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 real estate (not homes), you need to consider some complicated tax regulations. It’s essential to know these rules before investing in U.S. real estate. While people might not tell you about these laws, noncompliance penalties exist. The first thing to note is if you’re a foreign person who is not a tax resident of the U.S. who sells a house 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. laws. Similarly, the IRS makes sure you pay your fair share of the taxes owed after buying homes in the U.S. Example Let’s look at an example. If you sell U.S. real estate for $500,000, but the basis is $300,000, the gain would be $200,000. Under FIRPTA, the withholding that’s required would equal 15% of that $500,000, or $75,000. When you eventually file your 1040 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 1040 returns. See how much FIPTA you must pay to the IRS using our calculator and then use the 1031 exchange to minimise the tax liability. Exceptions to Withholding under FIRPTA Under FIRPTA, there are some withholding exceptions. One of these exceptions is when the sales price 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 asset is between $300,000 and $1,000,000, and the buyer fulfils personal use requirements. In this case, the FIRPTA withholding rate can be reduced 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 amount calculated. You have to submit this application on or before the day of the closing with all the correct 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 receive. To apply for this, you will need an identification number. Without these, the IRS won’t process your request. What is a 1031 exchange? Many of our clients ask, “What is a 1031 exchange?” when we discuss tax deferral opportunities to sell an investment. Another important factor for selling real estate in the U.S. is the 1031 exchange rules. This is essentially a swap of one investment property for another tax deferral refers to capital gains on the 1040 return reported to the IRS. 1031 is considered a tax-deferred charge because you may have to pay if you later sell the exchanged property. Many investors will continue to exchange assets to continue the deferred charge. If you meet the requirements for a 1031 exchange you will pay little to no none at the time of the exchange. Capital Gains A capital gain is an increase in a capital asset’s value that’s realized once sold. Assets include property. Capital gains might occur in the short or long term. You need to claim them on income taxes as well. Capital Gains Requirements Capital gains kick in when you enter a contract to sell your house. 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 from the sale. You’ll also be exempt until April 15th, when you file your 1040 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 several factors. The proceeds of your sales and the adjusted basis cost of the asset are essential. The capital gains will also differ based on the rates in different states. The 1031 exchange rules to mitigate FIRPTA is one way foreign expats avoid paying taxes when selling residential real estate property and homes. Capital Gains Example and FIRPTA Let’s look at an example of capital gains taxes for a property sale. Say your income is about $80,000 a year. You sell for $300,000 with a $200,000 adjusted basis cost. You gain about $100,000, and your capital gains are about $15,000 if it’s at a 15% FIRPTA tax rate. There’s also a 25% depreciation recapture rate. If the asset 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 to the HMRC in the UK. When does Capital Gains 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 until – You have received the money (if you are taxed at the 15% FIRPTA rate, more on this later) – 15th April When you file your 1040 return to the US and pay your liabilities – On 15th October, if you have requested a filing extension using Form 4868, Application for Automatic Extension of Time to File U.S. Individual Income Tax Return, you will have six more months to prepare your 1040 for your return. Mitigating Capital Gains and FIRPA Using 1031 Exchange rules You can use a 1031 exchange rule to mitigate capital gains tax and FIRPTA. This is done by exchanging U.S. real property for other U.S. assets. 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 the buyer to relieve them of withholding requirements. Current 1031 Exchange Rules Requirements The current IRS regulations require you to do a few things. You have to close the relinquished property while you purchase the replacement asset. Boot, or non-like-kind property, is not allowed in the exchange. As the seller, you also must tell your buyer that you’re not required to recognize any gains or losses. The buyer must also show the IRS that they met all the requirements within 20 days. You can also file Form 8288-B as a non-recognition notice to the IRS if you plan on completing a 1031 tax-deferred exchange. This can relieve you of FIRPTA withholding, but Form 8288 does take a while to process. A good understanding of the 1031 exchange rules is required to take advantage of this essential legal avoidance. 1031 tax deferred exchange rules: Like for like exchanges to avoid FIRPTA and Capital Gains It is possible to sell a real estate investment and use the proceeds to reinvest in a new investment under the 1031 deferred exchange rules to mitigate FIRPTA. This is what is known as like for life provided: – They sold real estate as an investment – The purchased asset is an investment – The amount of money reinvested into the new property is the same or more (cannot be less, even by $1) – Neither asset may be classed as stock (to be flipped) How many days do you have to use a 1031 deferred exchange rules? Understand the timelines to avoid a mistake The 1031 tax-deferred exchange rules specify that 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 must be with a qualified intermediary. Whatever tax you are looking to avoid must be reinvested in the property. If you sell for $300,000 and wish to avoid FIRPTA, you must invest the full $300,000 in residential or commercial investments. Let us imagine you sell a piece of real estate for $300,000 but only identify an asset with $200,000 as a replacement within the 1031 exchange rules timeline. The $100,000 balance would be subject to the 15% withholding FIRPTA. The asset purchased must be completed within 180 days of the original sale date. Failing to identify a replacement property or properties within 45 days and then complete the identified assets within 180 days will result in a 15% FIRPTA on money not re-invested. Important recap: Please note for the 1031 exchange, you need to sell investments, not flips or a home. You also need to reinvest the proceeds into residential or commercial investments, not a home and not stock (developments). A step by step guide of how to use a 1031 Exchange rules and process 1 – Start selling a real estate property which is not a process of exchanging homes. The 1031 exchange rules do not apply to home sales. 2 – Work out if there are ways of mitigating FIRPTA without the need for a 1031 exchange if this is a risk 3 – Use 1031 exchange rules through a Qualified Intermediary 4 – Reinvest the money in a new investment to mitigate both FIRPTA and CGT 5 – Consider the UK Capital Gains implications of selling a US-based real estate if a UK resident Albeit the 1031 exchange rules are effective in selling an investment, they cannot be used to exchange homes. Feel free to use the FIRTA calculator to see what you may need to pay the IRS when selling. Why you cannot use the 1031 exchange rules when you exchange homes There is a Capital Gains home exclusion of $250,000 for single persons and $500,000 for married couples on any gains made. This means that a single person can make a gain on a residential property of $250,000 without paying Capital Gains to the IRS when selling their home. FIRPTA ignores the home exclusion and will remain calculated at 15% of the sales proceeds received upon selling the home. We must remember that FIRPTA applies to foreign expats who are no longer living in the United States (US). Anyone who lives in the US will not have to pay FIRPTA. As such, the 1031 exchange rules are unnecessary when you exchange homes. FAQ FAQ What does 1031 Exchange mean in the context of an investment? A 1031 Exchange allows investors to sell one asset and reinvest the proceeds into another, without immediately incurring capital gains. The properties involved must be "like-kind" and held for investment or business purposes. Who can take advantage of this deferred transaction? Eligibility is broad and includes individuals as well as legal entities like partnerships and corporations. The important factor is that both the asset you're selling and the one you're acquiring are used for investment or in a trade or business. What guidelines should I be aware of? here are several important considerations: The properties must be similar in nature. You have 45 days to identify a replacement after selling your initial asset. You must complete the acquisition of the new asset within 180 days. The transaction must be facilitated through a qualified intermediary. Can I use this strategy for residential properties? Yes, but the homes in question must be investment properties, not personal residences. For example, if you own a rental house, you could exchange it for another rental or business-use asset. What are the consequences of not adhering to the guidelines? If you don't follow the rules, the transaction loses its deferred status. This means you'd owe capital gains on the sale, and you may also face penalties and interest.
