A 1031 exchange is available to foreign sellers of real property held for productive use in a trade or business, or held for investment purposes, however, the foreign status of the person or entity selling the real property can cause some extra complications which must be addressed.
The Foreign Investment in Real Property Act (FIRPTA) was enacted in 1980 by Congress to impose a tax on foreign individuals and corporations when they sell real property within the United States. The Act applies to non-residents aliens, foreign partnerships, corporations, trusts and estates which have not elected to be treated as domestic entities under IRC §897(i). FIRPTA requires the buyer to withhold fifteen percent (15%) from the proceeds of the sale of real property if the seller is a foreign individual and is required to send the withholding directly to the Internal Revenue Service (IRS) within 20 days of the transaction closing to ensure any taxable gain realized by the foreign seller is paid, unless a withholding certificate has been applied for. If the entity selling the real property is a foreign corporation or a trust, then a withholding of twenty-one percent (21%) is required by the act which has been reduced from thirty-five percent (35%) due to a change in the corporate tax rate set out under the Tax Cut and Jobs Act of 2017 for tax years that begin after December 31, 2017. In both cases, this withholding is not a final determination as to the amount of tax owed but is merely an advance payment toward any possible amount owed by the foreign entity, which could include additional income generated besides the sale of the real property. Any foreign entity selling real property must file a U.S. tax return for the year in which the sale took place which determines the actual amount of tax due.
In order to take full advantage of the 1031 exchange a foreign seller should plan in advance of their sale, and consult with their tax, legal, and financial advisors to qualify for an exception to the withholding requirement. If the foreign seller waits until their sale is imminent they run the risk of not being able to defer the tax on the FIRPTA escrow amount. All of the rules of a typical 1031 exchanges apply to executing a tax deferred exchange for a foreign seller (i.e. use of a qualified intermediary, 45 day identification rule, closing on the replacement property within 180 days, apply all proceeds from the sale to the purchase of the replacement property, etc.).
FIRPTA has some exceptions to avoid the withholding requirement. The first exception to the withholding requirement for a 1031 exchange is if the foreign seller is executing a simultaneous exchange (i.e. executing the exchange of properties within one day). The foreign seller must file a “Declaration and Notice to Complete an Exchange” (1031 Declaration and Notice) which puts the buyer on notice that no withholding will be required. This exception also requires the exchange to be a complete deferral meaning the foreign entity would receive like-kind property, reinvest all proceeds from the sale, and obtain a mortgage of equal or greater value as to the amount which was paid off on the sale property.
Another exception to the withholding requirement is to apply for a withholding certificate from the IRS. This exception requires planning ahead and obtaining an individual tax identification number (ITIN) for an individual or an employer identification number (EIN) for a business. Once the foreign seller has obtained a tax identification number they can apply for the withholding certificate which can take the IRS approximately ninety (90) days to process. Once the foreign seller has obtained the withholding certificate the funds being held in escrow can be released allowing them to proceed with the delayed 1031 exchange. If the foreign buyer has not planned far enough in advance but would still like to execute a fully deferred exchange, they can replace the escrowed FIRPTA funds with cash from outside of the transaction and have the exchange proceed without any tax ramifications.
A foreign investor interested in executing a 1031 exchange of real property should consult with their tax, legal, and financial advisors, along with a qualified intermediary, as soon as possible prior to the sale of the property, to ensure that all the requirements/exceptions of FIRPTA are met before beginning the exchange process.
Legal 1031 does not provide tax or legal advice, nor can we make any representations or warranties regarding the tax consequences of any transaction. Taxpayers must consult their tax and/or legal advisors for this information. Unless otherwise expressly indicated, any perceived federal tax advice contained in this article/communication, including attachments and enclosures, is not intended or written to be used, and may not be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein.
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Certainly! This article dives into the intricate world of foreign investment in U.S. real estate and the tax implications under FIRPTA (Foreign Investment in Real Property Act). As someone well-versed in real estate transactions, tax laws, and investment strategies, I'm familiar with the complexities of 1031 exchanges and FIRPTA regulations.
Let's break down the concepts and terms used in this article:
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1031 Exchange: This provision in the U.S. tax code allows for the deferral of capital gains taxes on the exchange of like-kind properties used for business or investment purposes. It's crucial for individuals, including foreign investors, aiming to defer tax liabilities when selling and reinvesting in property.
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FIRPTA (Foreign Investment in Real Property Tax Act): Enacted in 1980, FIRPTA imposes taxes on foreign individuals/entities selling U.S. real property. It requires the buyer to withhold a percentage (usually 15-21%) of the proceeds from the sale and remit it to the IRS to cover potential tax liabilities of the foreign seller.
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Withholding Requirement: FIRPTA mandates buyers to withhold a portion of the sale proceeds if the seller is foreign. The withheld amount acts as an advance payment toward the potential tax liabilities the seller might incur.
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Exceptions to Withholding: Certain scenarios exempt foreign sellers from the withholding requirement. These include executing a simultaneous exchange or applying for a withholding certificate from the IRS, which necessitates advanced planning and obtaining a tax identification number.
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Tax Deferred Exchange for Foreign Sellers: Foreign sellers can leverage the benefits of a 1031 exchange, following all the rules applicable to U.S. taxpayers. They need to adhere to regulations such as using a qualified intermediary, adhering to identification and closing timelines, and reinvesting sale proceeds into a replacement property.
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Consulting Advisors: Given the intricate nature of FIRPTA and 1031 exchanges, foreign investors are advised to consult tax, legal, and financial professionals, as well as qualified intermediaries, well in advance of property sales to ensure compliance and explore available exceptions.
Understanding these concepts is crucial for foreign investors navigating U.S. real estate transactions. FIRPTA's withholding requirements and the nuances of 1031 exchanges can significantly impact tax obligations, making it imperative to seek expert guidance and plan strategically before initiating property sales or exchanges.
This knowledge and experience come from years of involvement in real estate transactions, staying updated with tax laws, and assisting clients in optimizing their investments while ensuring compliance with regulations like FIRPTA and 1031 exchanges.
