The Internal Revenue Service (IRS) has recently made changes in its procedures that affect how buyers and sellers comply with the Foreign Investment in Real Property Tax Act (FIRPTA). Unfortunately, these changes make FIRPTA compliance more difficult, and therefore create a greater risk that FIRPTA issues could get in the way of a successful closing. They also increase the risk of post-closing tax liability for buyers, and, by extension, for their Realtors®. By knowing the rules and planning ahead, Realtors® can help their clients – and themselves – avoid these pitfalls.
FIRPTA is a part of the federal tax code that applies to any closing where the seller is “foreign” – that is, where the seller is neither a U.S. citizen nor a resident alien. FIRPTA states that, in closings involving a foreign seller, the buyer must withhold fifteen percent (15%) of the gross purchase price from the foreign seller’s sales proceeds and send it in to the IRS within 20 days of closing. By April 15 of the year after the closing, the foreign seller must file a U.S. income tax return, and the 15% withholding will apply as a credit against any capital gains tax due on the sale of the U.S. real property. If the tax is greater than the withholding, the foreign seller will owe additional taxes. If the withholding is greater than the tax, or there is no tax, the foreign seller will receive a tax refund.
Thus, while the closing agent will generally handle the paperwork associated with FIRPTA withholding on the buyer’s behalf, it is important to remember that federal law makes compliance with FIRPTA’s requirements the buyer’s responsibility. Moreover, if the IRS determines that FIRPTA’s requirements have not been met, the IRS can hold the buyer personally responsible for the amount of the uncollected withholding, plus penalties and interest.
Of course, this also means that buyers who receive that post-closing call from the IRS asserting withholding liability against them will likely be looking to everyone else involved in their closing – including the closing agent, attorneys, real estate agents, and brokers – to explain how this happened and to “share” in their liability to the IRS via negligence and malpractice lawsuits. To minimize these risks, it is important for Realtors® to understand FIRPTA’s requirements and foster compliance with them at closing.
(PLUS NEW IRS GUIDELINES THAT MAKE TWO EXCEPTIONS VERY DANGEROUS)
As you read the next six numbered paragraphs, remember the following: (a) the first two exceptions avoid all of the withholding; (b) the third exception reduces the withholding to the amount of the capital gains tax owed on the sale; (c) the fourth exception also avoids all of the withholding; (d) the fifth exception reduces the 15% withholding rate to 10%; and (e) the other exceptions listed in Paragraph 6 below may either eliminate all of the withholding or reduce it.
1. The Non-Foreign Certification.
The IRS assumes that FIRPTA withholding applies to every closing, unless one of the withholding exceptions is met. The most common exception applies where the sellers can certify that they are not “foreign persons” for FIRPTA purposes – in other words, that they are either U.S. citizens or resident aliens with “green cards.” This is the seller’s “Non-Foreign Certification” with which we are all familiar, and which we use whenever possible. The buyer (and the closing agent and Realtors®) can rely on the seller’s certification, as long as they have not received any notice or have any actual knowledge that the certification is false. If the seller can sign the non-foreign certification, there is no withholding requirement, and no risk of tax liability to the buyer. Of course, sellers who are in fact foreign cannot sign this certification, so the parties to the closing must either find another exception or comply with the 15% withholding requirement.
2. Substantial Presence Test.
Even if the foreign seller does not have a “green card,” the foreign seller may qualify as a resident alien (for tax purposes only) if they meet the “substantial presence test” which requires the foreign seller to be physically present in the United States at least 183 days in the current calendar year and the two (2) preceding years, counting all the days of physical presence in the current year (which must total at least 31 days, or the test is failed), but only 1/3 the number of days of presence in the first preceding year, only 1/6 the number of days in the second preceding year, and none of the days that the foreign seller is present as a teacher, student, or trainee on an “F,” “J,” “M,” or “Q” U.S. Visa.
Following is an example of how this formula works. Let’s say a foreign seller has been in the U.S. in January, February, and March of the current year; was in the U.S. the months of June through September, plus the first day of October, of the previous year; and was in the U.S. for all but 59 days of the year two years ago. Assuming no leap year, under this formula, the seller was in the U.S. 91 days in the current year, 123 days x 1/3 = 41 days in the previous year, and 306 days x 1/6 = 51 days two years ago. The substantial presence test would be barely met in this example because 91 days + 41 days + 51 days = 183 days.
As you can see, if the foreign seller has been present in the United States for 183 days in the current year, both the 31-day and the 183-day requirements are easily met (and calculated), but will the foreign seller have enough documentation to provide the buyer (who, remember, is responsible for complying with FIRPTA) with confidence that the foreign seller was in fact present in the United States for each of the 183 days in the current year?
On the other hand, if the foreign seller has not been present in the United States more than 31 days in the current calendar year, the 183-day requirement means that the foreign seller has to be present in the United States, on the average, at least 304 days in each of the previous 2 years in order to obtain the required remaining 152 days (183 total days – minimum required 31 days in the current year) of the 183 total days. The minimum 304 days is required, because, on the average, for the previous 2 years, only ¼ (the average of 1/6 and 1/3) of the days present can be counted, which means that the foreign seller must be present at least 608 days during the previous 2 years because 608 days x ¼ = the required 152 remaining days. The 608 days divided by 2 years equals 304 days of presence per year, which is approximately 83% of a 365-day year. This is a high standard for a foreign seller to meet, much less have enough documentation to provide the buyer (who, remember, is responsible for complying with FIRPTA) with confidence that the foreign seller was in fact present in the United States for each of the 31 or more days in the current year and each of the 608 or more days in the previous 2 years.
The complexity of calculating whether the requirements of the substantial presence test have been met, together with the even more difficult task of providing the buyer with documentation of the foreign seller’s presence for the required number of days (being an absolute minimum of 183 days) combine to make this a risky basis for a buyer to agree to waive the 15% FIRPTA withholding.
3. The Seller’s Withholding Certificate.
Foreign sellers can apply to the IRS for a certificate stating that they are entitled to a reduced or zero withholding requirement. If the sellers can demonstrate to the IRS that their tax liability is less than 15% of the purchase price, or that they do not owe tax on the sale (for example, they are selling their property at a loss), then the IRS will issue a certificate eliminating or reducing the withholding requirement.
Because the IRS generally takes between 45 and 90 days to respond to a request for a withholding certificate, that response will typically not be received until after closing. The closing agent will therefore withhold the entire 15% from the sellers’ proceeds and hold it in the closing agent’s escrow account until the IRS’s response is received. The advantages to this approach are: (i) the withholding stays with the closing agent rather than being sent to the IRS and can therefore be disbursed to the seller as soon as the closing agent receives the withholding certificate, and (ii) the buyer (and the closing agent and Realtors®) can rely on the withholding certificate without fear of future tax liability.
There are, however, several disadvantages to this approach. First, the sellers must file what amounts to a mini-tax return to show their eligibility for the certificate, which generally requires hiring a CPA who could charge as much as a $1,000 to prepare the certification paperwork. Second, the seller will still be required to file a U.S. income tax return in the year after closing.
4. The Buyer’s Certification of Residential Use for a Complete Exemption from Withholding for the Seller (Beware!).
This exemption is available if: (a) the purchase price of the property is not more than $300,000, and (b) the buyers are willing to certify that they (or a family member) intend to reside in the property for at least 50% of the time that the property will be in use during the first 24 months following closing. If the buyers sign this certification, then the transaction is exempt from FIRPTA withholding. While this sounds like a quick and easy avenue to FIRPTA compliance, it is actually very dangerous for the buyers. Recent IRS changes now make it even more risky.
First, it is important to note that the buyer’s certification only exempts the buyer from the withholding requirements. It does not exempt the seller from paying tax. Therefore, the seller will still be responsible for filing a tax return and paying the full amount of any tax due. If the seller fails to do so, all parties to the closing could face the consequences.
The certification carries significant risks for the buyer and, by extension, for closing agents, real estate agents, and brokers. If the seller does not pay the required tax, and if the buyer fails to meet the residence requirement, then the buyer could be liable for the tax not withheld. In other words, the buyer could wind up personally owing the IRS up to 15% of the purchase price, plus interest and penalties. Of course, as mentioned before, the buyer will then look to the closing agent, attorneys, real estate agents, and brokers for reimbursement, claiming that the latter parties were professionally negligent in allowing the buyer to sign the certification.
In evaluating whether or not to take this risk, there are certain factors that buyers (and their Realtors®) will want to consider:
a. If the seller for any reason does not pay the tax, and if the buyer does not live in the property for at least 50% of the time that it is in use during the first 24 months following closing, then the buyer will be liable for the withholding, unless the buyer can prove to the IRS that the buyer could not have “reasonably foreseen” the circumstances that prevented the buyer from living in the property, at the time the buyer signed the certification. Recent changes in IRS policy have increased this burden of proof on the buyer and therefore heightened the risk that buyers will be held liable if the buyers move away or otherwise do not live in the property at least 50% of the time.
• For example, if a buyer loses his job after closing and has to sell the property as a result, the buyer’s liability will hinge on whether the buyer could have reasonably foreseen being laid off. What if the buyer works in an industry where layoffs have become common in this economy, or if his employer had already laid off other employees? Do those facts mean it was unreasonable for the buyer not to anticipate being laid off himself?
• What if, at the time of closing, a relative has a chronic illness and that illness worsens afterwards, requiring the buyer to move out of the purchased property and move in with and take care of that relative during the first 24 months after closing. Would the IRS regard this situation as reasonably foreseeable and impose the tax on the buyer?
• Consider a buyer who is relocated to Manatee County by his or her employer prior to purchasing the property, but then, within 24 months after closing, receives a promotion and is required to move yet again. Again, would the IRS regard a second move, caused, just like the first move, by an employer action, as reasonably foreseeable and impose the withholding tax on the buyer?
• Finally, what if a buyer purchases the property, moves in, really dislikes the neighborhood and/or the neighbors, and decides to move out within 24 months after closing. Would the IRS argue that, considering the frequency with which people discover they dislike their neighborhood and/or their neighbors, the second move was reasonably foreseeable?
• Is the buyer willing to gamble on what the IRS will decide was “reasonably foreseeable” in any of these scenarios?
b. Even if buyers do ultimately prove that their failure to reside in the property was not reasonably foreseeable (and thus avoid actual withholding liability), they will have spent significant time, worry, and attorney’s and CPA’s fees doing it.
c. Title insurance will not provide buyers with any coverage for a FIRPTA claim, nor will it reimburse them for their expenses in defending against one, because FIRPTA compliance is not considered a title matter.
d. Nothing in the FR or FR/BAR contract requires the buyer to sign the certification, nor does the buyer get any compensation for signing it. In other words, agents who encourage their buyers to sign a certification could be telling them to take on a tremendous risk that they are not contractually obligated to take and that they will not be compensated for taking. And, remember, buyers facing a large IRS tax liability will be eager to point fingers at any other parties involved in the transaction – including the closing agent and the real estate agents and brokers. Any of these parties who advised the buyers to sign the certification, or who failed to disclose its risks, could then be forced to share that tax liability with the buyers through malpractice or negligence lawsuits.
Based on these risks, the safest course for buyers, closing agents, and Realtors® is to encourage foreign sellers to apply for a withholding certificate directly from the IRS (as described above) or to comply with the 15% withholding requirement, rather than relying on the buyer’s certification.
If, however, it happens that the buyer is absolutely certain that the buyer or a family member will reside on the property for 50% of the time the property is occupied for the first 24 months after closing, the seller is adamant about not complying with, or is unable to comply with, the FIRPTA or ITIN requirements (see below), and/or the buyer believes the buyer is receiving adequate consideration under the terms of sales transaction (e.g., a great price, a one-of-a-kind property, etc.) for taking the risk of signing a buyer’s certification, the buyer may be willing to sign the certification as a part of the deal. In such a case, because of the serious risks to Realtors®, their brokers, and closing agents, we recommend that the Realtors® have the buyer sign the attached FIRPTA Risk Disclosure Addendum to Real Estate Contract. (Please note that the use of this Addendum is no guarantee against the filing of a lawsuit or against the incurring of any losses, expenses, or damages in connection with the issues discussed in this article.)
5. The Buyer’s Certification of Residential Use to Reduce the Seller’s Withholding Rate (Beware, Again!)
In February 2016, the Treasury issued new regulations that allow for a reduced withholding rate of 10% for properties with a purchase price of more than $300,000, but less than $1 million. This 10% withholding rate is available if: (a) the purchase price of the property is more than $300,000, but does not exceed $1 million, and (b) the buyers are willing to certify that they (or a family member) intend to reside in the property for at least 50% of the time that the property will be in use during the first 24 months following closing. This exception carries with it all of the same issues, risks, and dangers to the buyer that the previous exception discussed in Paragraph 4 above has.
6. Other Exceptions.
There are other exceptions to the 15% FIRPTA withholding, including other ways foreign sellers can qualify as resident aliens (for tax purposes only) and exemptions under United States tax treaties with various countries, but identifying these exceptions requires the expertise of CPAs and/or attorneys who specialize in the taxation of foreign citizens, and, at a minimum, providing to the buyer a CPA and/or attorney opinion letter, which will cost the seller a significant fee. Even with such an opinion letter, if the CPA or attorney “expert” is wrong or the IRS simply disagrees with the expert, the buyer risks having to pay the 15% FIRPTA withholding, plus interest and penalties (and/or CPA and attorney fees if the buyer fights the IRS).
SELLER DOCUMENTATION REQUIREMENTS
Unless the buyer is willing to sign the certification – and take on all the risks described above – the seller will have to deal with the withholding requirement, either by applying for the withholding certificate or by having the 15% withheld at closing. In either case, the seller will need an individual tax identification number (ITIN). If the seller does not already have one, the seller can apply for one at the time of the withholding. However, the IRS has recently implemented rule changes that make it even more important for the seller to plan ahead in getting the documentation the IRS requires to issue an ITIN.
To obtain ITINs, foreign sellers must submit documentation to the IRS establishing their identity and foreign status, such as their passports. In the past, the IRS would accept copies notarized by a U.S. or foreign notary public. On June 22, 2012, however, the IRS issued an announcement that it would no longer accept notarized copies. Now, sellers must either: (1) provide their original passports to the IRS, which will keep them for a minimum of 2 months, (2) take their passports and apply for an ITIN at a specially designated IRS office (fortunately, the Sarasota IRS office is so designated), (3) take their passports and apply for an ITIN with a private ITIN Acceptance Agent (usually a CPA) appointed by the IRS, or (4) provide copies of their passports certified by the foreign seller’s government passport agency, which would have to be obtained while they are in their foreign country.
The first alternative leaves sellers without a passport for at least two months, which means the sellers will not be able to travel during that time, in addition to the risk that the IRS could lose the original passports. These problems make this alternative extremely unattractive if not impossible for most sellers, and could certainly hold up a closing if the foreign seller is not willing or able to part with his original passport. The fourth alternative avoids these problems, but requires sellers to plan ahead by obtaining the required certification from their home country’s passport agency. If the foreign seller is in the United States, we recommend the second or third alternative, i.e., either they go to the Sarasota IRS office to obtain their ITIN, or, if they will also need tax advice and assistance from a CPA, we will recommend a CPA who is an ITIN Acceptance Agent.
FIRPTA’S IMPACT ON SHORT SALES
As you might imagine, FIRPTA’s 15% withholding requirement has a very negative impact on short sales where the seller is a foreign citizen. First, the short sale lender is unfamiliar with FIRPTA, does not believe or accept that FIRPTA applies, and, when the short sale lender learns that 15% of the proceeds from the short sale must go to the IRS (which means that their payoff will be reduced by that 15%), they almost invariably balk and refuse to cooperate. With most short sales, the owner is selling the property for less than the price at which they purchased the property, which means that, if the 15% withholding is sent to the IRS and the foreign owner files a U.S. income tax return, the owner will receive a refund of all of the withholding because there is no tax on a loss. When the short sale lender realizes the foreign owner will receive a refund of the 15% that reduced the short sale lender’s payoff proceeds, the short sale lender becomes even angrier. At this point, the short sale will not be approved by the lender. Therefore, Barnes Walker, as a closing agent, and you, as a Realtor,® must prevent this point from being reached.
The key is to convince the seller to file the “mini-tax return” referenced in Page 3 above, so a withholding certificate from the IRS can be obtained either to waive altogether the 15% withholding in the case of a complete loss on the sale or at least reduce the withholding when there is a small profit on the sale and the withholding exceeds the tax. The benefit of this process, as indicated in Page 3 above, is that the IRS allows the closing agent to keep the 15% withholding in escrow until the IRS responds. When the IRS responds and reduces, or waives altogether, the withholding, then the closing agent can send all the monies, or the balance of the monies not required by the IRS, to the short sale lender. As you can see, this process avoids the requirement that the withholding be sent to the IRS, which would then mean any refund of the withholding would go to the foreign owner, not the short sale lender. This process however, has one obstacle that must be overcome. That obstacle is the $1,000.00 fee that a CPA typically charges for interviewing the foreign owner and preparing the mini-tax return and other associated tax forms. Typically (and rightfully), the foreign seller sees no benefit to himself/herself in paying $1,000.00 for a CPA to file documents with the U.S. IRS when, usually, the foreign seller is permanently leaving the U.S. and will not be receiving any refunds from the IRS. If the foreign seller takes this position, three (3) options remain:
1. If the short sale lender is being repaid most of its mortgage loan, it may be willing to pay the $1,000.00, since usually the withholding released back to the short sale lender is significantly more than $1,000.00, and $1,000.00 is certainly less than the combined costs of foreclosing on the property, then refurbishing the property, and finally reselling of the property.
2. If the buyer is purchasing a good quality property at a low price, perhaps the buyer could be convinced that payment of an additional $1,000.00 is worth it to preserve a great deal.
3. If neither the short sale lender nor the buyer is willing to pay the $1,000.00, and the real estate commission is high enough, as a last resort, the two Realtors® might want to agree to split and pay the $1,000.00 themselves to ensure the deal closes and they do not lose their commissions.
CURRENT REAL ESTATE CONTRACT FIRPTA PITFALLS
In the past, the risks of FIRPTA to buyers were often discounted or completely ignored. In recent years, however, new IRS policies have been instituted which create even greater risks to buyers. Further, attorneys who concentrate their practice on real estate closings have also become more aware of these risks. Barnes Walker, for a number of years, has been in the forefront of warning Realtors® of FIRPTA’s risks to buyers. These risks have now been addressed by the attorneys for both the Florida Realtors® and the Florida Bar in the 2013 revisions to both the FR/BAR Residential Contract for Sale and Purchase and the FR/BAR “AS IS” Residential Contract for Sale and Purchase, which have also been carried over to the most recent 2015 version of these forms. See Disclosures Paragraph 10.(i) and Standards Paragraph 18.V. in both Contracts.
We at Barnes Walker believe these revisions, however, now overly protect the buyer and have now swung the pendulum too far in favor of the buyer by allowing the buyer far too much discretion in determining how the seller complies with FIRPTA. To explain our position, let us examine some background information. FIRPTA’s 15% withholding requirement on foreign sellers is very unpopular with foreign sellers and, as a result, often endangers the completion of the closing of your sale and purchase. Therefore, the prudent use by closing agents of the various FIRPTA exceptions to the 15% withholding requirements is often required to obtain the cooperation of sellers in complying with FIRPTA’s requirements, while still protecting the buyers who are obligated to ensure the sellers’ compliance with FIRPTA. Closing agents thus often have to walk the “FIRPTA high wire” between sellers and buyers in order to close a sale.
You may not be aware of the fact that, in each and every closing, even when the sellers are U.S. citizens, FIRPTA compliance has to be documented. In every closing where the seller is a U.S. citizen, the closing agent requires the seller to both (1) provide proof of identity and (2) sign a Certificate of Non-Foreign Status to avoid 15% of the sales price being withheld from the seller’s proceeds and remitted to the IRS. (See Paragraph 1 on Page 2 of the enclosed Realtor® Alert! for more information.) This Certificate is the subject of the first change to the FR/BAR Contracts with which we at Barnes Walker disagree. Standards Paragraph 18.V.(i) begins with: “No withholding is required … if the Seller is not a “foreign person,” provided Buyer accepts proof of same from Seller, which may include Buyer’s receipt of certification of non-foreign status from Seller ….” [Emphases added.] The emphasized language gives discretion to the buyer as to whether the buyer has to accept the certification from seller. IRS Publication 515 specifically allows a buyer to safely not withhold 15% of the sales price if the seller provides a Certificate of Non-Foreign Status, unless the buyer has “actual knowledge” that the certification is false or the buyer receives a notice from buyer’s agent or the closing agent that the certification is false.
We believe the Certificate of Non-Foreign Status is a safe exception to FIRPTA’s 15% withholding requirement for the buyer to use, and the buyer should not have the discretion to arbitrarily require the 15% to be withheld from the seller’s proceeds, absent actual knowledge of the Certificate’s falsity. A buyer wishing to avoid purchasing a property under a contract and wishing to stop a closing, yet wishing to avoid a breach of the buyer’s obligation to close under that contract, could use the following strategy: First, the buyer could insist, under the new 2013 Contract revisions, on requiring the 15% withholding from the seller’s proceeds, even if the seller was a bona fide U.S. citizen to whom FIRPTA was never intended to apply! Then, this insistence would cause the U.S. seller to vehemently object, the closing would fall apart, the buyer could then blame the seller for not performing under the Contract, and demand the Contract be terminated and the deposit be returned to the buyer!
To avoid this scenario, we have prepared the attached FIRPTA Contract Addendum, which, in its Paragraph 1, amends Standards Paragraph 18.V.(i) by using the language of IRS Publication 515 that requires the buyer to have actual knowledge of, or notice of, the falseness of the Certificate of Non-Foreign Status before being able to reject the Certificate.
The second change with which we at Barnes Walker disagree in the 2013 Contract revisions is the buyer’s ability in Standards Paragraph 18.V.(iii) to reject the foreign seller’s application to the IRS for a Withholding Certificate, which, if the application is accepted by the IRS, would reduce or completely eliminate the 15% withholding. Allowing this procedure is also perfectly safe for buyers as a way of meeting their obligations under FIRPTA. (See Paragraph 3 on Page 3 of the enclosed Realtor® Alert! for more information.) If a seller is selling his or her property for less than the amount for which he or she purchased the property, and thus is selling it at a loss, no tax will be due on the sale, and therefore FIRPTA requires no withholding. The seller can request a waiver of the withholding based on such a loss by filing an application to the IRS for a Withholding Certificate. (Such an application is also used if the seller is making a profit or gain on the sale, but the tax on the gain or profit is less than the 15% withholding.)
Here is an example of how the buyer could abuse the newly revised Contract language in this second area. In the case of a $200,000.00 sale, the 15% withholding would equal $30,000.00, and if the foreign seller purchased the property, say, for $250,000.00, the seller would be thus losing $50,000.00 on the current sale. You can imagine the seller’s anger if the buyer arbitrarily insists that the $20,000.00 withholding be sent to the IRS, despite the seller already losing $50,000.00 on the deal and having paid a CPA $1,000.00 (the usual fee) to prepare the application (essentially a mini-tax return) for the waiver of the 15% withholding. Such a needless insistence by the buyer, again, would endanger the closing.
To avoid this second scenario, our attached FIRPTA Contract Addendum, in its Paragraph 2, amends Standards Paragraph 18.V.(iii) by eliminating the buyer’s option to remit the 15% withholding provided the seller delivers to the buyer, on or before closing, a copy of the application to the IRS for a Withholding Certificate, together with proof of the certificate’s mailing or delivery to a courier/delivery services company for subsequent delivery to the IRS.
In conclusion, if you are representing a foreign seller, we strongly recommend that you add to the real estate contract our attached FIRPTA Addendum.
In sum, the sooner that a Realtor® or Barnes Walker makes a foreign seller aware of FIRPTA’s withholding requirements and the new ITIN requirements, and the sooner the seller begins preparing for compliance with FIRPTA, the better the chance that FIRPTA will not delay or derail your next closing. We hope the information in this Alert will help you in dealing with the FIRPTA issues you and your sellers encounter. As always, we will answer your questions at no charge, or, if you desire, we will be more than happy to present a seminar at your office on this subject.