“What? The IRS is going to keep 15% of the sales price of my property? And I don’t get any deductions against my rental income?”
This is fairly typical of the response I get from a foreign investor who is in the process of selling their U.S. property. Why? Because most foreigners put the cart before the horse when it comes to investing in U.S. real estate.
If you get sick, you go to a doctor. If you get sued, you hire a lawyer. If you want to buy property, you hire a realtor. This is what most foreign investors do; they call up a realtor to find them a property and then they buy it. The problem is, realtors know how to buy and sell property; they usually don’t know the legal or tax ramifications of doing so.
Consider the following example. In 2012, the Choi family travelled from China – where they reside – to visit friends in Northern California. They loved the area and decided that they would like to invest in real estate there. They figured it could be a rental property for the time being and eventually a place for their son to live if he decides to attend college in the U.S. Unfortunately, the Choi’s made the common mistake of not getting tax or legal advice prior to purchasing a property.
The Chois rented out their property for several years, but ultimately decided to sell it when their son chose not to attend college in Northern California. The Chois called the realtor that sold them the property and asked that he list it for them. Soon after putting the house on the market they had an offer, which they accepted. During the escrow period the Chois were told that 15% of the sale price of their property was going to be withheld and paid to the IRS pursuant to FIRPTA (Foreign Investment in Real Property Tax Act). Not having been told about FIRPTA before, the Chois were skeptical as to whether the 15% tax withholding was correct so they contacted an international tax advisor for verification. What they found out is not what they expected, or wanted, to hear.
The bad news was that foreign investors in U.S. real estate are subject to income tax on two types of income; rental income and gain from the sale of the property.
Foreign investors are required to pay U.S. income taxes on their rental income.
There are two ways a foreign investor can be taxed on their U.S. rental income:
- Gross Basis Taxation
- Net Basis Taxation
Gross Basis Taxation is the default method of taxation that applies to foreign investors’ passive rental income. Gross basis taxation is pretty simple, you pay 30% tax on your gross rent—no deductions for expenses, such as mortgage, property taxes, repairs, insurance, or operating expenses. The 30% is supposed to be withheld by the “withholding agent” – generally the renter or property manager – and paid directly to the IRS. If the withholding agent fails to do so then the foreign investor, must pay it.
Net Basis Taxation, which is generally preferred, is where you pay tax on the rental profit—rental income, fewer expenses. The thing is, being taxed on the net basis requires the foreign investor to make an election. There is a procedure for making the net basis election, and if not followed the foreign investor gets stuck with gross basis taxation.
How does this impact the Chois? Since they were never told they needed to file a U.S. tax return, they didn’t make the net election. Now it is too late for them to make the net election for past years. They will be stuck paying 30% tax on their gross rents received because their renter failed to withhold it and pay it to the IRS. If you consider they received $24,000 per year in rent for 4 years, that comes to $28,800 plus penalties for late filing and payment.
Another consideration for foreign investors is the Foreign Investment in Real Property Tax Act (FIRPTA). FIRPTA applies to dispositions of U.S. real estate by nonresidents (foreign investors); sales, gifts, and transfers to business entities, just to name a few.
Foreign investors are required to pay tax on the gain from the disposition of U.S. real estate. The purpose of FIRPTA is to guarantee the payment of that tax. So here is how it works, a foreign investor sells a property. The buyer generally must withhold 15% of the sales price and pay it to the IRS. The foreign investor then files a tax return and if the 15% withheld turns out to be an overpayment of tax the foreign investor will get a refund. If an underpayment, the foreign investor will owe.
Now back to our friends, the Chois. Assume they purchased the property for $750,000 and are selling it for $1,000,000. The buyer is going to pay the Chois $850,000 and the IRS $150,000. The Chois will then file a tax return to report the sale and the gain of $250,000. The tax on $250,000 gain is $50,000 (20% long-term capital gains rate). This means the FIRPTA withholding was $100,000 more than the actual tax, so the IRS will refund that amount to them.
FIRPTA withholding applies even if the property is being sold at a loss or if it is being transferred to a business entity and no money is changing hands.
However, there are exceptions to FIRPTA, and ways to reduce or eliminate the FIRPTA withholding tax with advance planning and reliable advice.
Unfortunately, without proper guidance, the Choi family subjected themselves to a costly tax situation. Making the Net Basis Election could have saved them thousands of dollars in tax and penalties.
If you are a foreign investor and are considering an investment in U.S. real estate, or already have invested, be sure to get solid tax advice. Don’t rely on your realtor to educate you on the ins and outs of U.S. tax; that isn’t their area of expertise–their job is to sell you a property. Secure the help of a professional international tax advisor, like Esquire Group, to properly advise you.