Can Foreign Investors Do 1031 Exchanges?
UNDERSTANDING THE FOREIGN WITHHOLDING RULES
Purchasers of real estate from foreign sellers, and escrow agents and closing agents who close those transactions, need to be aware of the federal withholding requirements set out in the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA). Under FIRPTA, the buyer of U.S. real estate from a foreign person or entity must withhold tax equal to up to 15% of the “amount realized” from the sale. The amount realized includes the total amount received for the property including cash, the existing balance of mortgages encumbering the property (whether subject to or assumed) and any non-cash personal property. Because the amount realized can include all of these items, it is possible that the withholding could be more than the cash that is available at the closing.
BASIC RULES UNDER FIRPTA
Withholding is only necessary when the seller is a foreign person, which includes non-resident alien individuals, partnerships, trusts and estates and certain corporations domiciled outside of the United States. At or before the closing, if the seller signs a certification of non-foreign status stating under penalty of perjury that he is not a foreign person, the buyer can rely on that unless he has actual knowledge that it is not accurate. If the seller is able to sign the certification, no withholding is required, but the buyer must retain the certification for five years after the transfer.
If the seller is a foreign entity or person, the buyer must withhold the 15% and remit the tax to the IRS within 20 days of the date of closing. If the buyer fails to do so, the buyer is liable to the IRS for the tax that should have been withheld plus penalties and interest.
FIRPTA withholding is commonly referred to as a 15% tax; however, this is not technically correct. If the amount of tax ultimately due on the filing of the foreign seller’s U.S. tax return is less than the amount withheld, the overpayment is refunded. On the other hand, if the ultimate tax liability is greater than the 15% withheld, the difference will be due from the foreign seller.
If the ultimate tax liability is expected to be either zero or less than the required 15% withholding amount, the foreign seller can apply for a withholding certificate requesting a reduction in the withholding amount. This is done by filing IRS Form 8288-B. This form essentially constitutes a mini-tax return and must be filed prior to closing. The IRS takes approximately 90 days to process this form. In the meantime, the buyer must withhold but can wait for the IRS’s response before remitting the funds to the IRS. Once the buyer hears back from the IRS, he must send whatever withholding is required to the IRS within 20 days.
EXCEPTIONS TO WITHHOLDING REQUIREMENT
Use of Property as Home. No withholding is required when the sale price is $300,000 or less and the buyer acquires the property for use as a home. If the sale price is between $300,000 and $1,000,000, and the buyer acquires the property for use as a home, then the withholding amount is 10% of the full amount realized.
The buyer or a member of the buyer’s family must have definite plans to live at the property at least 50% of the time the property is occupied for the two years following the closing. Days when the property is vacant do not count in the calculation.
1031 Exchange. There is a common misconception that foreign sellers can avoid FIRPTA withholding by participating in a 1031 exchange. Previously, foreign sellers in a 1031 exchange were only required to give notice of their intent to the buyer to relieve the buyer of the withholding requirements. In cases where the subsequent purchase of the replacement property did not occur, the IRS was disadvantaged in its ability to recover the tax that should have been withheld.
In order for the sale of the relinquished property in a 1031 exchange to be exempt under current regulations: 1) the closing of the relinquished property must occur simultaneously with the purchase of the replacement property; 2) there can be no boot in the exchange; 3) the seller must notify the buyer that the seller is not required to recognize any gain or loss and; 4) the buyer must provide, within 20 days, a copy of the non-recognition notice to the IRS in which the buyer confirms that these requirements are satisfied.
ADDING FUNDS TO ACCOMPLISH AN EXCHANGE
For foreign sellers who want to do an exchange, it may be possible for them to use personal funds to come up with additional cash in order to pay the withholding so that the full amount of the cash from the sale can go to the exchange. Talk to your tax advisor, but this suggestion is analogous to when a seller adds cash to a relinquished property closing for tenant security deposits instead of providing a credit for those to the buyer, so that all cash can be available for the exchange.
This is a brief article summarizing some, but not all, of the FIRPTA rules. For further details, you can go to the IRS web site at www.irs.gov. Sellers, buyers and closing agents should consult with their advisors to get all of the details about FIRPTA. In addition, if the transaction will be structured as part of a 1031 exchange, the professionals at First American Exchange Company can help you and your advisors make it a seamless transaction.
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