The Florida real estate market has fluctuated over the last few years. Nevertheless, Florida continues to be a popular place for foreign investors to purchase real estate. In 2017, the National Association of Realtors (NARR) revealed that 22 percent of international investments in real estate within the United States were in Florida, the highest among all states, followed by California and Texas. (1) According to the NAR's study, foreign buyers and recent immigrants purchased approximately $153 billion of residential property between April 2016 and March 2017. (2) These foreign buyers will eventually become foreign sellers, and these foreign sellers may then be subject to the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA). (3)
Under FIRPTA, a foreign seller of U.S. real property is subject to a tax withholding at closing, and the buyer in such transaction is obligated to submit the tax withholding to the IRS. (4) This article provides a brief history of FIRPTA and lists the different types of sellers involved in transactions. Furthermore, it guides the reader through a step-by-step approach in determining 1) whether the seller is a U.S. person or foreign person (be it an individual, limited liability company, corporation, partnership, or trust); 2) whether the FIRPTA withholding applies to a given transaction or if it falls under an exception; and 3) what is the amount of the tax withholding. To help guide real estate practitioners through the analysis, included is a FIRPTA paradigm (decision matrix) divided into Part A--Seller Analysis and Part B--Residential Exceptions. Similarly, endnotes list many references and examples as resources to learn more about FIRPTA. The idea is for the real estate practitioner to be better equipped to handle real estate transactions in which FIRPTA issues arise. More importantly, the article increases awareness of FIRPTA and ensures compliance with its requirements, as noncompliance of FIRPTA requirements may result in late fees, payment of interest, civil liabilities, and even criminal penalties. (5)
Foreign Investment in Real Property Tax Act of 1980
In general, the IRS imposes an income tax on any given individual's or entity's net taxable income (the gross income earned minus any deductions, if applicable). (6) This income tax is mandatory and generally paid by all U.S. persons. In the late 1970s, a large number of foreign investments took place in the U.S. (7) By way of loopholes in tax laws at that time, foreign investors were able to avoid paying income tax on the gain earned on the sale of their U.S. real property, while U.S. persons still had to pay the income tax on their gains. (8) This meant that foreign investors were receiving tax advantages that exceeded those of U.S. persons (9) (i.e., foreign sellers were getting away with not paying income tax on their gains), which was viewed by many, understandingly so, as unfair. (10) The common argument among foreign investors then was that simply owning rental income property and receiving rental income did not rise to the level of being "effectively connected to a U.S. trade or business" qualifying the foreign investor to pay income tax in the U.S. (11) To balance the scale between foreign and U.S. real estate investors, on December 5, 1980, President Jimmy Carter signed the Omnibus Reconciliation Act of 1980, which included the Foreign Investment in Real Property Tax Act of 1980. (12) After FIRPTA was passed, a foreign individual or entity had to pay income tax on any gain from the sale or exchange of U.S. real property as if such gain was effectively connected to a U.S. trade or business during a given taxable year. (13) This meant that foreign investors could no longer avoid the payment of income tax.
Under FIRPTA, a buyer who purchases U.S. real estate from a foreign seller is obligated to withhold from seller's proceeds, and submit to the IRS, a percentage of the sales price of the U.S. real property. (14) This tax withholding is a sort of prepayment or credit to be applied toward the foreign seller's potential U.S. income tax liability. The foreign seller then files an income tax return for the transaction. However, in the event the seller flees the country without filing a tax return, then the IRS at least collected the income tax or a substantial portion of it. This prevents the foreign seller from avoiding income tax liability. A foreign seller may claim a refund, where the actual income tax liability due after deductions is less than the amount of the tax withheld, provided the claim is filed within a certain time period after the sale. (15)
The rate of the FIRPTA tax withholding was increased in February 2016. Prior to February 2016, a buyer who purchased real property from a foreign person was required to withhold from the seller's proceeds the amount equal to 10 percent of the sales price, subject to certain exceptions. (16) On December 18, 2015, President Barack Obama signed into law the Protecting America from Tax Hikes (PATH) Act, (17) which became effective on February 16, 2016. (18) The Path Act was responsible for the increase and, today, a foreign seller of U.S. real property is subject to a tax withholding equal to 15 percent of the sales price. (19) The PATH Act also amended the residential exceptions criteria, thereby, maintaining the withholding rate at 10 percent for qualifying transactions. (20)
The main purposes of the FIRPTA analysis is to determine whether the seller is a U.S. person or a foreign person. A "U.S. person" is defined as 1) a citizen or resident of the U.S.; 2) a domestic partnership; 3) a domestic corporation; 4) any estate, where its income derives from within the U.S. or such income is effectively connected with the conduct of a trade or business within the U.S.; and 5) a trust, where such trust allows for a U.S. court to exercise primary supervision over its administration and at least one U.S. person has the authority to control all its substantial decisions. (21) The term "domestic" refers to an entity created or organized in the U.S. or under the law of the U.S. or of any state. (22) Note that this definition omits limited liability companies from the definition of a "U.S. person," which is further discussed below. This article focuses on transactions involving sellers who are individuals, limited liability companies, corporations, partnerships, and trusts, because these are the types of sellers that real estate practitioners are more likely to encounter in their transactions. Trusts are discussed on a limited basis, and estates (as sellers) are not discussed.
An individual is deemed a "U.S. person" if he or she is either a citizen or a resident of the U.S. (23) A "citizen" is, generally, a person born in the U.S. (24) A "resident" of the U.S. is someone who is lawfully admitted for permanent residence (25)--a person issued an alien registration card, or Form I-551, more commonly known as a "green card." (26) For tax purposes, an individual may also be deemed a resident of the U.S. for a specific calendar year if the individual meets the "substantial presence test," which is a numerical formula measuring the days an individual is present in the U.S. (27) The substantial presence test can be met if the individual is physically present in the U.S. for at least 183 days during the most recent three-year period (the current year and two preceding years), with a minimum of 31 days in the current year. (28) The term "current year" means the calendar year for which an alien individual is attempting to determine his or her resident status. (29) For purposes of this test, each day of presence in the current year is counted as a full day, each day of presence within the first preceding year (the year right before the current year) is counted as one-third of a day, and each day of presence within the second preceding year (two years before the current year) is counted as one-sixth of a day. (30) The Code of Federal Regulations provides various examples (See Figure 1, page 23). (31) Once the substantial presence test is met, one must obtain evidence of seller's presence in the U.S. The U.S. Customs and Border Protection website (32) now has a function that permits individuals to access their most current five-year arrival and departure history after inputting information from the individual's passport. (33) When reviewing the travel history and calculating the days present, note that certain days are excluded and do not count toward the number of days the individual is physically present in the U.S. (34)
When an individual seller is a U.S. citizen or a U.S. resident (either by obtaining a green card or meeting the substantial presence test), the tax withholding is not required. This individual may issue a...