IPX1031 Insight Blog

FIRPTA in 1031 Exchanges: An Ongoing Issue Made Simple

It’s no secret. There is and will continue to be a vast amount of foreign owned real property in the United States. And because of this, many investors involved in 1031 Exchanges have or will run across Foreign Investment in Real Property Tax Act (FIRPTA) issues.

In a nutshell when a foreign investor (individual/partnership/ corporation/trust/estate) sells their United States Real Property Interest (USRPI), the buyer must withhold up to 15% of the total amount realized from the sale and remit that amount to the Internal Revenue Service unless certain exemptions are met. FIRPTA was implemented to reduce the risk of foreign taxpayers selling their USRPI and avoiding paying capital gains tax.

1031 Exchanges and Foreign Investors

In order to defer capital gains taxes and other taxes that would normally be due upon the sale of real estate, foreign investors may utilize Section 1031 to exchange their U.S. real property for other U.S. property. FIRPTA just imposes additional requirements.

For example, John, a citizen of France, is planning to complete a 1031 Exchange with his USRPI. First, he sells his USRPI for $1,000,000, to Sarah. Under FIRPTA, Sarah would be required to withhold $150,000 at the closing and remit the monies to the IRS.

Due to the unpredictably of the issuance of funds by the Internal Revenue Service,  the $150,000 withheld may not be available to John when he is scheduled to complete the purchase of his replacement property.

Here is a solution:

1.) File an 8288-B (“Application for Withholding Certificate for Dispositions be Foreign Persons of U.S. Real Property Interests”)

  • In John’s case, the filing of an 8288-B may serve as a non-recognition notice to the IRS because he is planning on completing a 1031 Exchange. This means that the 8288-B can potentially relieve a foreign taxpayer from the FIRPTA withholding. In order to qualify for the withholding relief, the 8288-B and a contract for the purchase of the replacement property, must be submitted on or before the replacement property’s closing. Complete filing guidelines are found in Rev. Proc. 2000-35.
  • The IRS should determine whether or not to accept the 8288-B within ninety (90) days of receiving all of all the necessary information. Therefore, the 8288-B needs to be submitted as soon as possible in order to get a determination before the close of the relinquished property.
  • However, there will be many instances where the determination will not be issued before the close of the relinquished property. In order to avoid the issues caused by a late determination or delayed refund, a taxpayer may:

2.) Deposit additional funds with the Settlement Agent before the close of escrow

  • In addition to filing an 8288-B, foreign taxpayers will commonly deposit an amount equal to the required withholding amount with the Settlement Agent.
  • In the previous example if John’s 8288-B is not granted or not granted in time, he will be unable to reinvest the full $1,000,000 of sales proceeds required for a fully tax deferred 11031 exchange. What does this mean? It creates a situation where John may have $150,000 of taxable boot, because he was only able to reinvest $850,000 of the sales proceeds.
  • To avoid this result, John may deposit an additional $150,000 with the Settlement Agent.  This will be used for the FIRPTA withholding leaving the entire $1,000,000 net proceeds to be sent to the Qualified Intermediary for the 1031 exchange.

Impact on buyers of Foreign Investor owned real property

Buyers and their closing agents need to be aware of FIRPTA’s federal withholding requirements, specific timelines and exemptions. Failure to comply with FIRPTA could make those parties financially responsible for significant penalties.

Navigating around FIRPTA can often be the difference between a successful and unsuccessful 1031 Exchange.  In regards to FIRPTA issues, sellers, buyers and closing agents should all consult with their tax and legal advisors. For any questions regarding 1031 Exchanges, please contact IPX1031.

It should be noted that there is currently a bipartisan effort in the US Congress to repeal FIRPTA.  Although it has the support of many real estate groups, the process will probably take a considerable amount of time.  We will provide an update, if and when it is appropriate.

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