When a foreigner sells US real property, the Foreign Investment in Real Property Tax Act (FIRPTA) requires that the buyer withhold 15% of the gross sale proceeds and remit this amount to the Internal Revenue Service (IRS) within 20 days of closing. The withholding and remittance is actually carried out by the escrow agent. This withholding requirement applies to Canadian sellers.
It must be noted that the FIRPTA withholding does not represent a Canadian seller’s actual tax liability. Instead, it is the means by which the IRS ensures that the capital gains tax owed by the seller, if any, is actually paid. Upon selling US real property, a Canadian must file a US tax return to declare the sale and his or her capital gains tax liability (if any). When filing the tax return, the seller may also apply for the reimbursement of (i) the entirety of the withheld 15% of the gross sale proceeds if the sale resulted in no capital gain or in a capital loss, or (ii) the portion of the withheld sale proceeds that exceeds the seller’s capital gains tax liability. However, the reimbursement process can easily take more than a year as of the closing date.
There are however a few exceptions to the mandatory FIRPTA withholding rule that either completely avoid the withholding obligation or reduce the withholding obligation. Under the first exception, a withholding is not required when a property is sold for a price of $300,000 USD or less and the buyer intends to use the property for his or her personal use at least 50% of the time the property is in use for the two twelve month periods following the purchase. The application of this exception can be illustrated with the following example:
- The property will be sold for $250,000 USD.
- The buyer intends for the property to be in use eight months of each year for the next two years. It will remain vacant for the four remaining months of each year for the next two years.
- The property will be rented out four months each year for the next two years.
- The buyer will personally use the property for the four remaining months each year for the next two years.
This US real estate transaction qualifies for the exception because the sale price does not exceed $300,000 USD and the property will be for the buyer’s personal use 50% of the time the property is in use for the next two years (4 ÷ 8 = 50%). If the buyer had intended to rent the property six months a year and personally use the property only two months a year, then the transaction would not qualify for the exception because the property would only be for the buyer’s personal use 25% of the time the property is in use.
The second exception allows for the withholding may be reduced from 15% to 10% in the case of a US real estate transaction that meets the two following criteria: (i) the sale price is more than $300,000 USD and less than $1,000,000 USD; and (ii) the buyer intends to use the property for his or her personal use at least 50% of the time the property is in use for the two twelve month periods following the purchase.
Unlike the first two exceptions, the FIRPTA withholding certificate, the third exception, does not avoid or reduce the withholding prior to closing. Instead, the FIRPTA withholding certificate reduces the withholding after closing, but it prevents 15% of the gross sale proceeds from being automatically remitted to the IRS.
The purpose of an application for a FIRPTA withholding certificate is to prove that the seller’s tax liability is less than required withholding of 15% of the gross sale proceeds. The application must be submitted to the IRS by or before the closing date. While the application is processed, the withholding agent (the escrow agent) is authorized to keep the withheld funds in escrow even 20 days after the closing date. This is due to the fact that the processing delay can be approximately 90 days or more provided the seller has US Individual Tax Identification Number (ITIN). If the seller does not have an ITIN, the delay is even longer because the seller will need to submit an ITIN application at the same time as the FIRPTA withholding certificate application.
Should the IRS issue a FIRPTA withholding certificate that reduces the required withholding, the withholding agent will then remit the required amount to the IRS, if any, and the balance of the withheld funds to the seller. The following is an example of a refund resulting from a FIRPTA withholding certificate:
- A property was purchased by a Canadian for $300,000 USD.
- The property is sold for $400,000 USD.
- The required withholding is $60,000 USD (400,000 × 15% = 60,000).
- The withholding agent withheld $60,000 USD and kept this amount in escrow pending an application for a FIRPTA withholding certificate.
- The estimated US capital gains tax liability is $15,000 USD.
- A FIRPTA withholding certificate is issued that reduces the required withholding from $60,000 USD to $15,000 USD.
The withholding agent will remit $15,000 USD to the IRS and will return the balance of $45,000 USD (60,000 – 15,000 = 45,000) to the seller.
Qualifying for an exception to the FIRPTA withholding requirement does not exempt a Canadian seller from filing a US tax return to declare the sale of US real estate. A US tax return must be filed. In addition, a Canadian seller must include the sale of US real estate in his or her Canadian tax return.
Should you own US real estate and contemplate selling it, our team can assist you with your US real estate transaction, including the preparation and submission of the requisite documentation should you qualify for an exception to the FIRPTA withholding requirement.
The comments offered in this article are meant to be general in nature and are not intended to provide legal advice regarding any individual situation. Before taking any action involving your individual situation, you should seek legal advice to ensure it is appropriate for your circumstances.