As the calendar flips from 2020 to 2021, we are seeing an uptick in real estate transactions, specifically in the area of vacation homes or cottages. The travel restrictions that have been in place since early 2020 may play a part in this decision as well. If you are a foreign (non-U.S.) person looking to move on from your ski property, vacation home or investment property, the withholding taxes under FIRPTA can sneak up on you.
What is FIRPTA? In a country synonymous for its acronyms, it is the Foreign Investment in Real Property Tax Act of 1980. FIRPTA is a 15% withholding tax on the gross sales price of real property owned by a foreign person (non-U.S. citizen or resident). The withholding requirement can also apply in cases surrounding certain classifications of domestic corporations or foreign corporations (at a higher 21% rate). In addition to sales of property to third parties, FIRPTA may apply to gifts of U.S. real property interests, or sales, transfers or distributions/redemptions of U.S. real property holding corporations.
A U.S. real property interest (“USRPI”) is an interest in real property located in the United States or the U.S. Virgin Islands, as well as certain personal property that is connected with the use of real property. A U.S. Real Property Holding Corporation is a corporation that holds USRPIs that make up at 50% or more of the sum, based on fair market value of USRPI, real estate outside of the U.S. and other business assets.
The IRS allows the seller of a USRPI to apply for reduced or eliminated withholding, if they can show that the ultimate tax on the transaction is less than the gross 15% withholding, which is often the case. The seller must apply to the IRS for a withholding certificate prior to the closing of the property and provide the buyer with this documentation. In the closing process, the buyer will hold the withholding amount in escrow until a determination is received from the IRS. Regardless of whether FIRPTA is applied on a gross basis, or relief is received from the IRS, a U.S. tax return ultimately still must be filed by the seller to report the transaction.
There are a few exceptions to these rules. The most frequent exception is that if the amount realized in the transaction is less than $300,000 and the purchaser is able to sign an affidavit that they are planning to use the property as a personal residence, then FIRPTA does not apply. Should the sales price exceed $300,000, then the withholding rate is reduced from 15% to 10%.
It is paramount that evaluation and planning for the transaction happen prior to the property even being listed for sale. The seller may need to obtain a U.S. Individual Taxpayer Identification Number, become current on U.S. income tax returns in the case of rental properties or accumulate documentation to support property improvements. Without proper planning, the seller may have to come to the property closing with a check to cover the withholding amount in the case of highly leveraged properties. While the excess withholding can eventually be recovered by filing a U.S. tax return, it is better to apply up front for a reduction. For a property sold in January by a calendar year tax filer, it could take 18 months or longer to recover the funds by the time a tax return is filed and processed by the IRS.
Also, to note, many states have their own withholding requirements similar to FIRPTA for non-residents selling real property in their states that should be evaluated as well.