Favorable debt terms, comparatively low asset values, positive cash flow, and economic stability make United States real estate some of the world's most enticing assets. With these advantages, it is no wonder that foreign buyers purchased over $78 billion of American real estate in 2019. When it comes time to sell these foreign-held assets, some investors use a 1031 Exchange to postpone capital gains taxes. This article will share the non-resident requirements to complete a 1031 Exchange according to IRS FIRPTA rules.
What is FIRPTA?
FIRPTA stands for the Foreign Investment in Real Property Tax Act of 1980. It was created to ensure that foreign owners of assets paid taxes when assets are sold, exchanged, gifted, transferred, or other similar acts. The law requires that a portion of the transaction amount be withheld to cover potential taxes on the asset's gains. This amount must be submitted to the IRS within 20 days of the transaction date. Otherwise, the buyer is subject to penalties and interest on the withholding amount.
The value of the transaction includes cash from the sale, the balance of assumed mortgages that encumber the property, and any non-cash personal property.
For most non-resident sellers, the general rule requires withholding 15% of the value. If the seller is a foreign corporation or a trust, the requirement increases to 21%.
These withholding amounts are not the final tax amounts owed. They are meant to ensure that the IRS receives some payment if a non-resident does not file the taxes. If the taxes owed are less than the amount withheld, they will get a refund. When the taxes owed are higher, they will have to pay the difference.
How does this law affect a 1031 Exchange for non-residents?
With a 1031 Exchange, real estate investors can postpone taxes by reinvesting the sale proceeds into another property. This transaction is complicated by the FIRPTA rules that require a buyer to withhold 15% of the purchase price.
When money is withheld from your 1031 Exchange, it creates artificial "boot" monies, that cannot be invested, which leads to capital gains taxed owed since the money was not reinvested into a qualified replacement property.
Four ways to avoid FIRPTA withholding in a 1031 Exchange
The potential of owing capital gains taxes on a portion of your sale is frustrating and defeats the purpose of the 1031 Exchange approach. There are, however, a few strategies that reduce or eliminate the FIRPTA withholding requirements.
Perform a same-day, simultaneous exchange
When you close on the sale and purchase like-kind property on the same day, this is considered a simultaneous exchange. As long as you meet 1031 exchange requirements for replacing the equity and loan amounts from your relinquished property on your replacement property, then you likely qualify. To ensure that the buyer does not withhold funds, the foreign seller should file a 1031 Declaration Notice.
Request a withholding certificate from the IRS
With advance planning, you can receive permission from the IRS to prevent FIRPTA withholding on your sale. Once you have received an ITIN or EIN, then you can apply. The approval process can take 90 days, so you must plan ahead accordingly so you don't miss any 1031 Exchange deadlines or delay the purchase of your replacement property.
Add funds to accomplish your 1031 Exchange
While it is not ideal to set aside additional funds to cover the withholding requirement, doing so will allow the total amount of your proceeds to be reinvested and avoid owing capital gains taxes. When you file your tax returns, you would receive a refund if there is no tax liability.
Real estate purchased as a home
When the buyer plans to use the property as a home, the withholding percentage is reduced. There is no withholding requirement for properties valued at $300,000 or less. Properties valued between $300,001 and $1,000,000, require that 10% be withheld. Above $1,000,000, the general rules apply.
To qualify, the buyer or eligible family members must have definitive plans to live in the property at least 50% of the time for the next two years.
The Bottom Line
Foreign real estate investors can use a 1031 Exchange to prevent having to pay capital gains on the sale of their investment properties. With FIRPTA rules, additional steps are involved to avert having to have withholding from the proceeds of the sale. These rules can be complicated and simple mistakes can result in significant taxes and penalties.
We recommend scheduling a call with one of our experts to discuss your proposed sale. We'll discuss your situation, answer your questions, and help you develop a plan to reduce or eliminate the impact of FIRPTA on your transaction.
Feel free to contact us today to schedule a consultation.