FIRPTA is the acronym for Foreign Investment in Real Property Tax Act of 1980 and applies to parties acquiring and disposing of real estate located within the United States (US) and owned by a foreign person. A foreign person is defined as a “nonresident alien individual, foreign corporation, foreign partnership, foreign trust or foreign estate, but not a resident alien individual” per Regulation § 1.4445-2(b)(2)(i)(C). The intent of FIRPTA is a 10 percent withholding of the sales price without regard to the cash paid by the buyer or transferee to the seller who is the nonresident alien individual. The withholding represents an advance payment towards the federal capital gains tax obligation collected at closing to be forwarded to the Internal Revenue Service rather than later given the potential difficulty of finding nonresidents should they relocate abroad.
1031 Exchange Implications
When the seller of US real property is a nonresident and their intention is to replace with US real property interests, then a 1031 exchange is a must consideration to defer the federal and state capital gains tax. In addition, a Withholding Certificate from the Internal Revenue Service should be requested to alleviate the 10 percent withholding providing the nonresident’s intent to initiate a 1031 exchange and acquire replacement property.
A 1031 exchange allows US taxpayers to defer, delay, or postpone indefinitely the payment of federal and state capital gains and recaptured depreciation taxes when replacing with property of equal or greater value within 180 calendar days of the initial sale. The deferred taxes are due when the replacement property sells unless they are deferred again with another 1031 exchange. The 1031 exchange requires the engagement of a Qualified Intermediary (QI) to accommodate the exchange by preparing 1031 exchange documentation in accordance with IRS requirements and hold the exchange proceeds or net equity from the sale in an escrow account under the taxpayer’s tax identification number. The IRS recognizes the role of a Qualified Intermediary as an entity not related to the taxpayer, providing a safe harbor to facilitate the 1031 exchange. It is critical that the taxpayer does not have access or touch the exchange proceeds during the exchange. If contact occurs, the IRS may take the position that the taxpayer has constructive receipt of the funds which could and will most likely nullify the 1031 exchange.
Role of Qualified Intermediary
According to Regulation § 1.1445-2(d)(2), the transferee, defined as “any person, foreign, or domestic, that acquires a United States real property interest (USRPI) by purchase, exchange, gift or any other transfer” (per Reg. § 1.1445-1(g)(4)), shall not be required to withhold under Code Section 1445 with respect to the transfer of USRPI if the transferor notifies the transferee that the operation of a nonrecognition provision of the Code results in a tax-free transfer. Consequently, the QI acts as the transferee rather than the buyer and submits to the IRS documentation including forms 8288, 8288a and 8288b, Notice of Nonrecognition and Notification to Buyer and a Withholding Certificate request. The Withholding Certificate request and documentation must be submitted by the 20th day after the date of the exchange.
The IRS will respond within three to four months, contacting the QI to request a copy of the replacement property settlement statement as evidence of a tax-free exchange. The IRS refers to a 1031 exchange as a tax-free exchange because if completed in accordance with regulations, there is no tax due in the year of the federal tax return. The tax does not disappear; rather the obligation to pay is deferred until the replacement property is sold. If another 1031 exchange is initiated, the tax continues to be deferred.
FIRPTA is a requirement when selling USRPIs by a foreign nonresident with failure to comply resulting in the transferee (in a 1031 exchange, typically the QI or buyer if not an exchange) being held liable for the tax and possible penalties plus interest. The transferor or the taxpayer selling or the transferee can request the Withholding Certificate.
Alabama, California, Georgia, Hawaii, Maine, Maryland, New Jersey, New York, Oregon, Rhode Island, South Carolina, West Virgina and Vermont have a comparable FIRPTA withholding requirement if the seller is a nonresident of the state. Withholding exemptions may be available.
