How does a 1031 exchange help British investors mitigate FIRPTA in the US?

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Simon Misiewicz

4th August 2021

The history behind Federal Investment in Real Property Tax Act or FIRPTA.

The United States real estate industry is a booming market that’s worth over $163 billion. If you’re a British citizen investing in the U.S. market, you’re probably on your way to making a good return.

However, investing in American real estate isn’t as simple as most of us would like it to be. There’s plenty of taxes, regulations, and requirements that must be met so you can receive your profit legally.

Much of that comes in the way of the Federal Investment in Real Property Tax Act or FIRPTA.

So what is FIRPTA? What do you need to know before you begin your U.S. real estate investment ventures?

In this article, we outline what FIRPTA is, the importance of an ITIN, and more to help you maximize your investments in U.S. real estate.

What Is FIRPTA and how does it affect British property investors buying US property?

The Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) allows the U.S. government to tax a foreign person who is also a non-resident alien selling real property interests in America. This also includes sales of parcel interests.

What Defines a Non-Resident Alien?

A non-resident alien is neither a U.S. citizen nor a resident or resident alien of the United States as per the Internal Revenue Code. You can become a resident if you obtain a green card.

Staying in the country for a substantial amount of time also allows you to be a resident. A British citizen living in the U.S. most likely counts as a non-resident alien unless they’re looking to live there permanently.

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Withholding Rules Under FIRPTA

If you’re a non-citizen or a non-resident of the United States and you own or want to sell property, there are some complicated tax regulations that you need to consider.

It’s important to know these rules before investing in U.S real estate. While people might not tell you about these laws, there are penalties for noncompliance.

The first thing to note is if you’re a foreign person who is not a tax resident of the U.S. that sells real estate in the country. You’ll need to remit 15% of the sales price to the Internal Revenue Service (IRS) under FIRPA withholding rules.

The IRS administers and enforces internal revenue laws. They make sure all taxpayers are complying with U.S. tax laws.

Similarly, the IRS makes sure you pay your fair share of the taxes owed after buying real estate property in the U.S.

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U.S. Income Tax Rate vs. Withholding Rate

When you compare the withholding tax to the actual state income tax, the former is usually higher than the latter.

This means when you file a U.S. tax return to report the real estate purchase, you’ll get a sizeable tax refund. You can calculate your taxable gain by subtracting the amount you paid for the property from the selling price.

If you own a property for more than a year, the highest U.S. tax rate in the long term is a capital gain rate of 20%. A large portion of the gain, however, has a tax rate of 15%.

Tax Example

Let’s look at an example. If you sell U.S. real estate for $500,000 but the basis for the property is $300,000, the gain would be $200,000. Under FIRPTA, the withholding that’s required would equal to 15% of that $500,000, or $75,000.

When you eventually file your tax return, you’d report a gain of $300,000. If the 15% tax applies to that gain, you’d only owe $45,000 in taxes. That means you get about $30,000 in tax returns.

It’s important to note that you can’t file these returns until about January or February. Any tax returns you’re owed probably won’t cash in until around June.

You’ll need to submit a Form 1040NR to claim back the FIRPTA tax. Additionally, you’ll need an Individual Tax Identification Number to do this, which we’ll cover later.

Exceptions to Withholding

There are some withholding exceptions under FIRPTA. One of these exceptions is when the sales price for your property is $300,000 or less. The buyer also has to sign an affidavit saying they’ll use the real estate for personal use about 50% of the time over the next two years.

Another exemption is when the property is between $300,000 and $1,000,000 and the buyer fulfills personal use requirements. In this case, the FIRPTA withholding rate can reduce to 10% instead of the regular 15 or 20.

If we think back to the previous example, this means the withholding would be about $50,000 instead of $75,000. Your expected refund then would be about $5,000 instead of $30,000.

Reduced Withholding

You can also apply for a Reduced Withholding Certificate. An application calculates your estimated gain and tax, and you request that your withholding be equal to the tax calculated.

You have to submit this application on or before the day of the closing with all the right calculations. The regular rate of FIRPTA withholding remains in an escrow account while the application is processed.

It takes about three months for the IRS to process the application. The withholding will then be paid to the escrow account, which you’ll then receive.

To apply for this, you’re going to need a taxpayer identification number or an employer identification number. Without these, the IRS won’t process your request.

Individual Tax Identification Number

So what is an Individual Tax Identification Number?

Abbreviated as ITIN, these are tax processing numbers issued by the IRS. ITINs are for people who need a U.S. tax identification number but can’t get a Social Security Number from the Social Security Administration.

ITINs help you comply with U.S tax laws. The IRS references these numbers to efficiently process tax returns and properly account for payments.

They’re given to you regardless of your nonresident status since the IRS understands you still have tax-related requirements, like FIRPTA.

ITINs don’t provide you with Social Security benefits, and they don’t authorize work in the U.S. It does, however, let you process tax returns through the IRS.

1031 Exchange that saves British people tax when selling US property

Another important factor for selling real estate in the U.S. is the 1031 exchange. This is essentially a swap of one investment property for another that defers capital gains.

If you meet the requirements for a 1031 exchange, you’ll pay little to no tax at the time of the exchange.

Capital Gains When Selling U.S. Real Estate Property

A capital gain is an increase in a capital asset’s value that’s realized once you sell an asset, such as property. Capital gains might occur in the short or long term. You need to claim them on income taxes as well.

Capital Gains Tax Requirements

Capitals gains kick in when you enter a contract to sell your property. You don’t need to pay any capital gains until a few things occur.

You won’t pay any capital gains until you’ve received the money for the sale. You’ll also be exempt until April 15th, when you file your 1040 tax return to the U.S. If you requested a filing extension using Form 4848, you have until October 15th to prepare your 1040.

Capital gains depend on a few different factors. The proceeds of your sales and the adjusted basis cost of the asset are key. The capital gains tax will also differ based on the tax rates of different states.

Capital Gains Tax Example

Let’s take a look at an example of capital gains taxes for a property sale.

Say your income is about $80,000 a year. You sell a property for $300,000 with a $200,000 adjusted basis cost.

You gain about $100,000, and your capital gains tax is about $15,000 if it’s at 15%. There’s also a 25% depreciation recapture rate. If the property depreciates by $50,000, then you’ll pay about $12,500 in depreciation recapture.

If you add those up, you’ll pay about $27,500 in capital gains tax to the HMRC in the UK.

When does Capital Gains Tax kick in?

Capital gains are made once you enter into a contract to sell the property in question. You do not need to pay  Capital Gains Tax until

– You have received the money (if you are taxed at the 15% FIRPTA tax rate, more on this later)

– 15th April When you file your 1040 tax return to the US and pay your liabilities

– 15th October if you have requested a filing extension using the Form 4868, Application for Automatic Extension of Time to File U.S. Individual Income Tax Return, which gives you six more months to prepare 1040 your tax return.

 

Mitigating Capital Gains Tax and FIRPA Using 1031 Exchange

You can actually use a 1031 exchange to mitigate both capital gains tax and FIRPTA. This is done by exchanging U.S. real property for other U.S. real property.

There is a misconception that a 1031 exchange can help you avoid FIRPTA withholding altogether. In the past, sellers in a 1031 exchange only needed to notify their intent to the buyer to relieve them of withholding requirements.

Current 1031 Exchange Requirements

The current IRS regulations require you to do a few things.

You have to close the relinquished property at the same time you purchase the replacement property. Boot, or non-like-kind property, is not allowed in the exchange.

As the seller, you also have to tell your buyer that you’re not required to recognize any gains or losses. The buyer also has to show the IRS that they met all the requirements within 20 days.

You can also file a Form 8288-B as a non-recognition notice to the IRS if you plan on completing a 1031 exchange. This can relieve you of FIRPTA withholding, but Form 8288 does take a while to process.

FIRPTA and CGT

It is possible that you have paid $90,000 for the 15%  FIPTA but have a $50,000 Capital Gains tax liability. You would then reclaim the overpaid tax on your 1040 tax return.

It may be advisable to put in your tax return soon after 1st January so that you can claim the overpaid taxes sooner rather than later.

I very much doubt, but it is possible that you have paid $90,000 FIRPTA but have a tax liability on the capital gains of $100,000. In these instances, you would need to pay the IRS the $10,000 difference when submitting your 1040 tax return to the IRS.

A step by step guide of how to use a 1031 Exchange

1 – Start the sales process of selling a real estate property

2 – Work out if there are ways of mitigating FIRPTA without the need for a 1031 exchange if this is a risk

3 – Use a 1031 exchange through a Qualified Intermediary

4 – Reinvest the money in a new investment property to mitigate both FIRPTA and CGT

5 – Consider the UK Capital Gains Tax implications of selling a US-based real estate if UK resident

1031 exchange mitigate the need to pay FIRPTA and Capital Gains Tax on the sale of real estate property

Like for like exchanges to avoid FIRPTA and Capital Gains Tax

It is possible to sell a real estate property investment and use the proceeds to reinvest in a new real estate property investment. This is what is known as like for life provided:

– The sold property is a property investment

– The purchased property is a property investment

– The amount of money reinvested into the new property is the same or more (cannot be less, even by $1)

– Neither property may be classed as stock (to be flipped)

How many days do you have to use a 1031 exchange?

You only have 45 days from the point of sale to identify a replacement asset to purchase. There must be an agreement to buy the replacement real estate property investment and documents are with a qualified intermediary.

In addition to the 45-day rule mentioned above the property in question must be completed within 180 days of the original sale date.

What can void the 1031 exchange?

The seller of the real; estate property wishing to use the 1031 exchange cannot take control or have access to the money involved in the sale. The said 1031 would become invalid of the seller of the real estate property obtains or controls the money received in the sales transaction.

Invest in U.S. Real Estate Property the Right Way

While investing in U.S. real estate property can be a hassle, knowing the right information will make the process that much simpler.

Leverage this guide to be 100% ready for your next property investment. You can overcome the complex bureaucracy and come out the other side with the profits you’ve earned.

You may be interested in services where we help Americans move to the UK with tax in mind. There are a number of legal matters and tax issues that you need to consider. We have also written a useful article about people moving from the US to the UK and getting a VISA.

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