FIRPTA Taxes: The devil’s in the details

(This article was published originally by the Texas Association of Realtors)

By Arturo Machado

On the surface, the Foreign Investment in Real Property Tax Act (FIRPTA) seems straightforward enough: Foreign people must pay a 10 percent or 15 percent tax when they sell a piece of U.S. real estate.

As always, though, the devil is in the details. And there are a lot of details, exceptions, and complicating factors. Take this one brief excerpt from the Internal Revenue Code related to FIRPTA, for example:

If a domestic corporation which is or has been a United States real property holding corporation (as defined in section 897(c)(2)) during the applicable period specified in section 897(c)(1)(A)(ii) distributes property to a foreign person in a transaction to which section 302 or part II of subchapter C applies, such corporation shall deduct and withhold under subsection (a) a tax equal to 15 percent of the amount realized by the foreign shareholder.”

If you think that was fun reading, there are 2,500 more words and 352 sets of parentheses in Section 1445 of the Code.

But before your eyes glaze over, you should know that real estate transactions with some level of foreign involvement are quite common in Texas—so common that the TREC residential contracts and Texas REALTORS® commercial contracts contain paragraphs related to FIRPTA. Sooner or later, you are likely to work on a deal subject to FIRPTA.

Eight percent of all homes sold by foreign sellers in the U.S. from April 2018 to March 2019 were sold in Texas, according to NAR. Texas accounted for 10 percent of all homes purchased in the U.S. by international homebuyers during that same time frame. That’s 18,310 homes that will eventually be sold again, triggering FIRPTA questions.

And that’s just one year of sales. Combine those data points with the existing stock of foreign-owned Texas homes plus the billions of dollars of foreign-owned commercial properties across the state, and the magnitude of FIRPTA-impacted deals becomes clearer.

If you get nothing else from this article, hold on to these points:

  1. The parties in the transaction need help on FIRPTA-affected deals from CPAs and attorneys experienced with FIRPTA. Period. Mistakes can be quite expensive, and there are countless ways to get it wrong if you don’t have the necessary expertise.
  2. Whether the seller is considered a U.S. person or a foreign person is critically important, and it’s not as simple as having a taxpayer identification number or a Social Security number.
  3. The amount of FIRPTA withholding is dependent on a variety of factors, as exemptions and reductions can apply in certain circumstances. This is one area where qualified CPA and attorney help is especially important.
  4. The buyer, not the seller, is responsible for acting as the withholding agent and making sure the IRS is paid the appropriate amount of tax.

If you want to dive deeper, here are additional details and complications that can arise.

The Basics: What FIRPTA is and How it Works

FIRPTA imposes a tax on capital gains derived by foreign people from the disposition of U.S. real property interests. Withholding of the funds is required at the time of sale, and the payment must be remitted to the IRS within 20 days following closing.

The job of making sure the IRS gets its money within 20 days falls to the buyer in most cases. The title company normally facilitates this function, but this does not imply the buyer has escaped the obligation to act as withholding agent.

In most cases, the buyer must complete IRS Forms 8288 and 8288-A, where they will enter the amount subject to 10 percent or 15 percent withholding.

The 10 percent withholding rate applies to properties sold above $300,000 but less than $1 million that the buyer intends to occupy as a primary residence. That same property will incur 15 percent withholding if the buyer does not intend to occupy it as a primary residence, regardless of the sales price. There is an exception to withholding in cases where the buyer intends to occupy the property as a primary residence and the sales price is $300,000 or less.

Who is Deemed a Foreign Person or a U.S person?

Since the buyer acts in the capacity of the withholding agent, it is imperative that buyers exercise utmost due diligence on this question, recognizing that a seller’s U.S. or foreign status is not always obvious.

It also isn’t always simple. The IRS defines a foreign seller as a non-resident alien individual, a foreign corporation not treated as a domestic corporation, or a foreign partnership, trust, or estate. If the seller holds U.S. citizenship or a permanent resident card, that person is typically exempt from FIRPTA withholding.

Having an international tax identification number (ITIN) has no bearing on whether the seller is a foreign person or U.S. person. The IRS issues ITINs to help individuals comply with U.S. tax laws and to provide a means to efficiently process tax returns and payments for those ineligible for Social Security numbers. “They are issued regardless of immigration status, because both resident and nonresident aliens may have a U.S. filing or reporting requirement under the Internal Revenue Code. ITINs do not serve any purpose other than federal tax reporting,” to quote directly from the IRS.

For an individual who is neither a U.S. citizen nor a permanent resident, there is a different way to determine this status. This alternative is known as the substantial presence test. That’s IRS lingo for addressing where the person in question spends time, regardless of citizenship status.

Here’s how it works: The seller is considered a United States resident and subject to U.S. taxes if that person meets the substantial presence test for the calendar year. Sellers will be considered substantially present in the U.S. if they are physically present in the U.S. on at least:

  • 31 days during the current year, and
  • 183 days during the three-year period that includes the current year and the two years immediately before that (counting all the days present in the current year, and one-third of the days present in the first year before the current year, and one-sixth of the days present in the second year before the current year.)

Got that? If the calculation outlined above indicates the seller is not a foreign person, the buyer should file what is commonly known as a FIRPTA affidavit attesting to the seller’s non-foreign status.

Clearly, questions of substantial presence—and FIRPTA overall—can be tricky. That’s probably why the Texas Real Estate Commission says:

“A prudent broker will have a list of CPAs or attorneys who are familiar with FIRPTA to provide to a seller with a foreign status. The CPA or attorney can guide the seller and advise them regarding their tax obligations under this law. A license holder should NOT take it upon themselves to determine whether or not the seller has a tax obligation under FIRPTA.”

TREC adds that the buyer should take care to ensure that this question is resolved before closing. “It is not the title company’s job to take care of these issues for the seller or the buyer,” according to TREC’s 2020-2021 Legal Update.

Common FIRPTA Situations and Common Mistakes

One problematic scenario that pops up often involves a seller that is a limited liability corporation (LLC) with a single member.

The common mistake here is assuming that the seller is a U.S. person, exempt from FIRPTA withholding, simply because the LLC was formed in the U.S. However, if that U.S.-based LLC has only one member, then you must determine whether that person is a U.S. person or foreign person. The same rules outlined above apply. It’s about the status of the LLC’s single member, not the location of the LLC.

The lone exception is when the LLC’s single member had previously made a tax election to be treated as a corporation.

That situation is the proverbial tip of the iceberg when it comes to challenging FIRPTA scenarios. Other frequent issues include:

  • The property is being sold at a loss, which has no bearing on whether FIRPTA withholding should be applied and definitely does not exempt the transaction.
  • A foreign seller sells the property to a foreign buyer. This, too, does not exempt the transaction. Also be aware that both parties must have taxpayer identification numbers to complete the sale.

So long as the buyer has no actual knowledge that the seller is making a false statement with regard to status, or has not received any notice to the contrary, the buyer can rely on the FIRPTA Affidavit signed at closing and will not be subject to any taxes or penalties.

Mitigating the Tax Obligation

Withholding can often be reduced or eliminated with proper planning and with help from a document known as a withholding certificate. The seller can use this document to show that the underlying tax liability from the sale of real property will be less than the amount of FIRPTA withholding. Supporting documentation must be included to support this claim.

But beware: The seller must apply for a withholding certificate using IRS Form 8288-B before or on the date of closing. If the withholding certificate is received prior to the sale, the buyer can rely on the withholding certificate for zero or reduced withholding. If, however, the withholding certificate is not approved at the time of the transaction, the IRS permits the buyer to place the withholding in escrow until the IRS responds by either approving the seller’s withholding certificate or denying it. It’s a good idea to have an attorney act as the withholding agent, with authority over the escrow funds, while the IRS reviews the application. If the IRS approves the withholding certificate, the buyer should then remit the amount placed in escrow back to the seller. If the application is denied, the buyer must remit the full amount to the IRS.

How to Become Better Prepared

Your ability to build strong relationships with buyers and sellers could easily lead them to expect you to resolve FIRPTA questions. But don’t fall into the trap of providing tax or legal advice. The time to prepare for a FIRPTA transaction is before one comes your way. As TREC recommends, brokers and agents should get to know CPAs and attorneys who have a significant portfolio of FIRPTA experience. Expert help can help you avoid leaving buyers with a heavy IRS obligation they didn’t see coming.

ARTURO MACHADO, CPA, is a shareholder and leader of the international practice group at Sol Schwartz & Associates in San Antonio, where he works on approximately 25-30 FIRPTA transactions annually and provides tax consulting and compliance services. He has more than 20 years of accounting experience with a particular concentration in international tax. Machado is a frequent speaker in the U.S. and Mexico and has participated in numerous tax forums on inbound and outbound tax issues to consider when doing business domestically and abroad.