Strategies for minimising tax withholdings on US real estate sales by foreign individuals

Background

Prager Metis CPAs consulted with prospective clients from Israel who invested in real estate properties through an LLC. The LLC sold its share in the investments and the paying agent informed them that 15% of the proceeds would need to be withheld for federal tax. Since the investors anticipated that the ultimate tax on the sale would be lower, they wanted to know whether they could file for a reduction in the rate of tax withheld.

Withholding tax 

The sale of a US real property interest by a foreign person is subject to the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) income tax withholding. The IRS requires that tax be withheld from the sales proceeds by the purchaser or purchaser’s paying agent to ensure that any potential capital gain tax liabilities of the seller are covered. The required withholding amount is generally 15% of the amount realised on the disposition. (There are special rules for foreign corporations.)

The amount to be withheld may be adjusted by filing an application with the IRS for a reduced withholding certificate. The IRS form for this application is Form 8288-B, Application for Withholding Certificate for Dispositions by Foreign Persons of U.S. Real Property Interests.

Form 8288-B computes the estimated gain and tax, and requests that the withholding be equal to the tax calculated. 

The following are key points to know to maximise the benefits of applying for a withholding certificate:

1. Form 8288-B must be submitted to the IRS on or before the day of the closing. 
2. While the application is pending, the regular rate of FIRPTA withholding must remain in an escrow account. 
3.  The IRS generally acts on the application within 90 days. 
4. A seller who applies for a withholding certificate must notify the buyer or paying agent in writing that the certificate has been applied for on the day of or the day prior to the transfer. 
5. A certificate issued before the transfer notifies the buyer that reduced withholding, or no withholding is required. A certificate issued after the transfer may authorise an early or a normal refund. 
6. Once processed and approved, the withholding will be paid from the escrow account and the balance of the escrow account can be paid to the seller.
7. After the sale, it is essential to file a US tax return to report the actual capital gains and tax liability. Any excess withholding on the sale will be refunded.

Exceptions

Withholding income tax under FIRPTA is not required in the following scenarios:

1. The buyer acquires the property as a residence and the sale price is not more than USD 300,000.
2. The property sold is in an interest in a domestic corporation and any class of the corporation is regularly traded on an established securities market.
3. The disposition is of an interest in a domestic corporation and that corporation furnishes the transferee with a certificate stating that the interest is not a US real property interest.
4. The seller certifies that the transferor is not a foreign person.
5. The seller provides written notice to the buyer that a nonrecognition provision of the Internal Revenue Code or a provision of a US Tax Treaty applies that prevents recognition of a gain by the seller.
6. The amount realised on the transfer by the seller is zero.
7. The property is acquired by the United States, a US state or possession, a political subdivision, or the District of Columbia.
8. The grantor realises an amount on the grant or lapse of an option to acquire a US real property interest. 
9. The disposition is of an interest in a publicly traded partnership or trust.

Analysis

The Israeli investors waited until after closing of the sale to consult on the best options available. Since the closing had already taken place, it was too late to adjust or eliminate the 15% withholding. Additionally, none of the exceptions mentioned above were available in this case. The only option remaining was to claim a refund for the over-withholding when filing their annual federal tax returns.

Conclusion

Complying with FIRPTA withholding requirements can be challenging. For the seller, the amount withheld may be reduced below the 15% threshold by obtaining a withholding certificate from the IRS in advance of the closing. For the buyer, failure to comply with FIRPTA withholding requirements could result in substantial liability. Consulting with a tax professional who is knowledgeable about international tax matters and has experience with these filings can reduce the risks of complications later.