Can foreign investors take advantage of IRS §1031 to execute a tax-deferred exchange when selling their U.S. real estate assets? The short answer is yes. The longer answer is a bit more complex.
Congress enacted the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”) to impose a tax on foreign investors selling real property assets in the United States. The act requires that anyone who buys real estate assets from foreign persons or entities must withhold a prescribed part of the purchase price, which would normally go to the foreign seller. Why exactly? To ensure that the foreign seller pays capital gains taxes when they are due.
Who is considered a foreign person or entity?
FIRPTA applies to nonresident aliens or a foreign partnership, trust, estate, or corporation that has not elected to be treated as a domestic corporation.
How much is withheld?
Purchasers are required to withhold up to 15 percent* of the gross sales price when dealing with individual sellers. For foreign entities, such as foreign corporations or trusts, buyers must withhold 35 percent of the capital gain realized on the sale.
* The withholding rate increased from 10 to 15 percent effective February 16. 2016 with the passage of the Consolidated Appropriations Act, 2016. See PATH Act Changes to Section 1445, February 19, 2016, 81 FR 8398-01, 2016 WL 642618(F.R.)
Can withholding be avoided?
Fortunately, three key exceptions apply to the act's withholding requirements. Let’s take a look.
- The first exception to the withholding requirements is when a property becomes a purchaser's personal residence. To qualify, the purchaser is required to sign an affidavit that the sales price is $300,000 or less, and that the purchaser—or a member of purchaser’s family—intends to use the property as a personal residence for at least 50% of the time that the property is used by any person during the first two years after the purchase closes.
- The second exception arises in the case of simultaneous 1031 exchanges, in which the purchaser is not required to withhold if the seller provides a “Declaration and Notice to Complete an Exchange,” which effectively declares that no recognition of any gain or loss on the sale is required.
It’s important to note that in order to rely on this declaration, the purchaser must ensure that the foreign seller:
- Completes a simultaneous exchange (i.e., the same day).
- Receives no cash or mortgage boot.
- If the property was the seller’s principal residence, the property’s sale price must be less than $300,000.
- The third exception is for transactions in which the IRS has issued a withholding certificate (literally, it is called a “Withholding Certificate”) to the foreign seller. The amount that must be withheld by a buyer can be reduced or eliminated in accord with the certificate. The seller, the seller’s agent, or the purchaser may request one, which may take 90 days or longer to obtain.
So how does a 1031 exchange work with FIRPTA?
Foreign investors can still take advantage of IRS §1031 to execute a tax-deferred exchange using the third exception above, but it takes up-front planning. The first thing to do is to consult with a professional tax advisor to verify if FIRPTA applies. If so, a tax professional can assist with applying for a US taxpayer identification number and requesting a withholding certificate.
The purchaser must be notified in writing that a withholding certificate has been requested. A professional qualified intermediary should be contacted well in advance of the closing date to help prepare all necessary documentation, which must be sent to the closing attorney. Once the sale is complete, the clock begins ticking on the 45-day and 180-day exchange deadlines.