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?
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.
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.
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%.
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.
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.
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.
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.
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.
For more information on FIRPTA and tax efficiency in the UK and the U.S., check out the rest of our site!
Need tax consultation? Book a tax call with us today!