Starting in 2016, US individual taxpayer ID numbers (“ITINs”) not used in the prior 5 years on a US tax return will be deactivated by the IRS. So, staring in 2016, if a foreign person hasn’t sold US real estate since (at the latest) 2010 (which should have led to them doing a tax return in 2011), the ITIN they are giving to their escrow officer is very likely no longer valid. In my experience as a tax attorney and the President of a tax firm which works daily with foreign sellers of US real estate, the use of an invalid ITIN can be one of the biggest headaches the foreign seller will ever encounter in their dealings with the IRS. And you can bet a foreign seller not receiving a proper IRS refund will be none too shy about letting their escrow officer know all about the problem. As the age old saying goes: happy foreign seller, happy escrow officer (or something like that).
Why is a Valid ITIN So important to the Foreign Seller?
The stakes for the foreign seller are simple- he or she will need a valid ITIN to obtain a (very possibly large) refund of the federal taxes sent into the IRS by escrow (and maybe the California state taxes too). The federal taxes are the big one. Recall the Internal Revenue Code generally requires the buyer (really the escrow company on the buyer’s behalf in California) to “withhold” 10% of the gross sales price from the foreign seller, and transmit the 10% withholding tax to the IRS at the time of sale (or at least keep the withholding tax in a client trust account while the IRS reviews the seller’s 8288-B withholding certificate application, if applicable). But the 10% withholding tax is almost surely more than the seller really owes in federal income taxes on the sale. For example, if a foreign person bought a Los Angeles vacation home a few years ago for $800,000, and then sold the house for $1,000,000, the escrow company would be required to withhold $100,000 ($1,000,000 x 10%) at the time of sale. The escrow company then sends the $100,000 into the IRS at close (assuming the seller does not file an IRS Form 8288-B with the escrow company holding the withholding tax in a trust account). But while the IRS holds onto $100,000 of the $1,000,000 sale’s proceeds, the foreign seller’s real income tax bill on the sale would likely be closer to $30,000 ($200,000 appreciation x 15% capital gains rate= $30,000). So in this example the IRS is holding onto an extra $70,000 of our foreign seller’s proceeds, and our seller will undoubtedly be quite eager to receive the $70,000 back. But our foreign seller could be in for quite a wait if the escrow company sent in the $100,000 withholding tax with an invalid ITIN. Let’s see why….
What Happens When an Invalid ITIN Is Used?
Recall that when a foreign person sells US real estate, the escrow officer typically transmits the 10% withholding tax to the IRS accompanied by the IRS Forms 8288 and 8288-A. The Form 8288 requires information about the buyer. The Form 8288-A, however, requires information about the buyer and the foreign seller, including the foreign seller’s name and ITIN. Many foreign sellers won’t have an ITIN yet at the date of close (one of the most problematic elements of the entire ITIN system is that the IRS will generally only issue an ITIN once the foreign person has entered into a real estate sales contract, and since the IRS turnaround time for ITIN’s is typically around a month upon receipt of the W-7 application, many foreign sellers will not have yet been issued an ITIN by the date of close; however, for foreign sellers who apply immediately upon signing a sales contract, it is certainly possible to have an ITIN issued by the date of close). Generally an escrow officer would write “applied for” where the 8288-A requests the identification number of the foreign person subject to withholding. And provided the seller eventually obtains an ITIN (and it is certainly “smoother” in our experience if the escrow company or the seller’s tax professional subsequently notifies the IRS of the newly issued number), this process (stating “applied for” on the 8288-A) does not typically lead to problems. However, for reasons maybe only the IRS can answer, when the number put on the 8288-A proves to be an invalid ITIN or invalid social security number (such as a previously issued number which has subsequently been deactivated by the IRS or Social Security Administration), all heck can break loose. When the seller completes a tax return requesting the refund (the $70,000 in our example) in the next year after the sale, the IRS will very possibly not be able to “locate” the seller’s 10% withholding (they can’t find the seller’s $100,000 withholding tax or they cannot issue the $70,000 refund!). Absent a valid US identification number, the withholding tax can apparently go into an IRS black hole- and stay there for quite some time. Phone calls, letters, attorneys, accountants- when the withholding tax is “lost”, none of it may matter. And we have witnessed this “black hole period” stretch literally into a period of years, with foreign sellers, escrow agents and tax preparers spending many hours and all at wits’ end trying to get the poor foreign seller their refund. Eventually, months or even more than a year down the road, the IRS does figure it out and the seller will get their excess withholding tax back, but the lesson here is obvious: at all costs do not use an invalid ITIN for your foreign sellers.
What is the New IRS Development on ITIN’s?
The IRS had previously stated that ITIN’s issued before January 1, 2013, would be valid indefinitely. In 2012, the IRS stated that ITIN’s issued on after January 1, 2013, would automatically expire five years. Under the new IRS guidance issued in 2014 (IR 2014-76), the IRS no longer mandates the automatic expiration of ITIN’s, but provides the following:
- An ITIN will expire for any taxpayer who fails to file a federal income tax return for five consecutive tax years.
- Any ITIN will remain in effect as long as a taxpayer continues to file US tax returns. This includes ITINs issued after Jan. 1, 2013. These taxpayers will no longer face mandatory expiration of their ITINs and the need to reapply starting in 2018, as was the case under the old policy.
- The IRS will begin deactivating unused ITINs in 2016.
- A taxpayer whose ITIN has been deactivated and needs to file a US return can reapply using Form W-7.
For the escrow officer working with a foreign seller and there is a question about whether the seller’s ITIN is still valid (which is basically every ITIN starting in 2016), the foreign person can simply call the IRS at 1-800-908-9982, and the IRS will verify over the phone (only for the foreign person, not the escrow officer on their behalf) whether the ITIN is still valid.
How do Foreign Sellers Obtain an ITIN Again?
So if you are an escrow officer with a transaction involving a foreign seller who needs to obtain an ITIN (whether for the first time or for a second time after a previously issued ITIN has been deactivated), how do they do it? First, the foreign person must obtain a “certified copy” of their foreign passport to submit to the IRS. What is a certified copy of the foreign passport? A passport reviewed and certified by one of the following: (a) a consulate office of the foreign person’s home country located in the US (such as the Canadian Consulate in Los Angeles); (b) a government office in the foreign citizen’s home country which issues passports (such as a Canadian governmental passport office in Vancouver); or private tax professionals in the US (or in foreign countries) specifically permitted by the IRS to certify foreign passports (an “IRS approved certifying acceptance agent”). My company DIRECTS is an IRS approved certified acceptance agent, specially permitted by the IRS to certify foreign passports. Next, the foreign seller (or typically the acceptance agent on his or her behalf) must complete the IRS Form W-7 (which is tricky to do correctly). In addition to the certified copy of the passport and the completed Form W-7, the application must include a copy of the signed real estate sales contract (remember, the IRS will not issue the foreign seller an ITIN without a signed sales contract) and a preliminary IRS Form 8288 for the sale (prepared by escrow or the acceptance working on the application). That’s a lot of information to put together along with properly completing an IRS Form W-7. It is quite common for the IRS to return the W-7 to the applicant (without an ITIN being issued) for one of many errors frequently committed on the W-7, or with respect to errors on the certified passport or one of the several required supplemental documents.
So Be Careful with Old ITIN’s and Helping Foreign Sellers Obtain New ITIN’s
Successfully obtaining newly issued ITIN’s from the IRS is a challenging exercise, and will now be more challenging than ever with previously issued ITIN’s being deactivated starting in 2016. More challenging, however, will the discipline each officer must summon in not unquestioningly accepting ITIN’s given to them by foreign sellers. Have the foreign seller call the IRS when in doubt to check whether the ITIN is still valid, have them call DIRECTS to check on the validity or simply insist the foreign seller obtain a new ITIN when there is any question. Playing it safe can save you and your company many wasted hours helping last year’s angry foreign seller obtain their tax refund. You have more important things to do.
Michael W. Brooks is a California tax attorney and the President and Owner of Domestic and International Real Estate Closing Tax Services, a tax firm specializing exclusively on the tax issues faced by non-US sellers of US/California real estate. Michael can be reached at the office at (760) 346-6140 or on his cell phone at (760) 898-3413, or email him at michael@directsllp.com. For more information about DIRECTS, visit www.directsllp.com
The information contained in this article is provided for informational purposes only, and should not be construed as legal advice on any subject matter. Michael W. Brooks and DIRECTS expressly disclaim all liability in respect to actions taken or not taken based on any or all the contents of this article.