FIRPTA rules impact U.S. real estate transactions
INSIGHT ARTICLE |
The Association of Foreign Investors in Real Estate released the group's 22nd annual survey in early 2014, indicating that the United States remained the most stable and secure country for foreign investment in real estate by more than 50 percentage points over the second most stable and secure country, Germany, the widest margin since 2006. The United States led the rankings for planned real estate acquisitions in 2014, with 48 percent of respondents projecting a modest increase in their U.S. portfolio size and 20 percent projecting a major increase. As these foreign holders of U.S. real estate dispose of their U.S. real estate holdings, prospective purchasers should be aware of potential withholding tax obligations and tax reporting requirements under the Foreign Investment in Real Property Tax Act (FIRPTA), P.L. 96-499, before entering into such transactions.
Taxation of foreign persons: Generally
The United States taxes U.S. citizens, resident aliens, and domestic corporations on worldwide income. However, for nonresident alien individuals and foreign corporations, the United States generally taxes only U.S.-source income of specified types and income effectively connected (or treated as effectively connected) with a trade or business conducted by the foreign person within the United States. Under sections 871(b) and 882, such nonresident alien individuals or foreign corporations generally pay U.S. income tax at the regular U.S. rates on income (including certain foreign-source income) that is effectively connected with a U.S. trade or business.
The FIRPTA rules
Under section 897 (a)(1) (enacted in 1980), a foreign seller's gain or loss on a sale or disposition of a U.S. real property interest (FIRPTA gain or loss) is considered effectively connected with a trade or business carried on in the United States, even if the property was a wholly passive investment of the taxpayer. Taxpayers must combine their FIRPTA gain or loss with income, gain, or loss for the tax year from any business actually carried on by the taxpayer in the United States and, if the taxpayer so elects, with other nonbusiness income from U.S. real property (e.g., rental income from U.S. real property). The sum of this income or loss constitutes effectively connected income (ECI), and non-U.S. taxpayers must pay tax at the rates provided by section 1 or 11.
Congress passed FIRPTA to achieve parity in the tax treatment of foreign and domestic investors in U.S. real estate. Thus, under FIRPTA, foreign sellers and U.S. sellers pay U.S. tax on the disposition of U.S. real estate at the same rates.
U.S. real property interests and U.S. real property holding corporations
Under section 897, gain or loss on the disposition of a U.S. real property (USRP) interest is ECI. Defined in section 897(c) and Regs. section 1.897-1, USRP interests include direct interests in real property (land, buildings, and other improvements) located in the United States. USRP interests also may include direct or indirect rights to share in appreciation in value, gross or net proceeds, or profits from real property, as well as growing crops, standing timber, mines, wells, and other natural deposits.
In addition, USRP interests may include interests in domestic corporations classified as U.S. real property holding corporations (USRPHCs), which are corporations with a majority of assets consisting of USRP interests. That is, a corporation is a USRPHC if the fair market value (FMV) of USRP interests held on any determination date equals or exceeds 50 percent of the sum of (1) USRP interests, (2) non-U.S. real property interests, and (3) other trade or business assets held by the corporation. If a domestic corporation has 50 percent or more control over another entity, the other entity's assets will be taken into account under a special lookthrough rule (see section 897(c)(5)). The rules for dispositions of interests in entities holding USRP were included in FIRPTA because, otherwise, a foreign investor could avoid tax on the gain by holding the real estate through a corporation, partnership, or trust and disposing of the interest in that entity rather than having the entity itself sell the real estate.
FIRPTA withholding tax obligations
Upon a foreign seller's disposition of a USRP, the purchaser or recipient of the real estate (i.e., the transferee) is treated as a withholding agent and generally required to withhold a tax equal to 10 percent of the amount realized by the foreign seller upon disposition of the USRP interest, provided the amount realized is greater than zero (Regs. section 1.1445-1(b)). The transferee is responsible for determining whether the transferor is a foreign person. If the transferor is a foreign person and the transferee fails to withhold, the transferee may be held liable for the tax. While the sale or purchase of real estate qualifies as a disposition, other transactions also qualify as dispositions, such as gifts, redemptions, and capital contributions, and such transactions could trigger an obligation to withhold if there is an amount realized. If no amount is realized, as in the case of a gift, no obligation to withhold arises.
The amount realized by the foreign seller on the disposition of the property is generally the sum of (1) the cash received, or to be received (principal only), (2) the FMV of other property transferred, or to be transferred, and (3) the amount of any liability assumed by the transferee or to which the property is subject immediately before and after the transfer (Regs. section 1.1445-1(g)(5)).
For property owned jointly by U.S. and foreign persons, the amount realized is allocated between or among the transferors based on the capital contribution of each transferor, and section 1445 withholding applies only to the amount allocable to the foreign transferors (Regs. section 1.1445-1(b)(2) ).
Under Regs. section 1.1445-1(b)(1) , joint transferees have joint and several liability with respect to the withholding obligation under section 1445. Furthermore, both domestic and foreign transferees are subject to the section 1445 withholding requirements. Note that neither section 1445 nor section 897 distinguishes foreign from U.S. transferees (see Regs. section 1.1445-1(g)(4)).
Exceptions from withholding tax
Section 1445(b) outlines several situations that are not subject to withholding, including:
- The transferee acquires the USRP for use as a home, and the amount realized does not exceed $300,000. The purchaser must show that the purchaser or members of the purchaser's family have definite plans to reside at the property for at least 50 percent of the number of days the property is used by any person during each of the first two years after acquisition (section 1445(b)(5) and Regs. section 1.1445-2(d)(1)).
- The property disposed of (other than certain dispositions of nonpublicly traded interests) is an interest in a domestic corporation that has a class of its stock regularly traded on an established securities market (Regs. section 1.1445-2(c)(2)). However, if the stock had been held by a foreign person who beneficially owned more than 5 percent of the FMV of that class at any time during the previous five-year period, that interest is a USRP interest if the corporation qualifies as a USRPHC, and the U.S. purchaser must withhold on any disposition.
- The disposition is of an interest in a domestic corporation, and that corporation furnishes the purchaser a certification stating, under penalties of perjury, that the interest is not a USRP interest. Generally, the corporation can make this certification only if (1) the corporation was not a USRPHC during the previous five years (or, if shorter, the period the interest was held by its present owner), or (2) as of the date of disposition, the interest in the corporation is not a USRP interest by reason of section 897(c)(1)(B). The certification must be dated not more than 30 days before the date of transfer (Regs. section 1.1445-2(c)(3)). Taxpayers relying on this exception must provide notice to the IRS within 30 days of issuing this certification (Regs. section 1.897-2(h)(2)(v)). Many taxpayers often fail to provide such notice and must seek relief under Rev. Proc. 2008-27.
- The seller provides the U.S. purchaser 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 (TIN), and home address (or office address, in the case of an entity) (section 1445(b)(2)).
- The withholding agent receives a withholding certificate from the IRS that excuses withholding (Regs. section 1.1445-2(d)(7)).
- The seller gives the U.S. purchaser written notice that no recognition of any gain or loss on the transfer is required because of a nonrecognition provision in the Code or a U.S. tax treaty. The purchaser must file a copy of the notice by the 20th day after the date of transfer with the Internal Revenue Service Center in Ogden, Utah.
- The amount realized by the foreign seller on the sale of a USRP interest is zero (Regs. section 1.1445-2(d)(8)).
- The property is acquired by the United States, a U.S. state or possession, a political subdivision thereof, or the District of Columbia (Regs. section 1.1445-2(d)(5)).
- The disposition (other than certain dispositions of nonpublicly traded interests) is of publicly traded partnerships or trusts. However, if an interest in a publicly traded partnership or trust was owned by a foreign person with a greater than 5 percent interest at any time during the previous five-year period, then that interest is a USRP interest (if the partnership or trust would otherwise qualify as a USRPHC if it were a corporation), and the disposition is subject to withholding (Regs. section 1.1445-2(c)(2)).
The certifications in items (3) and (4) are not valid if the withholding agent has actual knowledge, or receives notice from an agent, that the certifications are false. If the withholding agent is required by regulations to furnish a copy of the certification to the IRS and fails to do so in the time and manner prescribed, the certifications are not effective (see section 1445(b)(7)).
Tax reporting and payment of withholding tax
A resident or nonresident transferee, whether an individual, corporation, partnership, estate, or trust, must report and pay any tax withheld upon the purchase of USRP interests by filing either Form 8288,U.S. Withholding Tax Return for Dispositions by Foreign Persons of U.S. Real Property Interests, or Form 8288-A, Statement of Withholding on Dispositions by Foreign Persons of U.S. Real Property Interests. Taxpayers may find detailed guidance on FIRPTA withholding tax procedures on the IRS's website.
Taxpayer identification number requirement
According to IRS guidance, foreign sellers of USRP interests need TINs to request reduced tax withholding when disposing of the property interest and to pay any required withholding (see Regs. sections 1.1445-1 and 1.1441-3). Individuals who do not qualify for Social Security numbers may obtain individual taxpayer identification numbers (ITINs) to meet the requirement to supply a TIN. Regs. section 1.1445-2 requires all transferees (buyers) and foreign transferors (sellers) of USRP interests to provide their TINs on withholding tax returns, applications for withholding certificates, any notice of nonrecognition, and with elections under section 897(i) when disposing of a USRP interest.
A transferee reports and pays the U.S. withholding tax on the purchase of a USRP interest from a foreign person by completing and filing Form 8288, which also serves as the transmittal form for copies A and B of Form 8288-A. Generally, Form 8288 is due by the 20th day after the date of the transfer.
Form 8288-A: Statement of Withholding
The transferee/withholding agent must prepare a Form 8288-A for each foreign seller from which tax has been withheld. Copies A and B of Form 8288-A are included with Form 8288. The IRS stamps Copy B and sends it to the foreign seller subject to FIRPTA withholding. The foreign seller, in turn, must file a U.S. income tax return (likely Form 1120-F, U.S. Income Tax Return of a Foreign Corporation, or Form 1040NR, U.S. Nonresident Alien Income Tax Return) and attach the stamped Copy B of Form 8288-A to receive credit for any tax withheld. It is critical that the transferee/withholding agent include the foreign seller's TIN/ITIN on Form 8288-A. Without a TIN/ITIN, a Form 8288-A will not be provided to the foreign seller. If that is the case, for the foreign seller to obtain credit for the withheld amount, the foreign seller must attach to its U.S. income tax return substantial evidence of withholding (e.g., closing documents) and a statement that contains all the required information shown on Forms 8288 and 8288-A, including the transferor's TIN.
Form 8288-B: Application for Withholding Certificate
A foreign seller may request permission to reduce the withholding tax by sending the IRS an application for a withholding certificate via Form 8288-B, Application for Withholding Certificate for Dispositions by Foreign Persons of U.S. Real Property Interests . The foreign seller must file the form before or on the date of a transfer. If the application is still pending with the IRS on the date of sale, the transferee must withhold the correct amount of tax, but the amount withheld does not have to be reported and paid immediately. The amount withheld (or lesser amount as determined by the IRS) must be reported and paid within 20 days following the day on which a copy of the withholding certificate or notice of denial is mailed by the IRS.
Since Form 8288-B requires a TIN, a transferor and/or transferee who does not qualify for an SSN may apply for an ITIN by attaching Form 8288-B to Form W-7, Application for IRS Individual Taxpayer Identification Number. To obtain an ITIN for FIRPTA purposes, the taxpayer must complete Form W-7 or W-7(SP) (in Spanish).
As with most withholding taxes on payments made to foreign persons, the withholding agent needs to be aware of its withholding, remitting, and reporting obligations ahead of the transaction, as recouping any tax not originally withheld during the transaction is exceptionally difficult, especially in situations involving gross basis withholding. Therefore, transferees in any transaction involving the disposition of USRP interests in which the amount realized exceeds zero should determine from the outset of a transaction whether the foreign seller will provide a certification of reduced withholding. Without such a certificate, the transferee is obligated to withhold 10 percent on the amount realized and remit this amount to the IRS within 20 days of the transaction, as well as report the withholding tax on Form 8288.
Excerpted from the April 2015 issue of The Tax Adviser. Copyright © 2015 by the American Institute of Certified Public Accountants, Inc.