How the Foreign Investment in Real Property Tax Act Can Affect California Real Estate Investments

Legal News GavelAuthor: Staff

California offers a vast array of opportunities for real estate investors from around the world. In the San Diego area, for example, investors can participate in new residential and commercial developments, purchase distressed properties with the goal of rehabilitating and selling them, or acquire properties for rental, among many other options.

Investors from outside the United States who are considering properties or ventures in California need to be aware of certain legal requirements they must meet, including federal tax laws that specifically address foreign investors. The Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) requires withholding of income tax on sales and other dispositions of property with foreign owners. This includes both individual owners who reside outside the U.S. and foreign corporations. While foreign owners are liable for payment of tax under FIRPTA, the immediate obligation to withhold belongs to the buyer.

FIRPTA, Summarized

Congress passed FIRPTA as part of a massive budget bill, and it became law on December 5, 1980. A spending bill enacted in 2015 made numerous changes to the statute going forward. Under the Internal Revenue Code (IRC), nearly all income is subject to federal taxation to some extent. The IRC’s definition of “gross income” includes “gains derived from dealings in property.” The amount of the proceeds from the sale of property that exceed the amount of money the seller put into the property, which is known as the “basis,” would be the taxable gains.

The term “recognized gain” refers to the difference between sales price and basis. “Realized gain” refers to the amount of money the seller actually makes on the sale, which might include other forms of income or expenses. The IRC states that all gains from a sale of property must be recognized, unless a statute specifically provides otherwise. The FIRPTA provides such an exception for foreign sellers of real estate.

Real Property Interest, Defined

Section 897(c)(1)(A) of the IRC defines the types of “real property interests” that are subject to FIRPTA’s withholding provisions. These include ownership interests in real property located in any of the 50 U.S. states, the District of Columbia, and the U.S. Virgin Islands. It also includes ownership interests—i.e., shares—in U.S.-based corporations that own real property interests, with some exceptions. The types of property involved in most common real estate investments would fall under FIRPTA’s definition.

Income Taxes, Imposed

For a “nonresident alien individual” selling a U.S. real property interest, FIRPTA imposes the same tax as that for a foreigner “engaged in trade or business within the United States,” which is found in IRC § 871(b)(1). This amount of tax may consist of capital gains tax payable by an individual or the alternative minimum tax.

FIRPTA imposes taxes on foreign corporations for sales of U.S. real property interests according to § 882(a)(1) of the IRC, which may include the regular corporate tax rate, the alternative minimum tax, or the alternative tax for corporate capital gains.

Tax on Recognized Gains, Withheld

The 2015 amendments to FIRPTA made the buyers of real property interests from foreign sellers—both individuals and corporations—responsible for withholding taxes owed on the gain. The amount to be withheld equals 15 percent of the realized gain. The buyer is required to file a form with the IRS about the withholding. A buyer who fails to withhold taxes as required by FIRPTA may be held liable for the tax payment themselves.

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