Are you planning to buy a property in the US from a foreign individual or entity? If so, then it is important for you to be aware of the Foreign Investment in Real Property Tax Act (FIRPTA). This Act levies taxes on profits made by foreign (non-US) individuals when disposing of U.S. real property interests and requires certain parties involved in such transactions to generally withhold 15% of the amount realized on the disposition. In this blog post, we will discuss what FIRPTA is, explain what constitutes a U.S. real property interest, and explore withholding rates that may apply to Canadians under FIRPTA.
What is the Foreign Investment in Real Property Tax Act (FIRPTA)?
FIRPTA levies taxes on the profits made by foreign individuals from disposing of US Real Property Interests (USRPIs) as outlined in the Internal Revenue Code (IRC). A disposition, under the U.S. IRC, generally refers to any action involving the transfer or sale of property. This can include sales, exchanges, liquidations, redemptions, gifts, and other transfers. When purchasing U.S. real property interests from foreign individuals or entities, certain parties are generally required to withhold 15% of the amount realized on the disposition. Special rules apply to foreign corporations.
The buyer is typically responsible for withholding taxes. It is important for the buyer to determine if the seller is a foreign person. If the seller is indeed a foreign person and the buyer fails to withhold taxes, the buyer may be held accountable for the unpaid taxes. However, in situations where a U.S. business entity, such as a corporation or partnership, sells a U.S. real property interest, the entity itself is responsible for withholding taxes.
What is U.S. Real Property Interest?
A U.S. real property interest refers to any ownership stake in real property located in the United States or the U.S. Virgin Islands. This includes interests in mines, wells, and other natural deposits, as well as certain personal property used in connection with real property, such as farming machinery. It also includes any ownership stake in a domestic corporation, unless it can be proven that the corporation never qualified as a U.S. real property holding corporation within the relevant time periods.
To avoid being considered a U.S. real property interest, a corporation must meet the following criteria:
- The corporation did not possess any U.S. real property interests at the time of the disposition.
- Any U.S. real property interests that the corporation did have at any point during a specific time were sold, with the full amount of any gains recognized.
- Starting from December 17, 2015, neither the corporation nor any previous entity it was associated with was classified as a RIC or a REIT during the period in which the interest was held.
Optimize Your Property Income Treatment
As a non-resident alien, you have the power to choose how your income from US property is treated. By making a Section 871(d) election, all income generated from that property can be considered effectively connected with a US trade or business.
By electing this option, you can claim deductions related to the income from real property, allowing you to only pay taxes on the net income. This treatment applies to all income received from real estate situated within the US.
How to Make the Election for Effectively Connected Income with a U.S. Trade or Business
To ensure that your income is treated as effectively connected with a US trade or business, simply include a statement with your annual tax return. The statement should provide the following information:
- Clearly state that you are making the election.
- Provide a list of all the properties you own or have an interest in within the US.
- Include the dates of ownership for these properties.
- Specify any income generated from US property.
Once you have made this election, it will remain in effect for all future years unless you decide to revoke it. To revoke the election, simply file IRS Form 1040-X.
For more detailed instructions, please refer to the IRS instructions.
Why This Election Matters: Understanding the Tax Benefits for Non-US Citizens
When purchasing property as a non-US citizen, it is crucial to understand the potential impact of making a Section 871(d) election on your tax liabilities.
Imagine this: With rental property gross income of $30,000, without a Section 871(d) election, you’d be facing a tax bill of $10,000 (30% of $30,000). However, by making the election, you open the door to deductions such as mortgage interest, property tax, and more. This means your taxable income is reduced, resulting in a lower tax payable of just 30% of the net amount.
What Withholding Rates Apply to Canadians Under FIRPTA?
The transferee has the responsibility of deducting and withholding taxes on the full amount received by the foreign individual during the sale. Typically, the withholding rate is 15%.
The total amount realized includes the following:
- The cash paid or to be paid (principal only).
- The fair market value of any other property transferred or to be transferred.
- The amount of any liability assumed by the recipient or existing on the property before and after the transfer.
When a property is transferred by a foreign individual who co-owns it with someone else, the total amount received is divided among the transferors based on their respective capital contributions.
The Foreign Investment in Real Property Tax Act (FIRPTA) is an important law to be aware of when investing in U.S. real property interests, as it requires the buyer to withhold taxes on any dispositions made by foreign individuals or entities.
Exceptions to 15% Withholding
There are a few exceptions to the 15% withholding requirement. These exceptions include:
- If the sale price of the property is less than $300,000 and the buyer plans to use at least 50% of the home as their primary residence, the withholding can be reduced to zero.
- If the sale price is between $300,000 and $1,000,000 and the buyer intends to use at least 50% of the home as their principal residence, the withholding is reduced to 10%.
- Alternatively, you may request a withholding certificate from the IRS if you anticipate that your U.S. tax liability will be less than 10% or 15%.
These exceptions can provide potential buyers with options for reducing their withholding obligations.
Looking To Lower Your FIRPTA Withholding Taxes? Here’s How:
In addition to the FIRPTA exceptions, if you believe the amount of taxes you actually owe will be lower than the withholding tax, you can apply to reduce the withholding taxes paid by obtaining a withholding certificate from the IRS.
To apply for the certificate, you’ll need to file Form 8288-B with the IRS before the sale date and inform the buyer that you’ve applied for a FIRPTA certificate. If approved, the reduced withholding amount will be the maximum tax applicable to the net gain (purchase price minus cost). Make sure to include supporting documents for the original purchase price, cost of capital improvements, and selling price.
Keep in mind that filing Form 8288-B requires providing an Individual Tax Identification Number (ITIN). If you don’t have one yet, you can apply for it by completing Form W-7 and submitting it to the IRS along with Form 8288-B.
To Retrieve Withheld Amounts Under FIRPTA, Follow These Steps:
After your taxes have been withheld, you may file a US Income Tax Return (Form 1040NR) to report the sale of the property and pay taxes on any gains.
The amounts withheld by the buyer will be used to offset any taxes owed from the sale.
You may also qualify for a foreign tax credit on your Canadian tax return for the US federal income taxes paid.
Understanding ITIN Number Canada: Meeting IRS Requirements for Canadian Tax Filers
If you’re a Canadian individual in need of filing a U.S. tax return, the IRS mandates that you obtain an ITIN.
What is an ITIN? It’s a tax processing number assigned by the IRS specifically for Canadians and other non-residents of the U.S. who meet these criteria:
- You don’t possess a U.S. social security number.
- You don’t fulfill the eligibility requirements to obtain this number.
Numerous situations may require you to file a U.S. tax return, so it’s essential to understand the implications and meet the necessary ITIN requirements.
What Are The Tax Implications For Canadians Selling Property In The USA?
Regardless of their residency or tax obligations, all owners of U.S. real property are required to pay income tax due on any profit made from the sale of that property. For non-U.S. citizens, the IRS enforces withholding tax on the sale proceeds of U.S. real property. This withholding tax is crucial for the IRS in case you fail to file or pay the required taxes.
To ensure compliance, the IRS designates the buyer of your property as its agent who will collect and remit the withholding tax. U.S. title agents are familiar with this requirement and will verify whether you are a foreign seller to safeguard the buyer’s interests. The purchaser/title agent will submit the withholding tax along with Form 8288 – U.S. Withholding Tax Return for Dispositions by Foreign Persons of U.S. Real Property Interests.
Before Filing Your U.S. And Canadian Income Tax Returns, Make Sure You Complete These Key Steps:
Key steps to complete prior to filing your U.S. and Canadian income tax returns include:
- Determine the withholding tax rate for the sale proceeds and ensure it is correctly withheld by the buyer or their agent and remitted to the IRS.
- Fill out any necessary withholding forms and submit them to the IRS.
- Canadian taxpayers must obtain an ITIN from the IRS for filing a U.S. tax return. If you don’t have one, it’s crucial to apply for it promptly after closing your sale.
- Calculate the capital gain or loss from the sale accurately. This depends on factors such as how long you owned the property, your income range and tax bracket, as well as the property’s use.
FIRPTA is an important law to be aware of when investing in U.S. real property interests, as it requires the buyer to withhold taxes on any dispositions made by foreign individuals or entities.
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Karlene J. Mulraine, EA, CPA, CA, CPA (NH) is the President of Cross-Border Financial Professional Corporation. Follow us on Linkedin and Twitter, or hang out on Facebook.
The views expressed in this article are those of the author and should not be relied on to make decisions. Consider discussing your specific circumstances with an appropriate specialist.
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