The sale of an interest in real property within the United States by a “foreign person” is subject to tax liability under Foreign Investment in Real Property Tax Act of 1980 (FIRPTA). FIRPTA authorized the United States to tax foreign persons on dispositions of U.S. real property interests. Generally, any buyer of real property from a foreign individual is required to withhold 15% of the amount realized on the sale. If the seller is a foreign person and the buyer fails to withhold, the buyer may be held liable for the tax.
The question frequently arises, who is a “foreign person” for the purposes of the tax. With regard to individuals, the answer can only be derived through an analysis of the Internal Revenue Code and the regulations thereunder, and the result is not obvious.
The regulatory framework begins with the simple proposition that the term “foreign person” means any person that is not a “U.S. person.” Unfortunately, the analysis becomes more complicated from there. First, the IRC regulations define the term “U.S. person” as, among other things, a citizen or “resident” of the United States.
Because a “resident” of the United States falls within the definition of a “U.S. Person” – and is therefore not a “foreign person” under FIRPTA – we must also look to the definition of a “resident alien.” To qualify as a resident alien, a foreign individual must meet at least one of the following three criteria:
- The individual was a “lawful permanent resident” of the United States at any time during the relevant calendar year. Lawful permanent residents are often referred to as “green card” holders who are authorized by the federal government to live permanently within the United States as immigrants.
- The individual passes the “substantial presence test.” An individual meets the substantial presence test if such individual was present in the United States for a sufficient number of days in the current and previous two calendar years. The IRS applies a mathematical formula using the number of days present within the current and previous two calendar years to determine if this requirement is satisfied. All of the days present within the U.S. in the current year, one-third of the days present within the first preceding year, and one-sixth of the days present within the second preceding year are added together. If the sum is equal to or greater than 183, then individual passes the test, so long as the individual was present within the United States for at least 31 days in the current year.
- The individual meets the requirements necessary to make a “first year election.” To determine if this criterion is met, another complicated mathematical formula is used. Subject to other additional requirements, an individual may qualify as a resident alien – and therefore not a “foreign person” under FIRPTA, if the individual was present within the United States for a period of 31 consecutive days followed by presence within the United States for 75% of the remaining days in the calendar year.
Sellers who are uncertain of their tax liability under FIRPTA should consult with a tax advisor. A “foreign person” selling U.S. real property should know that 15% (or 35% for foreign corporations) of the amount realized from the sale must be withheld to comply with FIRPTA.
Buyers can take precautions to protect themselves from FIRPTA tax liability flowing from the purchase of real property from a “foreign person.” To begin, when presenting an offer, a buyer should ensure that the buyer has not checked the box in Section 15.8.1 of the Commission-approved Contract to Buy and Sell Real Estate. A seller who accepts an offer with this box unchecked thereby represents that the seller is not a “foreign person” under FIRPTA. If the seller is a “foreign person,” the seller should present a counterproposal with the box in Section 15.8.1 checked. By doing so, the foreign seller avoids making a misrepresentation and the seller also thereby authorizes the closing company to withhold a sufficient amount from the seller’s proceeds to comply with FIRPTA.
Even where a seller represents that they are not a “foreign person” under FIRPTA, a buyer should still consider taking action, prior to closing, to confirm that the seller will execute a FIRPTA Affidavit as part of the “reasonably required documents” referenced in Section 15.8.1. Many, but not all, title companies in Colorado will ordinarily include a FIRPTA Affidavit in their standard closing packet. Therefore, a buyer should confirm that a FIRPTA Affidavit will be available for the seller’s execution at closing. Notably, a seller could reasonably dispute whether it is “reasonable” to require that the seller execute a FIRPTA Affidavit under Section 15.8.1. For example, it could be debated whether, by entering into the buy-sell agreement, the seller has agreed to provide at closing sworn statements regarding the seller’s tax liability, and that is what the FIRPTA affidavit contemplates. To anticipate and counter this argument, a buyer should confirm, prior to closing and in writing, that the seller is willing to sign the FIRPTA Affidavit at closing. The seller’s failure to object prior to closing could be helpful evidence for a buyer involved in any earnest money dispute. In any event, by obtaining the FIRPTA Affidavit at closing, a buyer takes advantage of a safe haven that the IRS has created and the buyer will face no tax liability under FIRPTA.
For questions about this article please contact Jon Goodman.