Articles Posted in Directs

By Michael W. Brooks, Esq.

President DIRECTS

At DIRECTS (Domestic and International Real Estate Closing Tax Services, Inc.), all day, every day, we work on tax matters relating to FIRPTA (the Foreign Investment in Real Property Tax Act). We work for clients from throughout the world who invest in real estate throughout the United States, but most of our clients own (or owned) real estate in California, and some of our clients are owed tax refunds from the IRS from real estate sales years which took place several years ago.

By Michael W. Brooks, Esq. (President DIRECTS)

In January 2017, the IRS suspended the right of privately licensed tax professionals and companies (such as my firm- DIRECTS) to certify non-US passports, which slowed down significantly the time it took for a non-US person who sold US real estate to obtain an ITIN (an Individual Taxpayer ID Number)  in connection with their real estate sale, and therefore slowed down significantly the time it took for non-US persons to obtain a refund of the mandatory (up-front at the time of sale of US real estate) IRS withholding tax. By the end of 2017, the IRS had reinstated the right to private certifying acceptance agents to certify passports, but a lot of damage had already been done.

Recall the Basic Rules of FIRPTA, and What the Goal of the Foreign Seller is with Respect to FIRPTA- Get the Big Refund!

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.

 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….

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.