FIRPTA Tax Blog
By Michael W. Brooks, Esq.
As discussed in Part 1, we know Foreign Investors are permitted to enter IRC Section 1031 (like-kind exchange) transactions provided certain conditions are met. The Foreign Investor can avoid (really delay) paying tax on the sale of the first property (the relinquished property), provided the Foreign Investor identifies a qualifying replacement property within 45 days of the sale and completes the purchase of the replacement property within 180 days of the sale. But what about the 15% (of the gross sales price) non-US seller withholding tax? Must the escrow company withhold 15% of the sales price because the seller is foreign (even though the foreign party is entering into a 1031 like-kind exchange)? The answer is yes- 15% of the gross sales price must still generally be withheld at the time of closing, and not distributed to the Foreign Investor or to the 1031 Accommodator. This is where 1031 transactions and the rules of FIRPTA (the Foreign Investment in Real Property Tax Act) intersect. The Foreign Investor entering into a like-kind exchange transaction has a big problem with respect to this 15% withholding tax requirement under FIRPTA. For IRC Section 1031 to work, the Foreign Investor must complete the purchase of the replacement property within six months, so he or she will need the 15% held by escrow back quickly, or he or she will blow the like-kind exchange and not be able to avoid the recognition of taxes on the sale relinquished property.
Consider the example below, where a Canadian couple needs their 15% back quickly, or they will owe tax on the sale of their first property.
Example. Canadians Steve and Claire purchase a rental property in Los Angeles in 2016 for $1M. On February 1, 2019, Steve and Claire sell their Los Angeles property for $1.6M. After realtor and escrow fees of around $100,000 total, let’s say Steve and Claire make a $500,000 profit on the sale of the Los Angeles property ($1,600,000 sales price- $100,000 realtor/escrow fees- $1,000,000 original purchase price= $500,000 net profit). The general federal rate for lower level capital gains is 15%. So Steve and Claire are on their way to owing the IRS $75,000 ($500,000 profit x 15% capital gains rate) for the tax year 2019. But Steve and Claire engage a qualified 1031 accommodator, they identify a replacement property in Irvine, California, within 45 days of the Feb 1 sale, and finally they submit an offer which is ultimately accepted, to purchase the new property in Irvine for 1.5M. The close date for the Irvine replacement property is scheduled for July 1, 2019, easily within 1031’s six-month deadline. Everything looks perfect for Steve and Claire to avoid paying tax in 2019. But Foreign Investors Steve and Claire have one big problem still to address: as non-US sellers, Steve and Claire are subject to the mandatory 15% withholding tax at the time of sale. On February 1, 2019, the escrow company had no choice but to withhold $240,000. What happened to the $240,000, and can Steve and Claire rescue their 1031 like-kind exchange?
If Steve and Claire had not prepared in advance for the $240,000 non-US seller withholding tax, on February 1, 2019, the escrow agent overseeing the sale of the Los Angeles property would have sent the $240,000 into the IRS. Even though Steve and Claire were entering into a 1031 tax-free exchange in 2019, the $240,000 would not have been wired to the accommodator, nor would it have been wired to Steve and Claire as their proceeds from the sale…no, escrow, by law, would have mailed the $240,000 into the IRS, where it would have stayed probably for a minimum of 17 months! Unless Steve and Claire had another $240,000 at their disposal, they could not have completed the Irvine purchase or obtained tax-free recognition to avoid paying the $75,000 capital gains tax on the sale of the Los Angeles home. $240,000 stuck in the IRS (maybe for a very long time…) and $75,000 in capital gains still required on Steve and Claire’s US federal tax return for 2019. Not good…
What was Steve and Claire’s best option to avoid this worsening catastrophe? If they were prepared in advance, or perhaps their realtor was prepared, they would have contacted DIRECTS (Domestic and International Real Estate Closing Tax Services, Inc.) before the sale of the Los Angeles property. Via DIRECTS intimate knowledge of the 8288-B withholding certificate process, Michael Brooks or other members of the DIRECTS’ team would have prepared the escrow company, so they would feel comfortable in not sending in the $240,000 withholding tax at the close on Feb 1, 2019 (the escrow is permitted to not send in the withholding tax if the seller’s tax professionals are preparing an 8288-B withholding certificate application not later than the date of close), and, assuming a normal 8288-B processing time by the IRS, in around 4 months after the close (say June 1 in the example of the sale by Canadians Steve and Claire), the IRS would have notified the escrow company that the withholding certificate had been issued, and the entire $240,000 would be free for immediate release (to the accommodators or sellers or to the escrow company handling the Irvine purchase), where it could be used in plenty of time to complete the Irvine property purchase under the IRC Section 1031 180 days limit. Steve and Claire get their $240,000 back without it ever going into the IRS (important!), and the purchase of the replacement property is made within the 180 day requirement, so Claire and Steve owe no $75,000 tax on the sale of the Los Angeles property in 2019. Quite an ending, yes!
Some final thoughts on foreign sellers entering into 1031 transactions is Part 3, to follow soon…