Income Tax Return Deduction Refund Concept
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 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).

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At DIRECTS (Domestic and International Real Estate Closing Services), we help 100’s of non-US sellers of US real estate obtain their US Individual Taxpayer ID Numbers (ITIN’s) each year. The ITIN procurement process is critical for foreign sellers of US real estate. If they do not successfully obtain an ITIN, they will never obtain a refund of the large 15% of the gross sales price withholding tax withheld from them at sale (which is entirely refundable if they did not make a large gain on their sale of US real estate).  The ITIN procurement rules have recently undergone significant change (although they have returned, more or less, to where they were before the changes mandated by Congress in January 2017).

Q1) What Were the Changes to the ITIN Program?

A1) Effective January 1, 2017, certifying acceptance agents (private tax professionals who are approved by the IRS) (“CAA’s”) were no longer permitted to certify the passports of non-US sellers of US real estate. This became a huge problem for foreign sellers of US real estate, who need ITIN’s to obtain refunds of their IRS and withholding taxes.

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What is the 8288-B Process?

By Michael W. Brooks

Non- US sellers of US real estate are subject to a withholding tax at time of sale (either 15% or 10% of the gross sales price). The withholding tax isn’t really a tax, it’s better thought of as a security deposit to ensure the real tax eventually is paid by the non-US person (so the IRS doesn’t have to trust the foreign seller to mail in a check from their home in Shanghai). In 98 or 99 out of 100 instances , the withholding tax amount of 15% or 10% of the sales price will exceed (and maybe greatly exceed) the actual federal income tax owed by the foreign seller (for a rough estimate of the income tax due- simply multiply the seller’s gain made on the sale x 15%). But note the normal refund process (of the withholding tax minus the real tax) requires the foreign seller to wait until January of the next calendar year to simply file a tax return to obtain the refund, and the refund itself will take a few months to arrive after the filing. So the foreign seller must sometimes wait up to a year and a half after the sale to obtain this sizable refund. The IRS Form 8288-B withholding certificate application (via an experienced tax professional because this work is tricky) offers an alternative to this absurdly long wait.

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Congress just enacted a significant change to the required withholding tax on sales of US real estate by non-US persons, effective on real estate sales closing on or after February 17, 2016. On December 18, 2015, Congress enacted the “Protecting Americans From Tax Hikes Act of 2015 (the “New Tax Law”).

Here’s all an escrow officer really needs to know about the New Tax Law…

What Was the Withholding Tax Law on Real Estate Sales By Non-US Persons (prior to the February

2016)? First, let’s review what the withholding tax law was (prior the February 2016 change). The withholding rule on real estate sales by non-US persons generally could be summarized as follows:

The buyer (or in California and many other states- the escrow company on behalf of the buyer) must withhold 10% of the gross sales price of the real estate, unless the sale was for $300,000 or less, and the buyer (who must be an individual for this exemption to be valid) acquires the property for use as a residence (in which case $0 withholding was required).

So notice under the prior version of the law, when it came to how much tax had to be withheld on real estate sales by non-US persons, there was generally one of two possible outcomes; either: (a) 10% of the gross sales price had to be withheld; or (b) $0 was to be withheld.  10% of the gross sales price or $0, those were the two possibilities.  And notice what the requirements were to obtain the $0 treatment:

(i) that the sale had to be no more than $300,000 and (ii) the buyer had to acquire the property for use as a residence. We discuss in detail below the meaning of the condition the buyer acquiring the property for use as a residence, as that condition survives (and plays an even more meaningful role) under the New Tax Law.

What is the Revised Withholding Tax Requirement on Real Estate Sales By Non-US Persons Under the New Tax Law?  Under the New Tax Law, effective for sales closing on February 17, 2016 or later, instead of two possible general outcomes for how much tax must be withheld on real estate sales by non-US persons, there now exists three possible outcomes. Perhaps the revised withholding tax rules under the

New Tax Law are best understood by reviewing the following summary table:

APPROPRIATE WITHHOLDING TAX RATE UNDER NEW TAX LAW

Buyer Intends To Use Property as a Residence? YES No
$300,000 and Under $0 15%
$300,001- $1,000,000 10% 15%
Over $1,000,000 15% 15%

Or stated (somewhat) into  English, the revised withholding tax rules under the New Tax Law on real estate sales by non-US persons  looks as follows:

The buyer (or in California and other states- the escrow company on behalf of the buyer) must withhold 15% of the gross sales price of the real estate, unless the gross sales price is between $300,001 and $1,000,000  and the buyer (who must be an individual or this reduction is not valid) acquires the property for use as residence, in which case 10% of the gross sales price must be withheld; or if the gross sales price is $300,000 or under and the buyer (who must be an individual or this exemption is not valid) acquires the property for use as residence, in which case $0 of the gross sales price must be withheld.

Notice the question of whether the buyer acquires the property for use as a residence is extremely relevant for real estate sales by non-US persons of $300,000 or under (in which case the withholding rate is 0 instead of 15%) and for real estate sales of $300,001 to $1,000,000 (in which case the withholding rate is 10% instead of 15%), but it is of no consequence at all for sales over $1,000,000. The withholding rate for sales above $1,000,000 is 15% regardless of the buyer’s planned use of the acquired residence.

So What Does the Condition That the Buyer Acquire the Property For Use As a Residence Mean? It does not mean the buyer must certify he or she will use the acquired property as a primary residence. Under Treasury Regulation Section 1.1445-2(d), the buyer is acquiring the property for use as a residence if on the date of the transfer the buyer(s) (or the buyer’s family) has definite plans to reside at the property for at least 50 percent of the number of days that the property is used by any person during each of the first two 12-month periods following the date of the transfer. The number of days that the property will be vacant is not taken into account in determining the number of days such property is used by any person.  So this in an intent test as of the date of closing- the buyer is being asked to forecast his or her planned use for the acquired property for the next two years. For example, If the buyer has definite plans he or his family will reside at the acquired property for two months for each of the next two years, and the buyer has definite plans to rent the property to outside parties for one month a year for each of the next two years (and the rest of the year the buyer plans for the acquired property to remain empty), then the buyer is acquiring the property for use as a residence because the buyer has definite plans to use the property for personal or family use the majority of time anybody will use the property each of the next two years.  Finally, note there exists no formal requirement that the buyer document his or her intent in writing, although in practice escrow officers should require the buyer to declare their intent to use the acquired property as a residence via the Buyer’s Affidavit (for protection of the escrow officer in withholding 0 or 10%, as the case may be), as discussed below.

Note that IRS Will Have to Revise The Form 8288. The IRS will now have to amend their Form 8288 (and the instructions) to reflect the new withholding tax rates under the New Tax Law.  Presumably they will have to issue the revised Form 8288 (and the corresponding instructions) before the February 17, 2016 effective date.

Escrow Companies Should Revise Their Buyer’s Affidavit.    In addition, many escrow companies currently have forms given to buyers which might be titled something like: BUYER’S AFFIDAVIT THAT THE BUYER IS ACQUIRING PROPERTY FOR USE AS RESIDENCE AND THAT THE SALE PRICE DOES NOT EXCEED $300,000.00 (the “Buyer’s Affidavit”). On the typical Buyer’s Affidavit, the buyer signs a statement providing that he or she is acquiring the real property for use as a residence, and that the buyer has definite plans that he or she or a member of their family will reside at the property for at least 50% of the number of days the property will be in use during each of the two 12 months periods following the transfer of the property. Escrow companies may wish to revise their Buyer’s Affidavit to detail the new withholding tax distinctions under the New Tax Law, if for no other reason than the clear understanding of the appropriate withholding tax rate by the escrow officer administering the sale.   We at DIRECTS can assist any escrow company review and revise the Buyers Affidavit Form to reflect the new withholding tax rates under the New Tax Law.

Any Other Changes of Note for Escrow Officers To the Withholding Tax Rules Under the New Tax Law? Really the answer is no. There are some sophisticated changes to the required withholding tax rates on sales of interests in partnerships and REITs (Real Estate Investment Trusts) when the partnership or REITS is owned (at least in part) by a foreign pension plan.  If any escrow personnel oversees the sale of interests in partnerships or REITs owned by a foreign pension plan, call or email us at DIRECTS.

Who We Are and What we Do at DIRECTS. DIRECTS, Inc. (Domestic and International Real Estate Closing Tax Services) is a California tax preparation company, owned and operated by a California licensed tax attorney. DIRECTS focuses exclusively on the tax issues encountered by non-US persons engaging in real estate transactions. DIRECTS can help foreign sellers of US real estate by assisting them in obtaining US taxpayer ID numbers (“ITIN’s”); by preparing withholding certificate applications for IRS permitted reduced withholding or for non-recognition (IRC Section 1031) transactions (IRS Form 8288-B applications); by preparing California withholding tax forms (Forms 593, 593-C and 593-E); and by preparing US and California tax returns required of the non-US sellers. DIRECTS helps escrow companies understand and administer the required withholding tax on sales by non-US sellers, and assists in their preparation of the IRS Forms 8288 and 8288-A (transmitting the required withholding tax to the IRS).

IF you have any questions on this Client Alert or the contents herein, or if you need assistance on any matters with respect to the required withholding tax on sales by non-US persons, call us at 760-346-6140 or email us at info@directsllp.com.  For more information about DIRECTS, visit us at www.directsllp.com.

Michael W. Brooks is a California tax attorney and the President and Owner of DIRECTS. 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.

The information contained in this article is provided for informational purposes only, and should not be construed as legal or tax 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.

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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….

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As you know, procuring ITIN’s for non-US citizen/residents is essential when these individuals sell (or rent) US/California real estate.  Starting in 2015, the IRS has made an already challenging process even more cumbersome.  In 2016, the IRS plans to add yet another layer of complexity.
2015 Change- Form 8288’s Now Really Must be Included in ITIN Applications
If you’ve ever read through the W-7 Instructions (Application for ITIN’s), where a foreign person needs an ITIN due to 3rd party withholding on a disposition of US real estate, you’ll note there has always been a requirement that an IRS Form 8288 be included (showing the amount withheld at the close).  But prior to 2015 at DIRECTS we were able to routinely obtain ITIN’s for our clients without submitting the Form 8288’s.  This was a real advantage since the other requirements of the W-7 (the certified passport (we are permitted by the IRS to certify foreign passports at DIRECTS), the estimated closing statement, the sales contract) all could be sent into the IRS at the beginning of escrow.  This meant there was a good chance we could get our client the ITIN (assigned by the IRS) before the closing date. This allowed the foreign seller to avail him or herself of the reduced California withholding if applicable (the 12.3% x the appreciation or no withholding for a loss sale…either usually better than the default of 3.3% x the gross sales price requirement), since the seller must have an ID number in place at close to take advantage of those options).  In addition,  some escrow companies want the ITIN in place as of the close date for the purposes of the IRS Form 1099.  But under the new interpretation of the rule (requiring an 8288 with the W-7), it would really be impossible to have an ITIN by the close since the 8288 is not completed typically until right at the close.
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