FIRPTA Tax Blog

 By Michael W. Brooks, Esq.

As with US persons, non-US persons and parties (“Foreign Investors”) are allowed to enter into Internal Revenue Code Section 1031 (like-kind exchange) transactions. Foreign Investor exchanges allow owners of investment and business real estate to delay paying income tax on the appreciation of the property being sold (the “relinquished property”), provided the owner identifies a “replacement property” within 45 days of the sale of the relinquished property, and completes the purchase of the replacement property within 180 days of the sale of the relinquished property. This allows the person (even a Foreign Investor) to avoid paying the US (and California) tax on the sale of the relinquished property, but the investor will carry a lower basis from the relinquished property into the replacement property.

Take the example of a Chinese person who purchases an investment property (used as a rental property) in Irvine for $1,000,000. Three years after the purchase, the value of the Irvine property rises, and the Chinese person receives an offer to purchase the Irvine property for $1.5M. If the Chinese investor were to sell the property and not enter into a 1031 transaction, the investor might owe around $60,000 in tax to the IRS ($500,000 gain minus (say) $100,000 in realtor fees= $400,000 gain; $400,000 x 15% (federal capital gains tax rate)= $60,000 in tax owed to the IRS). The investor might also owe a tax to the State of California under this scenario, perhaps around $36,000 ($400,000 x 9% (average California tax rate)= $36,000). So in this case, our Chinese person will owe around $96,000 in total taxes on the sale if he does not take some action.   So what can he do to at least delay paying the $96,000 total tax on the sale? As long as he is willing to purchase another parcel of California real estate in the next 180 days the answer is simple- enter into a valid 1031 transaction. So to complete the example, let’s assume our Chinese person, within 45 days of the sale, identifies a Newport Beach property he wishes to buy (and again rent out) for $1.5M. Provided he completes the purchase of the Newport Beach property (the “replacement property”) within 180 days of the sale of the Irvine property (the “relinquished property”), our Chinese investor can delay paying any of the $96,000 in total tax pursuant to Internal Revenue Code Section 1031. In three years however, when our Chinese investor sells the Newport Beach property for $2M, he will owe probably $200,000 in total tax to the IRS and California (i.e., he must then pay the tax on the gain from the sale of both properties…but at least he was able to delay the tax on the sale of the Irvine property for three years because of Internal Revenue Code Section 1031).

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….