My article was published in the EA Journal recently. Check it out using this link (requires NAEA membership). If not, please see the article below.
Foreign Investment in Real Property Tax Act (FIRPTA) – A Primer
- By Krishnamurthi G Perinkulam, EA, MST
The US Tax system allows for US residents[1] and nonresidents[2] to file a Federal Income Tax return and pay any taxes owed, by the due date of the return. Though the IRS has various tools in its arsenal to go after individuals who fail or refuse to pay their taxes, it is difficult to enforce them on nonresident individuals as they are outside the country.
History of FIRPTA
The IRS imposes a Federal Income tax on an individual’s taxable income (gross income minus applicable deductions)[3][4]. In the 1970s, there arose a perception that the ability of foreigners to avoid the United States income tax stimulated investment in real property in the United States, primarily farm property, thus driving up prices to the disadvantage of American farmers. For several years (prior to 1980), foreign investors were able to invest in real property located in the United States and to legally avoid, to a great extent, the payment of United States Federal Income tax on the operating income from the property and on the gain realized upon the disposition of the property[5].
A foreign investor was subject to United States income taxation on the gain realized from the sale or exchange of real estate only if the gain was “effectively connected” with a United States trade or business in which the investor was engaged during the year in which the gain was realized. The mere ownership of one piece of real property subject to a net lease would not cause the foreign investor to be engaged in a United States trade or business. However, the investor’s activities almost always extended beyond this level such that they were engaged in a United States trade or business. This ability of foreign investors to own real estate in the United States for extended periods and sell it free of United States Federal Income tax on the gain was viewed as an unfair tax avoidance[6]. This forced Congress to enact the Foreign Investment in Real Property Tax Act (FIRPTA) of 1980[7]. One of the main ways Congress enforced this was through I.R.C. 897, which classified gains and losses from the disposition of a US real property by a foreign person to be “effectively connected income” and thus subject to regular net-basis income tax. This article will give you an overview of FIRPTA, some common issues, and potential solutions to those issues.
Withholding
Consider the following scenario when it comes to real estate. Let us assume a foreign national, (say someone from Europe), purchased an investment property in the United States for $400,000 during the real estate crash in 2008. The property has since appreciated, and they subsequently sold the property in 2021 for $1,000,000 with a gain of $600,000. If the escrow company were to give the entire $1,000,000 to this foreign national, there is little to no chance that this individual would file a United States Federal Income Tax return and remit the appropriate amount of tax to the US Treasury.
To avoid such problems, many countries (including United States, Canada, India, etc.) have adopted a policy of withholding tax on the gross income from sources within their respective countries. For example, the IRS has a withholding provision for nonresident individuals that requires a 30% tax to be deducted and withheld on items of income (such as rent, salaries, wages, interest, compensation, etc.) under I.R.C. 1441. These are categorized as “Fixed, Determinable, Annual, or Periodical” income (or FDAP for short). Therefore, if a bank were to issue a $1,000 in interest to a nonresident, they must deduct $300 as tax (30% of $1,000) and remit it to the IRS and give the remainder ($700) to the nonresident. This frees the nonresident from any obligation to file a nonresident Federal Income Tax return with the IRS[8] (although they are free to file a return). If there is a lower withholding available in a treaty between the United States and the nonresident alien’s country, then the lower withholding can be honored.
Withholding by the buyer
FIRPTA is a tax law that imposes U.S. Federal Income tax on foreign persons selling U.S. real estate. Under FIRPTA, if a buyer buys U.S. real estate from a foreign person, the buyer is responsible to withhold 15% of the amount realized from the sale[9]. The amount realized is the sum of any money received (normally the purchase price) and the fair market value of any property received[10]. Unlike the FDAP withholding, which is equal to the actual amount of tax, the FIRPTA withholding on the sale of the U.S. real estate is merely a prepayment of tax. If the withholding exceeds the tax liability, the foreign seller can obtain a refund by filing a U.S. Federal Income Tax return.
There are some exceptions available to the buyer.
a. If the seller furnishes an affidavit stating that he/she is not a foreign person, then no withholding is required[11].
b. If the buyer furnishes an affidavit that they intend to use the property as their residence, and the amount realized does not exceed $300,000, then no withholding is required by the buyer[12].
c. If the buyer furnishes an affidavit that they intend to use the property as their residence, and the amount realized exceeds $300,000 but does not exceed $1,000,000, then a reduced 10% withholding applies (instead of 15%)[13].
Procedure
Let us look at the same example of the foreign national who purchased an investment property in the United States.
Original Purchase Price (Basis) of the U.S. real estate property = $400,000#
Sale Price of the U.S. real estate property = $1,000,000
Capital Gain (Short-Term or Long-Term) = $600,000
FIRPTA Amount Withheld = 15% of $1,000,000 = $150,000.
(#-Assume no improvements were done that would have increased their basis).
Under FIRPTA, the buyer (generally through their escrow agent) must withhold $150,000 (15% of $1,000,000) from the seller and remit this $150,000 withholding to the IRS. The buyer (through their escrow agent) must report and remit the withholding amount to the I.R.S by the 20th day after the date of the transfer using forms 8288, U.S. Withholding Tax Return for Dispositions by Foreign Persons of U.S. Real Property Interests, and 8288-A[14], Statement of Withholding on Dispositions by Foreign Persons of U.S. Real Property Interests.
A timely mailing of Forms 8288 and 8288-A will be treated as timely filed under I.R.C. 7502. Form 8288-A will be stamped by the IRS to show receipt, and a stamped copy will be mailed by the IRS to the transferor (the seller) at the address reported on the form. The seller can then use the stamped Form 8288-A for filing their tax returns.
I will now attempt to highlight a couple of the most common issues faced by nonresident taxpayers, and potential solution on how to solve them.
General issues
Issue #1
If the U.S. real estate property that is sold is jointly owned by a married couple (assume a 50-50 ownership between the two spouses), the escrow agents (generally) report the total amount on a single Form 8288 and 8288-A with one of the spouses as the primary taxpayer. Using our example above, the escrow agent files the Form 8288-A with $1,000,000 as the Amount Realized (Box 3), and $150,000 (Box 2). While this looks correct superficially, a problem arises when the married couple attempt to file a non-resident Federal Income Tax return (1040-NR). Since the 1040-NR cannot be filed using the Married-Filing-Joint status, each spouse needs to file their own 1040-NR with 50% of the sale proceeds as income, and 50% of the withholding as their tax withheld. However, the filing of this 8288-A gives IRS the impression that the primary spouse (whose Tax Identification Number appears on the form) paid 100% of the withholding, and the secondary spouse did not withhold any amount from the proceeds. (See Figure 1.1)
Figure 1.1: Incorrect Way to issue 8288-A in the case of a joint disposition
The easiest way to fix is to request the escrow agent to issue two separate 8288-A forms, with 50% of the sale proceeds and 50% of the withholding to each of the two spouses. (See Figures 1.2 & 1.3). [If the spouses own different percentages, you will request the escrow agent to prepare two separate 8288-A forms based on their percentage of ownership].
If the nonresident taxpayers do not have a U.S. Social Security Number assigned to them, they can apply for an Individual Tax Identification Number (ITIN) at this time using Form W-7, with the Exception code 4 – Disposition by a foreign person of U.S. real property interest – third-party withholding.
Figure 1.2: Correct way for the primary seller taxpayer to file the 8288-A
Figure 1.3: Correct way for the secondary seller taxpayer to file the 8288-A
Issue #2
Many nonresidents with U.S. investment properties from which they collect rental income are not aware that there is a tax obligation equal to 30% of the gross rental income received[15]. This frees the nonresident taxpayer the burden of filing a United States nonresident Federal Income tax return. Deductions are allowed for a nonresident alien only if the income is effectively connected with the conduct of a trade or business within the United States[16]. Since rental income generally does not rise to the level of effectively connected with a trade or business, deductions associated with the rental property are not allowed.
Because of the uncertainties in determining whether a rental activity constituted a trade or business, Congress provides the nonresident taxpayer an election under Code section 871(d). This election allows the (rental) income to be treated as effectively connected with the conduct of a trade or business within the United States[17]. One of the benefits of having the (rental) income to be treated as effectively connected is that the nonresident alien taxpayer can be taxed at graduated rates[18] on the taxable income as provided in § 1 (as opposed to the harsh 30% of the gross income).
How to make the §871(d) election?
The §871(d) election is made by filing a statement that the election is made, and including the following[19] with the Nonresident Federal Income Tax return:
(a) a complete schedule of all real property, any interest in real property, of which the taxpayer is titular or beneficial owner, which is located in the United States,
(b) an indication of the extent to which the taxpayer has direct or beneficial ownership in each such item of real property, or interest in real property,
(c) the location of the real property or interest,
(d) a description of any substantial improvements on any such property, and
(e) an identification of any taxable year or years in respect of which a revocation or a new election under this (871(d)) section has previously occurred.
This election is made in the first year and remains in effect for all subsequent taxable years.
Nonresidents with U.S. investment properties might not have filed a Nonresident Federal Income tax return for multiple years. One of the common mistakes is to assume that the deduction for expenses be taken for granted when the returns are prepared for the respective tax years. If nonresidents can catch up and file all their years of missing returns along with the full benefit of deductions and credits, then everyone would do that, and there would not be an incentive for them to file the nonresident tax returns on time. Unless such nonresident alien individuals are precluded from obtaining deductions and credits, nonresident aliens can delay filing their income tax returns until the Commissioner has prepared a return and suffer no economic loss other than the general late filing and late payment penalties[20] (currently capped at 25%)[21]. By providing an incentive to timely file the Nonresident Federal Income tax returns, a nonresident alien individual shall receive the benefit of deductions and credits only if they timely file their tax return. Such a tax return must be filed within 16 months of the due date to claim deductions and credits[22].
This filing deadline may be waived by the I.R.S, however, the burden of proof falls on the nonresident alien individual to establish to the satisfaction of the Commissioner that they acted reasonably and in good faith in failing to file a U.S. Federal Income tax return[23]. This is based on facts and circumstances of the taxpayer, and there is always a risk that this waiver is not granted and ultimately lead to the I.R.S. disallowing the deductions. The safest alternative is to file the nonresident Federal Income tax returns on time.
These were just a few of the aspects of the FIRPTA provisions. I hope it was informative. Please feel free to send me an email in case of any questions.
Biography:
Krish Perinkulam (PK) is the President of North Phoenix Tax Relief based in Phoenix, Arizona. He has a Master of Science degree in Taxation from Golden Gate University, and an MBA with a specialization in Finance from Aspen University, Colorado. He is an Enrolled Agent, an NTPI Fellow®, a Certified Tax Resolution Specialist, and a Certifying Acceptance Agent. His current practice includes Audit representation, Tax resolution, and Income Tax preparation for ex-pats and visa holders. He can be reached at Info@NorthPhoenixTaxRelief.com, or through http://www.NorthPhoenixTaxRelief.com/ .
[1] I.R.C. 7701(b)(1)(A) [2] I.R.C. 7701(b)(1)(B) [3] I.R.C. 63 [4] I.R.C. -1- [5] Petkun, Lisa B. (1982) "The Foreign Investment in Real Property Act of 1980," Penn State International Law Review: Vol. 1: No. 1, Article 2. Available at: http://elibrary.law.psu.edu/psilr/vol1/iss1/2 [6] Id. [7] Omnibus Reconciliation Act of 1980 (Foreign Investment in Real Property Tax Act of 1980), Pub. L. No. 96-499, §94 Stat. 2682 (1980). [8] Treas. Reg. 1.6012-1(b)(2)(i) [9] I.R.C. 1445(a). [10] I.R.C. 1001(b). [11] I.R.C. 1445(b)(2). [12] I.R.C. 1445(b)(5). [13] I.R.C. 1445(c)(4). [14] Treas. Reg. 1.1445-1(c)(1) [15] I.R.C. 871(a)(1)(A). [16] I.R.C. 873(a). [17] I.R.C. 871(d)(1). [18] I.R.C. 871(b)(1). [19] Treas. Reg. 1.871-10(d)(1)(ii). [20] I.R.C. 6651(a). [21] Espinosa v. Commissioner 107 T.C. 146 (1996) [22] Treas. Reg. 1.874-1(a) & (b)(1). [23] Treas. Reg. 1.874-1(b)(2).
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