The United States real estate market boomed in 2020 in certain parts of the country and many people sold their US residences and vacation homes for a nice profit. Many Canadians who owned winter or vacation homes in the US were part of this boom and parted with their homes as well. Because the real estate is located in the US, it reserves the right to tax any profits on those sales. In addition, most states reserve the right to impose their own income tax on those profits, too. The following tax implications may affect U.S. property buyers.
What does this mean for your real estate?
At the federal level, when a non-US person sells US real estate, the buyer is supposed to remit federal tax withholding to the IRS on the seller’s behalf. This is referred to as FIRPTA withholding and stands for Foreign Investment in Real Property Tax Act. The baseline amount of withholding is 15% of gross proceeds on the sale. You read that right – 15% of gross proceeds. This means the withholding is often in excess of the actual federal tax on the sale since the actual tax is calculated on the gain, not on the gross proceeds.
When a non-US person sells US real estate, the buyer (or rather the buyer’s agents) prepares Form 8288 reporting information about the sale to the IRS. This form also calculates the amount of withholding required under FIRPTA. The buyer also prepares Forms 8288-A for each seller (say a husband and wife if the property is owned jointly) reporting each seller’s share of the gross proceeds and withholding. When the property transaction closes, the buyer’s agents withhold 15% of gross proceeds from the amount that is paid to the seller. They then send Forms 8288, 8288-A, and a check for the withholding amount to the IRS.
What to expect when the IRS processes your forms:
Once the IRS receives the forms and withholding, it processes them. It checks to make sure the reporting was done properly and cashes the withholding check. Then, the IRS applies the withholding to the sellers’ accounts, so they have a credit of tax paid. Last but not least, it stamps each seller’s Form 8288-A and mails them back to the sellers at the address listed on the 8288-A. The sellers must have this stamped Form 8288-A when they file their US income tax return to report the sale – this is how IRS ties everything together.
As you might imagine, this process is ripe for error, especially during a pandemic. COVID-19 precautions taken by the IRS have caused significant delays when processing forms and payments mailed to them. The IRS has not yet been able to do all these steps for many people, which means the sellers’ accounts may not have been credited for the withholding mailed to the IRS on their behalf.
As such, the IRS cannot match up the withholding reported on the sellers’ US income tax returns and they may deny the withholding. They may send out notices to the sellers requesting payment for the entire tax calculated on the tax return. The sellers then must provide additional documentation proving that the withholding was in fact mailed in on their behalf and does in fact belong to them. The issue is generally corrected, but not without considerable time, effort, and expense.
How can you prepare for this process?
- Because the withholding is 15% of gross proceeds, most people have way more tax withholding sitting with the IRS than the actual tax due. This means their income tax returns will calculate significant refunds due to them. These issues combined with the additional identity verification IRS must do means there could be 2-3 years from the time of the sale until the sellers get their refunds from IRS. As this is not an insignificant amount of money, sellers need to plan not to have access to those funds for that amount of time.
- If the sellers choose to pay a knowledgeable tax preparer to prepare and file their income tax returns, they may end up paying more professional fees than anticipated if the preparer has to correspond with the IRS to prove the withholding was actually paid in on the taxpayers’ behalf.
- It’s possible to apply for reduced or eliminated FIRPTA withholding in advance of the sale. However, this is a complicated and specialized area, and professional fees to prepare the required forms can be expensive. It must be lined out well in advance of the sale because the calculations take time and the paperwork must be in place at the time of the sale. It may be worth it though, especially if the withholding is excessive when compared to the amount of tax the seller will actually pay.
We know this process is confusing and can be difficult to navigate. In order to find the best outcome, we recommend taking the above actions. If you have questions or need the assistance of an expert in international tax, our accountants are pleased to be a resource to you. Please contact us with any questions!
This article was written by Erin Stockwell, CPA, Shareholder, and International Tax Team Lead at the Anderson ZurMuehlen Great Falls Office.