On September 14, 2020 and October 5, 2020 the IRS announced the launch of two campaigns that would target the real estate investment activities of non US persons in the United States. The October 5, 2020 campaign focuses on NRAs receiving rental income from U.S. property and the requirement to comply with the Internal Revenue Code’s reporting and filing requirements. The IRS September NRA U.S. real estate campaign targeted compliance with the withholding and reporting obligations of the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA).
Why These Two Campaigns?
The purchase of U.S. real estate by foreign nationals is a major source of investment in the United States. Property sales to foreign buyers in 2019 totaled $78 billion. In recent years, the largest share of foreign residential buyers originated from China and Canada, followed by Mexico. So, it is not surprising that the IRS might want to target tax compliance in this area.
FIRPTA In a Nutshell
Purpose. FIRPTA was enacted to ensure that foreign investors pay U.S. federal income tax on the sale or disposition of U.S. real property interests (USRPI), similar to the obligations imposed on U.S. persons. Prior to the enactment of FIRPTA, it was possible for a foreign investor to structure an investment in U.S. real estate and avoid paying U.S. federal income tax thereon.
USRPI. A USRPI is an interest, other than as a creditor, in real property located in the U.S. or the U.S. Virgin Islands, as well as certain personal property that is associated with the use of real property.
Tax and Collection. Tax levied under FIRPTA initially is collected through withholding, and the obligation to withhold is placed on the purchaser, rather than the seller, of the USRPI. Unless an exemption otherwise applies, the purchaser is required to withhold 15 percent of the total purchase price if the seller of the property is a foreign person. The three most common FIRPTA exemptions are: 1) the seller is a U.S. taxpayer (a U.S. citizen, green card holder or “substantial presence” taxpayer), 2) the 15 percent withheld tax exceeds the maximum tax liability (in which case, the seller can apply for a withholding certificate to reduce the withholding to the maximum amount of tax due), or 3) the purchase price of the real property is not more than $300,000 and the purchaser intends to reside in the property for at least 50 percent of the time for the first 24 months following the closing.
The 15 percent withheld tax has no correlation to the actual amount of U.S. tax due on the sale of the real property, and even if an exemption may apply to eliminate the withholding tax requirement, that does not impact on the seller’s requirement to file a U.S. federal income tax return and pay U.S. federal (and perhaps state) tax on the gain derived from the sale. The withholding tax requirement simply ensures that U.S. tax will be collected and incentivizes NRAs to file appropriate tax returns to report income from the sale and to claim a credit for the withheld funds, particularly if the withheld tax exceeds the actual U.S. tax due.
For a typical disposition of U.S. real property interest subject to the FIRPTA regime, the purchaser is required to file Form 8288, U.S. Withholding Tax Return for Dispositions by Foreign Persons of U.S. Real Property Interests, and 8288-A, Statement of Withholding on Dispositions by Foreign Persons of U.S. Real Property Interests, together with payment of the withheld tax by the 20th day following the sale. After receiving the submitted forms, the IRS will stamp Form 8288-A to acknowledge receipt of the withheld tax and send a copy to the seller for inclusion in filing a tax return. When there is more than one foreign seller, the purchaser is required to prepare separate Forms 8288-A for each transferor and withhold tax from each based on the full amount realized, as allocated among the transferors.
In addition to the Form 8288 and 8288-A filing requirements, the NRA seller also must file a U.S. federal income tax return on Form 1040NR, U.S. Nonresident Alien Income Tax Return, reporting the sale and paying the actual tax due on the gain (calculated using the applicable graduated tax rates) or requesting a tax refund to the extent that the withheld amount is more than the tax due.
FIRPTA Compliance Issues. FIRPTA compliance is complicated, and reporting and payment mistakes are not uncommon. Sellers may not provide appropriate confirmations of NRA or U.S. status, thereby causing an error in withholding; purchasers applying for exempt or reduced withholding for use of the property as a personal residence ultimately may not satisfy all of the requirements for the exemption (e.g., if they relocate for employment or other unforeseen purposes within the 24-month period); sellers may incorrectly believe that their U.S. tax obligations are satisfied through withholding and fail to file appropriate U.S. tax returns, etc.
U.S. Taxation of Rental Income
Apart from the FIRPTA taxation regime that applies to the disposition of U.S. real property interests, NRAs that are not in a U.S. trade or business in connection with the rental property and file the appropriate W-8 form are subject to a 30 percent U.S. withholding tax imposed on the gross amount of the rents received (i.e., without the benefit of deductions), unless a so-called “net election” is made under the Internal Revenue Code or a bilateral income tax treaty. The benefit of making the net election is to treat the rental income as effectively connected with the conduct of a U.S. trade or business, which enables the NRA to reduce the gross rental income by attributable deductions, including operating expenses, interest and depreciation, provided that a true and accurate U.S. federal income tax return is timely filed. In that case, the net income would be subject to U.S. tax at ordinary income tax rates, which may be beneficial compared to the imposition of a 30 percent withholding tax on the gross amount of the rental income. The net election is made on the non resident 1040NR tax return and also using form W-8ECI.
The takeaway from the two recently issued NRA-related U.S. real estate campaigns is that the IRS is focusing on NRA noncompliance in this area. Both initiatives are intended to enhance NRA compliance through targeted, issue-based examinations, education and guidance.
In view of the complexity of this area, NRA investors in advance of a purchase of U.S. real estate should seek appropriate U.S. tax advice with respect to the acquisition, operation and disposition of U.S. real property interests. Here at Hart & Associates, we are experts in this area and would be happy to help. Please contact us for any questions or more information.