If you have been involved with the sale or purchase of real estate the last several years, whether as an investor, broker or escrow officer, you are likely familiar with Hawaii's non-resident withholding requirements (HARPTA). In a nutshell, Hawaii law requires a buyer to withhold 5% of the sales price and send it to the Hawaii Department of Taxation as a "prepayment" of the state tax a non-resident seller owes on the sale of real estate. Under the law, it is the Buyer's obligation to withhold the tax. In practice, provided that instructions are given to escrow, the amount to be withheld can be shown on the settlement statement and the Escrow Officer would remit the withholding amount to the Department of Taxation on behalf of Seller and Buyer, unless one of the specified exclusions apply.

When non-resident investors are utilizing IRC §1031 Exchanges on the disposition of Hawaii property, they simply complete Form N289 at escrow, on which they can indicate no withholding of tax is due because of a "non-recognition provision", (i.e. the 1031 exchange). The result is that all proceeds are then available to go toward the 1031 exchange. A withholding only becomes necessary if the exchange fails- in which case 5% of the sales price becomes due- and the Qualified Intermediary (QI) assumes responsibility for paying this to the Department of Taxation. If the exchange is partially complete and there is taxable "boot" remaining in the exchange account, then 5% of the boot is withheld by the QI.

Many investors misunderstand the nature of the withholding tax. The withholding is really a deposit towards the tax that will be due once the seller files a return (Form N288C). It is computed based on an arbitrary number - 5% of the sales price - rather than the amount of tax that will actually be due based on the gain. Because of this, many investors, both in Hawaii and California, have criticized the law for requiring them to pay substantially more than would be due, with the refund of the difference only coming months later.

It may be of interest to note that the California legislature has responded to this criticism by amending their withholding law (referred to as Cal-FIRPTA). As of January 1, 2007, sellers of real estate in California will have the ability to choose a different method of withholding that will be a closer approximation to the actual amount of tax that will be due. The new law allows a seller to choose between the traditional withholding equal to 3.33% of the sales price, or withholding based upon computing the amount of tax that would be due on the actual gain using the maximum tax rate.

Currently, no such changes are on the horizon for Hawaii. The California amendment should make an interesting case study of feasibility, however, and perhaps set an example for other States.

For more information and a list of applicable forms, visit http://hawaii.gov/tax.

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All information contained herein is provided as a matter of courtesy to our clients. First American Exchange Company, its officers and agents make no representations as to the completeness and applicability of the information contained herein to each individual taxpayer. As a Qualified Intermediary, First American Exchange Company is precluded from providing tax or legal advice to its clients. Please consult your own independent tax or legal advisor regarding your specific circumstances.