a resident of the U.S.  A person is a resident alien if he/she meets either the “green card test” or the “substantial presence test”.  The green card test states that upon receipt of a green card, an individual is deemed to be a resident of the U.S. and will be taxed on his/her worldwide income (in generally the same manner as a U.S. citizen).  Under the substantial presence test, a foreigner is considered a resident for U.S. Federal tax purposes if he/she is physically present in the U.S. for an average of more than 120 days a year over an extended period of time or for 183 days or more during a single calendar year.  If the seller is not a U.S. citizen and does not have a green card or meet the substantial presence text, then he/she will be subject to FIRPTA withholding.

Applicability of FIRPTA to USRPI

A USRPI is defined as any interest in real property located within the U.S. and U.S. Virgin Islands.  Real property includes such expected items as vacant land, residential and commercial buildings, condominiums, timber and mineral interests, but also some unexpected items such as movable walls, mining equipment, drilling rigs and certain other property associated with the use of real property.  Beyond these direct interests, a USRPI also includes the stock of a domestic (formed in the U.S.) corporation that is or has been a U.S. real property holding corporation (USRPHC).  A domestic corporation is a USRPHC if it owns USRPIs with a total fair market value (FMV) equal to at least 50% of the FMV of the total of its worldwide real property interests and other business assets during a five year look back period.  Consequently, under FIRPTA, a foreigner cannot avoid U.S. taxation on the sale of U.S. real property by holding the property indirectly through a U.S. corporation and disposing of the corporation’s stock.  As a result, prior to acquiring stock of a corporation from a foreign person, a buyer should always confirm that the stock is not a USRPI.

Disposition, Withholding and Reporting

The tax imposed under FIRPTA is applicable in the event of a disposition of a USRPI for any purpose under the Internal Revenue Code (IRC) and regulations thereunder.  A disposition includes:  sales, capital contributions, redemptions, distributions, changes in interests in a partnership, trust or estate, corporate reorganizations, mergers or liquidations and even foreclosures.  In order to ensure collection of tax, FIRPTA places the burden on the buyer to withhold 10% of the total amount realized by the foreign seller.  The buyer must then remit the amount withheld to the IRS as prepayment of the foreign seller’s tax.  The 10% withholding tax is not the amount of tax actually due, but is merely an advance payment towards the foreign seller’s U.S. income tax obligation arising from the sale of U.S. real property.  The 10% withholding amount is generally more than the tax owed on any gain.  The buyer must report and pay over the withheld tax to the IRS by the 20th day following the transfer date.  A buyer that fails to withhold may be liable for the tax, including interest and penalties.  With the payment of the tax, the buyer must file Form 8288 (U.S. Withholding Tax Return for Dispositions by Foreign Persons of U.S. Real Property Interests) and Form 8288-A (Statement of Withholding on Dispositions by Foreign Persons of USRPIs).

FIRPTA Certification

Section 1445 presumes that every seller of a USRPI is a foreign person who is responsible for paying the tax unless the buyer is provided prior to closing with a “non-foreign certification” executed by the seller certifying that the seller is not a foreign person (as defined in the IRC) and providing the seller’s name, address and taxpayer identification number.  The “non-foreign certification” may be relied upon by the buyer (unless the buyer has actual knowledge that the certification is false) and should be retained by the buyer for a period of at least five years.  In order to assuage seller concerns about providing tax identification numbers to buyers, the recently enacted Housing and Economic Recovery Act of 2008 provides that for dispositions occurring after July 30, 2008 sellers are no longer required to provide directly to a buyer a “non-foreign certification”.  Instead, as another option, no Federal withholding is required if the seller furnishes a “non-foreign certification” (with a tax identification number)  to a “qualified substitute” who in turn, furnishes a statement to the buyer stating, under penalty of perjury, that it has the “non-foreign certification” in its possession.  A “qualified substitute” is a person responsible for closing a transaction, such as an escrow company, title company or buyer’s agent (but specifically not a seller’s agent).

Exemptions to FIRPTA Withholding Requirement

            While FIRPTA is generally applicable to a disposition by a foreign investor of a USRPI, it specifically does not apply in the following cases:

            (1)        the real property was purchased for use as a personal residence and the purchase price was not more than $300,000;

            (2)        the interest in real property is solely a creditor’s interest, including a mortgage interest or other security interest;

            (3)        the seller receives a like-kind property in exchange; however, no other property (i.e., cash) may be received as part of the transaction;

            (4)        the amount the seller realizes on the transfer of a USRPI is zero (i.e., in the case when a property is gifted); and

            (5)        the transaction involves a 5% or less interest in a publicly traded corporation, an interest in a domestically-controlled REIT or an interest in a U.S. company that has disposed of all of its USRPIs in a taxable sale.

 Finally, in the case where the foreign seller may have lost money on the sale or only made a small profit (i.e., where the 10% of the purchase price withholding greatly exceeds the real tax the foreign seller would be required to pay), the foreign seller may submit an application to the IRS requesting that the amount withheld by the buyer be a lower amount.  If at closing the seller provides the buyer with a notice that the seller has applied for a withholding certificate, the buyer retains the withheld amount (generally in an escrow arrangement with counsel) pending receipt of the IRS approval or denial.  It is important for buyers to confirm that a proper and timely application for the withholding certificate has been made by the seller.  It is also critical to apply for a withholding certificate as soon as any property transfer has been arranged (i.e., well in advance of closing) because it can take the IRS up to three months (and sometimes even longer) to approve an application and issue a withholding certificate.  In order to submit an application for reduced withholding (Form 8288-B), FIRPTA now requires that both buyer and seller must have tax identification numbers.  Accordingly, the best practice is for a foreign owner to obtain a tax identification number upon purchasing U.S. real property (whether or not it is then needed), as now it will ultimately be needed upon sale. 

Conclusion

 Navigating the framework of withholding rules can be quite daunting to the practitioner not familiar with FIRPTA.  Most general FIRPTA principles have numerous exceptions that are interpreted by regulations, judicial decisions and rulings by tax authorities.  Transactions involving the interplay between FIRPTA and Section 1031 exchanges or short sales pose even greater complexity.  It should also be noted that FIRPTA is only one of several U.S. tax issues which must be considered when representing a foreign real estate investor.  Additional U.S. tax laws such as the Branch Profits Tax, Earnings Stripping, Partnership Withholding and Estate Taxation are often applicable as well.  Accordingly, it is important to obtain the advice of professionals who regularly represent international investors and have experience in navigating FIRPTA and such other laws in order to avoid expensive mistakes.