How to Avoid U.S. FIRPTA Tax for Foreign Real Estate Investors

FAS CPA & Consultants

FIRPTA is the abbreviation used for the Foreign Investment Real Property Tax Act. It is a very important piece of legislation and aims to rule the sales of U.S. real estate made by foreign owners. Those can be both individuals and business entities. One of the main rulings of the FIRPTA is that the party who buys the U.S. property from a foreign seller should withhold 10% of the selling price if the seller is an individual and 35% if it is a business entity. IRS shall be informed of the transaction and the applicable withheld amount within 20 days of it taking place. If the buyer fails to do that, they may be liable for the payment of the seller’s tax.

To make this a bit clearer, here’s an example with figures. If a foreign investor has bought a house in Florida for $700,000 three years ago and now wishes to sell it for $ 1 million, the buyer will have to withhold $100,000. From that amount withheld, the foreign seller will file at year end a tax return and pay between 15% and 20% on capital gains over the difference of the sales price and purchase price plus renovations.

The bad news is that the FIRPTA withholding rule applies even if the property was sold at a loss. The good news is that after the IRS has been notified about the transaction and the 10% (or 35%) have been received, the seller is required to fill in a tax return for the following year reporting the profit and tax calculation for the taxes over that profit @ 15%.  The great news is in 90% of the cases sellers do get refunds on the 10% that has been withheld.

The Foreign Investment In Real Property Tax ACT (FIRPTA) And You

  • FIRPTA was enacted in 1980.  In 2016 the withholding rate was increased and new exemptions were added.
  • FIRPTA is set up to capture taxes on the gains that result from the sale of US real property interests owned directly or indirectly (corporation or partnership) if the seller is a foreign entity not ordinarily subject to US income taxes.
  • It imposes a withholding requirement on BUYERS of US real property interests from non-US owners if the deal is worth more than $300,000.
  • In 2016, the withholding increased to 15% of the entire price paid by the buyer and not only on the capital gain.
  • FIRPTA complicates sales by foreign owners of interests in US real estate and associated property. FIRPTA does not only entail a one-time transaction data analysis. Sometimes the IRS requires a five-year look back.

FIRPTA really came into prominence because of the growth of REITs (Real Estate Investment Trusts) and the lowering of barriers to international investments in the US.

What should be kept in mind, is that with FIRPTA, the withholding takes place at the start of the transaction, and not at the year-end.  You must prepare for it to mitigate its impact right from the start.  It would be disastrous for a seller to wait for the transaction to take place before coming to grips with their FIRPTA obligations, mainly because sellers might not be expecting the 15% withholding.

How FIRTPA Define Real Property

The FIRPTA definition is broader than most other tax codes.  In terms of it, assets that are commonly considered to be personal property or property which does not resemble real estate can be real property for FIRPTA purposes.

This happens if the same meet the IRS FIRPTA criteria for ‘inherently permanent’ assets, which pulls a full spectrum of assets, including underground fiber optic cabling, for example,  into the frail.  All assets that are dedicated to serving a fixed property, including farming and mining equipment, can fall under FIRPTA real property designations; assets typically used in the telecommunications, retail and or and gas industries capitalize assets that are personal property for accounting purposes but are considered real property in terms of FIRPTA. Even some cryptocurrency transactions can be exposed to FIRPTA requirements, when tokens involved in initial coin offerings come to represent an investment in real estate on US soil.

Selling Share Of A Company That Owns US Real Property 

FIRPTA withholding is required only if 50% or more of the company value (of all real property and other business assets) is represented by US real property interests at the time of the sale, AND for five years before the sale.

IRS guidance provide details for all the dates that must be explicitly tested, including the end of the tax year and specific dates the real property was acquired or disposed of.

The Five-Year Lookback

This can be a tough call.  Things change over time and people (and management) come and go and financial systems develop and change.  If the buyer feels any doubt over the accuracy of the seller’s test results, believing it to be based on erroneous or incomplete data, the buyer can reject the FIRPTA-exempt assurances and withhold the tax anyway.

This becomes a real problem when it is challenging to get the correct data from such a long time ago and when it becomes necessary to reconstruct or approximate data, the results become uncertain, to the point where the buyer might refuse to accept it and withholds to mitigate own risk.

To create clarity foreign investors are adding FIRPTA testing mandates into their shareholder and sale agreements that sometimes reduce the purchase price for assets subject to FIRPTA withholding.

It is wise to get your documentation and analysis in order early to prevent costly lookbacks when it is inconvenient.

How to Avoid FIRPTA If You Are a U.S. Greencard Holder

The best way to avoid FIRPTA would be if you have a U.S. citizen or hold a green card. But for any other foreign sellers who can’t provide such documentation, there are also some solutions for avoiding or at least reducing the withheld amount via FIRPTA.

A foreign seller can escape FIRPTA if:

  • They are selling the property for $300,000 or less, and
  • The buyer signs an affidavit, confirming that he or she will use that property as their main residence for the minimum period of 2 years after the sale.

A foreign seller can reduce the FIRPTA withheld amount if they apply for a Withholding Certificate (Form 8288-B). That means they would need to have first a TIN (tax identification number) and if they don’t they should apply for one as soon as possible and before the closing of the deal. You should note that it may take between 4 and 6 weeks for the application to be processed and a TIN to be issued. For the Withholding Certificate itself, it will take up to 90 days for the IRS to act. In some cases, though, there might be delays in processing times and in such instances, the 10% will be escrowed until the IRS takes a decision and acts.

FIRPTA in Summary:

  • When a foreign citizen or company sells a U.S. real estate property, the buyer must withhold 10% (if the seller is an individual) or 35% (if the seller is a business entity of the selling price under the FIRPTA.
  • If the buyer fails to follow the rule they are liable for the whole of the seller’s tax.
  • The FIRPTA rule applies even if the property is sold at a loss.
  • The seller may request a refund after the 10% (or 35%) have been paid to the IRS and a tax return for the following year has been filed.

What are Capital Gains?

Simply put, Capital Gains is the profit made from the sale of a capital asset, for example, a real estate property. There are different tax rates on Capital Gains depending on the duration of the ownership of the property before it was sold. For instance, if you had owned a property for more than a year and then decide to sell it, your Capital Gains will be taxed at a preferred tax rate which is between 10% and 20%. If, however, you’ve owned the property for a short-term (a year or less), then your profit will be taxed at ordinary tax rates, varying from 15% to 39.6% depending on the size of your ordinary income. Certain things may have an impact on the sale profit figure, which would decrease the amount of tax due on Capital Gains. This could be any improvements or renovations you’ve carried out on the property while you were the owner.

Let’s look at the following scenario. Mr. A bought a house in New Orleans in 2015 for $600,000 and he fixed the broken pipes which cost him $30,000. He has just sold the property for $900,000. The sales profit is $300,000, but we need to deduct $30,000 for the renovation that has been done, therefore the profit is decreased to $270,000. Mr. A owes Capital Gains tax on that figure and he will be taxed at a preferred tax rate of 15% because he owned the property for 2 years before he sold it.

Tax on Capital Gains can considerably decrease your net profit, but fortunately there are some solutions, which can delay the payment of such taxes. One of them is Section 1031, which allows taxes on Capital Gains to be deferred when a property is being sold with the intention to be exchanged for another one. There’s no limit on the times this mechanism can be used, which means postponing the taxes indefinitely. If it sounds too good to be true, that’s probably because there are certain conditions that need to be met for the Section 1031 to be applicable. The main things you should pay attention to when considering the 1031 are:

  • Like-kind Property
  • Mixed Exchanges
  • Deferred Exchange

Like-kind Property

For the Section 1031 exemption to be used the exchanged properties need to be of the same kind. As this can be freely interpreted, the legislation provides a list of common properties that are eligible to benefit from the 1031 exchange. In some cases the exemption will not be applicable, like for example, if the property has been utilized for personal use (a house, flat, etc.).

Mixed Exchanges

In very rare and specific cases the IRC allows a deferral on Capital Gain taxes if the goods are not of the same kind. For instance, one good can be exchanged for many other goods of the same kind or there has been money paid to one of the parties in addition to the exchanged goods. There are also special rules for the exchange of the public debts and other financial instruments.

Deferred Exchange

It is not compulsory for the two exchange parties to be contextual, in order to be able to take advantage of Section 1031, however they must satisfy certain temporal requirements, which are outlined in the IRC legislation dedicated to deferred exchange.

For a foreigner who wants to do business in the USA, it is essential to have an ITIN and a TAX ID.

What is an ITIN?

The ITIN is tax identification number, issued by the IRS to individuals who are not eligible for a Social Security Number, but have tax obligations in the US. It doesn’t depend on the immigration status and it is only used for reporting federal tax. The ITIN consists of 9 digits from 900-70-0000 to 999-99-999. Generally, resident or non-resident aliens, who need to file a tax return in the US, but don’t qualify for SSN, and their dependents and/or spouses, need to obtain an ITIN.

What is a Tax ID?

A Tax ID is often referred to as an Employer Identification Number (EIN) and is issued by the IRS to businesses. These may be sole-proprietorship, partnerships, corporations or any other business entity. You may need a Tax ID for a number of reasons, for example, hiring employees, starting a new venture or establishing a pension plan.

Click Here To Get more Info About ITIN and Tax ID

Readers should note that this article is only intended to convey general information on these issues and that FAS CPA & Consultants (FAS) in no way intended for the contents of this article to be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services.  This article cannot serve as a substitute for such professional services or advice.  Any decision or action that may affect the reader’s business should not rely solely on the contents of this article, but should rather be consulted on with a qualified professional adviser. FAS shall not be responsible for any loss sustained by any person who relies on this presentation.  This article is subject to change at any time and for any reason.

Contact us for more info about tax strategies for Real Estate Investments. 

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