In 1980, Congress enacted the Foreign Investment in Real Property Tax Act (FIRPTA) to address concerns about increasing foreign land ownership in the US. The Act implemented a requirement for withholding taxes on foreign entities' sale of US properties. What’s interesting about the withholding requirement is that the property buyer is responsible for ensuring the amount is withheld and transferred to the IRS.
The amount that needs to be withheld from the proceeds depends on the sale amount and other variables, like whether the seller is an individual or a corporation and the intended function. For example, the withholding percentage is lower if the property is a primary residence. On the other hand, if the seller is a corporation, the withholding is much higher than that applied to an individual.
Why was FIRPTA necessary?
The legislation was motivated by concern that foreign investors were avoiding payment of taxes on their investments in the US. FIRPTA applies to non-resident aliens, foreign partnerships, trusts, estates, and corporations. The Act corrected a perceived advantage that foreign investors received by not having to pay capital gains taxes on the disposition of real property interests in the US, unlike US residents, who must. Previously, non-US entities and individuals only paid taxes on income derived from the conduct of a US trade or business.
Section 897 changed the definition of income for foreign entities.
Section 897 changes the treatment of gains and losses from the disposition of US property by a foreign entity to being “effectively connected” with the conduct of a US trade or business, which makes the income from such activities subject to taxation. It defines USRPI (US Real Property Interests) as including any of these:
- Land and unsevered natural products of the land
- Improvements
- Personal property associated with the use of real property
- Timber
- Crops
- Mines
- Wells
- Buildings
- Oil and gas pipelines
- Leaseholds
Can a foreign seller perform a 1031 exchange to defer the taxes?
Yes, there are two ways that the foreign entity can defer the taxes due under 897 (and relieve the buyer from the responsibility of withholding). First, if the seller is executing a simultaneous 1031 exchange and receives no boot. Instant exchanges are challenging and thus not as common as delayed exchanges.
Delayed exchanges are also possible if the foreign seller has a taxpayer identification number already issued by the IRS and requests a withholding certificate. Participants in this transaction should ensure that their Qualified Intermediary is familiar with the additional requirements involved in the exchange.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Examples are hypothetical and for illustrative purposes only. Withdrawal strategies should take into account the investment objectives, financial situation and particular needs of the individual.
Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
