Foreign Investment in Real Property Tax Act (Updated: 11/29/17)
The federal Foreign Investment in Real Property Tax Act (“FIRPTA”) attempts to reduce opportunities for foreign persons to avoid U.S. income tax on their sales of U.S. real property interests. For that purpose, FIRPTA generally obligates any person who buys a U.S. real property interest from a foreign person to withhold 15% of the “amount realized” on the transaction and pay that withheld amount to the I.R.S., unless an exemption applies. The “amount realized” will generally be the gross purchase price in the transaction. The amount withheld and paid to the I.R.S. is applied against the seller’s ultimate tax liability. To recover any amount by which that withholding exceeds the seller’s actual tax liability, the foreign seller must file a U.S. income tax return.
The consequences are severe for a buyer who assumes incorrectly that the seller is not a foreign person (whether individual or entity) and who fails to comply with this withholding requirement – the buyer will be liable for the foreign seller’s unpaid tax, and probably penalties and interest too. Anyone buying real estate, then, should either establish an exemption from, or comply with, the FIRPTA withholding requirement.
An exemption exists under FIRPTA for a transaction in which (i) the buyer is an individual or individuals, (ii) the property is acquired by the buyer for use as a residence, and (iii) the purchase price is no more than $300,000. The FIRPTA statute does not define when a property is “acquired for use as a residence,” but some fairly complicated regulations have been adopted which interpret that phrase. Generally, in order to qualify under those regulations, the buyer should intend to reside at the property for at least 50% of the number of days that the property is used by any person during each of the first two years following the date of the purchase. In that calculation, the number of days the property is vacant is not taken into account in determining the number of days the property is used by any person. A buyer relying on this exemption as the basis for not withholding should understand, however, that if the buyer does not end up residing in the property for the required minimum number of days, the buyer will be liable for the foreign seller’s unpaid tax, along with penalties and interest, unless the buyer is able to establish that the failure to reside there the minimum number of days was caused by changed circumstances that could not reasonably have been anticipated at the time of the purchase. If the purchase price exceeds $300,000 but does not exceed $1,000,000, this exemption will not be available, but in that situation the amount required to be withheld and paid to the I.R.S. by an individual buyer or buyers who acquire the property for use as a residence (applying, for that purpose, the same complicated rules referred to above) is only 10% of the amount realized, rather than the 15% generally required by FIRPTA.
Another FIRPTA provision exempts the buyer from the withholding requirement if the seller signs and delivers an affidavit that certifies the seller is not a foreign person and that meets other FIRPTA requirements. This exemption requires that the buyer keep the seller’s non-foreign status affidavit until the end of the 5th year after the taxable year in which the transaction occurs, and make it available to the I.R.S. upon request. This exemption will not be available to a buyer if the buyer has actual knowledge that the seller’s non-foreign status affidavit is false, or if the buyer has been given notice of such falsity by an agent of the buyer or seller. The buyer’s broker should be aware in that regard that if he or she has such actual knowledge of falsity and fails to inform the buyer, certain provisions of FIRPTA may make the broker liable for the foreign seller’s unpaid tax and associated penalties and interest.
The regulations provide sample forms for a non-foreign status affidavit (one for an individual seller, and another for an entity or trust), and it is safest to use the applicable one of those forms to ensure the affidavit includes the required information. If the seller is a trust, limited liability company or other entity, part of the required information for such an affidavit is a certification that the seller is not a disregarded entity for U.S. income tax purposes – because such a disregarded entity may not provide a valid non-foreign status affidavit. If the seller is a disregarded entity, the buyer must obtain the non-foreign status affidavit from the owner of the disregarded entity.
A valid non-foreign status affidavit also includes the seller’s U.S. taxpayer identification number. Because some sellers are uncomfortable giving their social security numbers or EINs to buyers, Congress revised FIRPTA in 2008 to provide an alternative under which the non-foreign status affidavit can be delivered to and held by the closing company, who acts as the buyer’s “Qualified Substitute.” This alternative approach, however, requires that the “Qualified Substitute” provide the buyer with a “Qualified Substitute Statement” indicating, among other things, that the Qualified Substitute has received and retained a qualifying non-foreign status affidavit from the seller, and the exemption will not apply if the Qualified Substitute has actual knowledge, or receives notice from an agent of the buyer or seller, that the affidavit is false.
If a buyer is purchasing property from a foreign seller (whether individual or entity), it is possible that the foreign seller might be able to obtain from the I.R.S. a withholding certificate permitting no withholding, or decreased withholding, in the particular circumstances of the transaction. For example, a withholding certificate allowing for no withholding might be obtained if the seller demonstrates to the I.R.S. that no taxable gain will be realized on the sale. A seller must apply to the I.R.S. to obtain a withholding certificate. It takes some time for such an application to be processed, so a foreign seller intending to obtain such a certificate should work with its tax and real estate advisors in advance of a sale to prepare for it. Such a seller may want to include language in the sales contract providing for (1) the buyer’s cooperation (the buyer’s EIN or social security number is needed for such an application, for example), and (2) the establishment of an escrow at closing if the withholding certificate sought by such an application has not yet been obtained, with the amount required to be withheld by the buyer being held by the escrow agent and disbursed in accordance with the final determination of the I.R.S. regarding the application.
The buyer and buyer’s broker who want to take charge of these FIRPTA issues might do that by first addressing the subject explicitly in any purchase offer. For example, unless the $300,000 or less/residential use exemption will apply, consideration should be given in making any purchase offer to including (1) a representation from the seller that the seller is not a foreign person or entity (and if an entity, a further representation that the seller is not a disregarded entity for U.S. income tax purposes), and (2) an agreement from the seller to sign and deliver to the buyer at closing an affidavit to that effect in the applicable form contained in the Treasury Regulations. A seller’s refusal to accept such provisions then alerts the buyer to the need to explore other possible exemptions or comply with the withholding requirement.
Attention to FIRPTA is needed at the closing as well. Some companies handling real estate closings overlook FIRPTA compliance or ask the buyer to sign documents in which the closing company specifically disclaims any obligation to deal with FIRPTA, and other companies who attempt to address the subject sometimes fail to obtain and deliver everything needed by the buyer to establish an exemption (while also failing to withhold from the seller and pay to the I.R.S. the amount required by FIRPTA). For example, some closing companies will obtain an appropriate non-foreign status affidavit from the seller but then fail to give the buyer either the original signed affidavit or the original of the alternative “Qualified Substitute Statement.”
In addition to addressing FIRPTA explicitly in the purchase contract then, the buyer and buyer’s broker should monitor the subject at closing, to ensure that the buyer either establishes an exemption from, or complies with, the FIRPTA withholding requirement.