How Are USRPI Dispositions Taxed for Foreign Persons?
Disposing of U.S. real property as a foreign person involves a specific tax framework. Learn how the initial withholding connects to your final tax liability.
When a foreign person or entity sells an interest in United States real estate, the transaction is subject to a distinct set of U.S. tax rules. These regulations were established to create tax parity between domestic and foreign investors in U.S. property. The disposition, which can include a sale, exchange, or gift, triggers specific tax obligations. The rules encompass direct ownership of land and buildings and interests in certain U.S. entities that hold significant real estate assets.
Defining a United States Real Property Interest
A United States Real Property Interest (USRPI) includes land, improvements, and natural resources like mines or wells located within the U.S. The definition also covers personal property associated with the use of the real property, such as equipment used in farming or mining.
The definition broadens to include interests in a U.S. Real Property Holding Corporation (USRPHC). An interest in a domestic corporation is treated as a USRPI if the corporation is a USRPHC, which is determined by an asset test. A corporation qualifies as a USRPHC if the fair market value of its USRPIs equals or exceeds 50% of the combined fair market value of its worldwide real property and business assets.
This 50% test is not just a snapshot at the time of the sale. A corporation is deemed a USRPHC if it met the asset threshold at any point during the five-year period ending on the date the foreign person disposes of their interest. This lookback provision prevents corporations from avoiding the tax by selling real estate assets just before a foreign shareholder sells their stock.
An exception applies to shares of a corporation that are regularly traded on an established securities market. An interest in such a publicly traded corporation is not treated as a USRPI if the foreign person owned 5% or less of that class of stock throughout the testing period. This allows for smaller portfolio investments in publicly traded real estate companies without triggering these tax rules.
Tax Implications of Disposing a USRPI
The disposition of a USRPI by a foreign person has direct U.S. income tax consequences. Under the Foreign Investment in Real Property Tax Act (FIRPTA), any gain or loss from such a sale is treated as “effectively connected with a trade or business within the United States” (ECI). This ensures that profits from U.S. real estate investments are subject to U.S. taxation, similar to how a U.S. resident would be taxed on the same transaction.
Treating the gain as ECI means it is taxed at the same graduated rates applicable to U.S. persons. For a non-resident alien individual, the net gain is subject to standard individual income tax rates. For a foreign corporation, the net gain is taxed at the prevailing corporate income tax rates.
This tax liability is calculated when the foreign seller files a U.S. income tax return for the year of the sale. The final tax owed could be more or less than the initial withholding, depending on the seller’s basis in the property and other factors.
The FIRPTA Withholding Requirement
A primary component of the tax collection process for USRPI dispositions is the withholding requirement under FIRPTA. The responsibility for this withholding falls on the buyer, who is generally required to deduct and withhold 15% of the total amount realized from the sale and remit it to the Internal Revenue Service (IRS).
The “amount realized” includes the cash paid to the seller and the fair market value of any other property transferred. It also encompasses the value of any liabilities the buyer assumes from the seller or any debt the property remains subject to after the transfer.
Several exceptions can reduce or eliminate the 15% withholding. One common exception applies when the buyer acquires the property to use as a personal residence. If the sales price is $300,000 or less, the withholding is waived, and if the price is over $300,000 but not more than $1,000,000, the rate is reduced to 10%. For residences sold for over $1,000,000, the full 15% rate applies. Other situations where withholding may not apply include transactions where the amount realized is zero.
Required Forms and Tax Filings
Information and Form Preparation
The buyer uses Form 8288, U.S. Withholding Tax Return for Dispositions by Foreign Persons of U.S. Real Property Interests, and Form 8288-A, Statement of Withholding on Dispositions by Foreign Persons of U.S. Real Property Interests, to report and pay the withheld tax. These forms require details like the names, addresses, and Taxpayer Identification Numbers (TINs) for both parties, a property description, transfer date, amount realized, and amount withheld.
A foreign seller can apply for a withholding certificate to reduce or eliminate the withholding by filing Form 8288-B, Application for Withholding Certificate for Dispositions by Foreign Persons of U.S. Real Property Interests. This is often done when the seller’s actual tax liability is expected to be much lower than the 15% withholding. If the IRS approves the application, it can authorize the buyer to withhold a smaller amount or nothing at all.
Procedural Filing Actions
The completed Forms 8288 and 8288-A, along with the withheld funds, must be sent to the IRS by the 20th day after the date of the property transfer. The IRS processes the payment and stamps Form 8288-A, which it then mails to the foreign seller as proof of the tax withheld.
The seller must file a U.S. income tax return for the year of the disposition, using Form 1040-NR for individuals or Form 1120-F for corporations. On this return, the seller reports the sale, calculates the final tax liability, and attaches the stamped Form 8288-A to claim a credit for the amount withheld. This can result in a tax refund or an additional tax payment.