For foreign owners selling real estate, the tax law is extensive and intricate, and having a clear understanding of the rules can help leaders navigate and plan for a sale. The Foreign Investment in Real Property Tax Act (FIRPTA) was enacted in 1980 to target foreign individuals and businesses that invest in U.S. real estate. The belief at the time was that the lack of capital gains tax on foreign investors of U.S. real estate gave them an unfair advantage over U.S. investors. The goal of FIRPTA was to prevent non-U.S. persons from avoiding U.S. capital gains on the sale of U.S. real property. 

Pursuant to these rules, when a nonresident alien (individual) or a foreign corporation disposes of a U.S. Real Property Interest (USRPI), the gains are taxed as if the taxpayer was engaged in a U.S. trade of business and that the gain or loss was Effectively Connected Income (ECI). A USRPI includes direct ownership in U.S. real estate, as well as indirect ownership through a U.S. Real Property Holding Company (USRPHC). A U.S. corporation is a USRPHC if the fair market value of its USRPIs is at least 50% of the fair market value of its worldwide assets.

The buyer of real property from a foreign investor is generally required to withhold 15% of the entire gross proceeds unless certain exceptions are met. Because of the intricacies of this law, taxpayers could fall into a trap if they do not fully grasp the issues relating to the sale of U.S. real estate held through a U.S. corporation or a partnership.

INTEREST IN A U.S. C CORPORATION 

Under the rules established by FIRPTA, a USPRI includes any interest in U.S. real property (including property in the U.S. Virgin Islands) or any interest in a domestic corporation, unless it is determined that the corporation is not a USRPHC. In other words, an interest in a U.S. C Corporation is presumed to be a USRPHC. This means that a foreign person that disposes of shares in a U.S. C Corporation can potentially become subject to the FIRPTA regime. 

In order for an interest in a U.S. corporation to not be considered a USRPI, the corporation cannot be classified as a USRPHC at any time during a five-year period ending on the date of the disposition of such interest. For example, if a U.S. corporation was never a USRPHC from Jan. 1, 2020 through Dec. 31, 2024, then the sale of shares in this corporation on Dec. 31, 2024 would not be a sale of a USRPI.

EXCEPTIONS FROM FIRPTA WITHHOLDING

There are several exceptions to the default FIRPTA withholding. If the disposition is of an interest in a domestic corporation, the corporation may provide the buyer a certification that states that the interest is not a USRPI. This means that the fair market value of U.S. real estate held by the company is less than 50% of the total value of the company’s worldwide real estate and assets used in the trade or business.

Note that even a U.S. seller must provide an affidavit to confirm the seller’s non-foreign status to the buyer. Both types of notices or certifications must be provided to the buyer and filed with the IRS timely to be considered effective.

Other exceptions from FIRPTA withholding include a sale of an interest in a publicly traded U.S. corporation or an interest in a publicly traded partnership or trust.

PARTNERSHIP RULES

If a U.S. partnership disposes of USRPI, the partnership itself should not be subject to withholding tax under Section 1445. However, a foreign partner of a partnership may be subject to FIRPTA on its share of the entity's gain from the disposition of a USRPI, much like it would if the foreign partner disposed of the interest directly. The domestic partnership itself then becomes the withholding agent and must withhold taxes on the gains that are allocable to a foreign partner.

On the other hand, when a foreign partnership disposes of a USRPI, the entire proceeds are subject to FIRPTA withholding, even if all the partners are U.S. persons. The partnership, in this case, may apply for a Withholding Certificate from the IRS using Form 8288-B, Application for Withholding Certificate for Dispositions by Foreign Persons of U.S. Real Property Interests. 

WITHHOLDING CERTIFICATE

Applying for a Withholding Certificate with the IRS to reduce or fully eliminate withholding tax can be extremely significant in its effect on the cash flow of the seller, since the withholding tax rate of 15% is applied on gross proceeds. Only when a tax return is filed by the seller can the actual gain on sale be reported and a refund obtained for any over-withholding. Depending on the timing of a sale, this period can be quite lengthy from the date of sale to that of filing a tax return and receiving a refund. 

A Withholding Certificate should be requested prior to the close of the transaction in most cases. Otherwise, a buyer is required to withhold and remit the tax to the IRS. Sellers in a partnership transaction, much like the one described above would need to provide sufficient documentation with the Certificate to ascertain the residency of the partners and that the calculations demonstrating the maximum tax liability on the sale is less than the default 15% withholding of the sale proceeds. 

It is important to note that the IRS normally has at least 90 days to act on such application and may not accept it based on the supporting documents. Therefore, any potential sellers of a USRPI should plan ahead if they intend to rely on a withholding certificate to reduce FIRPTA withholding on a transaction.

ELECTIONS AVAILABLE

There are various elections available for foreign persons that hold a USRPI. Under Section 897(i), for example, a foreign corporation holding a USPRI may make an election to be treated as a domestic corporation for FIRPTA purposes if the corporation is entitled to non-discriminatory treatment under a U.S. income tax treaty.  A foreign corporation that sells a USRPI with this election in effect will not be subject to FIRPTA withholding. It will instead be subject to standard U.S. corporate income tax rules. This means that the corporation will report its tax liability on the net capital gains on its U.S. income tax return. The election is irrevocable without the consent of the IRS.

PLANNING OPPORTUNITIES

The FIRPTA regime has a very broad application, and the rules are not always intuitive. It is crucial for foreign investors to discuss with an experienced tax advisor before investing in or disposing of any U.S. real property or business interests. GHJ’s International Tax Services Practice is available to discuss tax-efficient options tailored to the structure and needs of a business.