State of the “Union”
Did you watch the President’s state of the union address the other night? Was it as you expected? Were you hoping for something more? Were you disappointed? Did you find it informative? Maybe entertaining? Embarrassing?
Speaking for myself: yes, yes, yes, yes, no, somewhat, and definitely.[i]
Mind you, I wasn’t expecting much in the way of tax policy; after all, the GOP controls the House. That said, I did hope for more than yet another reference to a billionaires’ tax.[ii]
I also have to say that I briefly wondered whether those among my fellow Americans – citizens and permanent residents alike – who until then were on the proverbial fence about expatriating, may have been persuaded by the shameless political drama that it was time to go.
Of course, one thought often leads to another. In my case, the idea of anyone leaving the country reminded me of a problem we recently encountered involving a bank with a troubled loan to a nonresident alien[iii] (“Taxpayer”) who completed a short sale of their New York home shortly before their departure.[iv]
As you probably know, a “short sale” occurs where a real property is sold for less than the amount of the debt encumbering the property; in other words, the seller has no equity in the property. The lender will be entitled to the net proceeds from the sale of the property and will generally forgive the unpaid balance of the debt.
In general, the amount realized from a sale of property includes the amount of the debt from which the seller is discharged as a result of the sale.[v]
The fair market value of the property (the collateral for the debt) at the time of sale is not relevant for purposes of determining the amount of debt from which the taxpayer is discharged or treated as discharged, at least where the debt secured by the property is nonrecourse. Thus, the fact that the fair market value of the property is less than the amount of the debt it secures does not prevent the full amount of such debt from being treated as money received from the sale of the property.[vi]
However, the amount realized on a sale of residential property that secures a recourse debt (as in the case of the Taxpayer) does not include amounts that are (or would be if realized and recognized) income from the discharge of such debt.[vii] In that case, the amount realized from the sale is limited to the fair market value of the property.[viii]
Notwithstanding that the seller experiences an accretion in value by virtue of the sale and discharge, they are left without any liquidity with which to pay any income tax liability imposed with respect to the gain from the sale.
Then again, if the seller’s adjusted basis for the property – i.e., the amount they paid for the acquisition of the property, plus the cost of any improvements thereto – exceeds the fair market value of the property at the time of the sale (as reflected in the sale price), then the seller has not realized a taxable gain or incurred a tax liability.
The Taxpayer found themselves in the situation described above: a mortgage and an adjusted basis in excess of the fair market value of their home. In other words, no gain was realized.
Unfortunately for the purchaser and the Taxpayer’s lender, they did not appreciate the application of FIRPTA’s withholding rules to the short sale and the importance of demonstrating to the IRS the Taxpayer’s actual tax liability as early in the sale process as possible.
The taxation of gain realized by a nonresident alien[ix] (like Taxpayer) on the sale of an interest in U.S. real property (“USRP”) is governed by the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”).[x]
FIRPTA treats the gain from the sale of USRP by a foreign individual as income that is effectively connected with the conduct of a U.S. trade or business by the foreign individual.[xi]
Consequently, the gain recognized by a foreign individual on the sale of USRP will be subject to federal income tax at the rate of 20 percent, assuming the property was a capital asset – such as a personal residence – that the foreigner seller held for more than one year.[xii]
In order to ensure payment of the resulting tax liability,[xiii] FIRPTA requires the purchaser of the foreign-owned USRP to withhold an amount equal to 15 percent of the amount realized by the foreign seller.[xiv] It then requires that the amount withheld be reported and remitted to the IRS by the 20th day after the date of the sale.[xv]
The regulations issued under FIRPTA define the “amount realized” by the seller for the transfer of USRP as the sum of: (i) the cash paid, or to be paid, (ii) the fair market value of other property transferred, or to be transferred, and (iii) the outstanding amount of any liability assumed by the purchaser or to which the USRP is subject immediately before and after the sale.[xvi]
Significantly, neither the purchaser’s duty to withhold nor the amount required to be withheld is affected by the amount of cash to be paid by the purchaser.[xvii]
The duty to withhold is subject to modifications; for example, the amount required to be withheld may be modified pursuant to a withholding certificate issued by the IRS.[xviii]
If a purchaser who is required to deduct and withhold the tax fails to do so, they may be held liable for the payment of the tax and any applicable penalties and interest; the tax will be assessed against and collected from the purchaser.[xix]
Show Me the Money
As we saw above, the net cash proceeds from a short sale will ultimately be paid to the lender in partial satisfaction of their loan – the seller has no equity in the property.
However, the amount realized on a sale of the USRP that secures the lender’s loan to the foreign seller includes the amount of such debt from which the foreign seller is discharged in the short sale.
The purchaser is required to withhold 15 percent of the amount realized on the sale without regard to the amount of cash to be paid by the purchaser.
Because the 15 percent withholding does not necessarily bear any relationship to the amount of tax actually incurred on the sale – indeed, the foreign seller may have realized a loss on the sale, as in Taxpayer’s case – IRS regulations allow either the foreign seller or the purchaser to apply for a “withholding certificate” from the IRS that authorizes the purchaser to withhold a lesser amount, based upon information that establishes the seller’s actual tax liability.
For example, one may apply for a withholding certificate based on a calculation of the foreigner’s maximum tax liability. In the case of an individual seller in a short sale, that amount will generally be the amount realized minus the property’s adjusted basis, multiplied by the maximum individual income tax rate applicable to long term capital gain.[xx] The application must include a calculation of the maximum tax that may be imposed on the sale, and must be accompanied by a copy of the relevant evidence that confirms the contract price and adjusted basis of the property.[xxi]
The IRS is required to act upon an application for such a certificate not later than the 90th day after it is received.[xxii]
If an application for a withholding certificate is submitted by the seller on the day of or any time prior to the sale, the seller must notify the purchaser prior to the sale. No particular form is required but the notice must include certain information, including the date the application was submitted to the IRS.
At that point, the purchaser must still withhold 15 percent of the amount realized but need not report or pay over to the IRS the amount withheld until the 20th day following the IRS’s final determination with respect to the application.[xxiii]
In the context of the short sale described above, it appears that the interests of the lender to which the foreign Taxpayer was indebted and of the purchaser to whom the Taxpayer was selling the real property that secured such debt were aligned in that the lender’s ability to recover any portion of their loan was contingent upon the purchaser’s ability to eliminate their withholding obligation under FIRPTA.[xxiv]
Based on the foregoing, the lender should have appreciated how the purchaser’s withholding obligation would affect the lender’s ability to recover any of its money from the Taxpayer.
By the same token, the purchaser should have appreciated the economic cost of FIRPTA withholding where the Taxpayer’s amount realized exceeded the cash contract price for the property.
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The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.
[i] I never realized how “close” the First Lady and Second Gentleman are. I wondered what ran through Senator Schumer’s mind when Mr. Biden congratulated him for serving another term as Senate Minority Leader. And what’s up with the President’s joke about not being able to attend the Super Bowl “next week”? All that in just the first few minutes of the speech.
Then there was the heckling and, worse, the shouts of “liar.” Can I say this is worse than theatrically tearing up your copy of a President’s speech? And all this as the world looks on.
It appears we’re governed by self-aggrandizing, vindictive, childish buffoons who are unable to police themselves; but we voted them in and do so year after year.
Once again, I turn to Jefferson’s statement about “The government you elect is the government you deserve.” Doesn’t say much about us.
[ii] Speaking of things that were left unsaid, I was surprised that Mr. Biden said nothing about the earthquake in Turkey and Syria, which began Jan. 6.
[iii] An individual who is neither a citizen nor a permanent resident of the U.S.
[iv] One does not necessarily follow from the other. I’m merely stating that’s how these thoughts were ordered in my mind. Defective synapses? Probably.
[v] Reg. Sec. 1.1001-2(a).
[vi] Reg. Sec. 1.1001-2(b).
[vii] Reg. Sec. 1.1001-2(a). See IRC Sec. 108, especially Sec. 108(a)(1)(E) and 108(h).
If the buyer had assumed the personal liability, then the amount thereof would have been included in the amount realized. See, e.g., Reg. Sec. 1.1001-2(c), Ex. 1.
[viii] See, e.g., Reg. Sec. 1.1001-2(c), Ex. 8.
[ix] Or a foreign corporation.
[x] P.L. No. 96-499.
[xi] IRC Sec. 897.
[xii] IRC Sec. 1(h), 1221, 1222 and 1223.
[xiii] After all, we are talking about sellers who are not U.S. persons.
[xiv] IRC Sec. 1445(a); Reg. Sec. 1.1445-1(b).
[xv] IRS Forms 8288 and 8288-A are used for this purpose. Note that the identifying numbers of both the seller and the buyer must be provided. Reg. Sec. 1.1445-1(c) and 1.1445-1(d).
[xvi] Reg. Sec. 1.1445-1(g).
[xvii] Reg. Sec. 1.1445-1(b)(1).
[xviii] Reg. Sec. 1.1445-3.
[xix] Reg. Sec. 1.1445-1(e).
The withholding of tax under IRC Sec. 1445 does not excuse a foreign seller that disposes of a USRP interest from timely filing a U.S. tax return (such as Form 1040NR) with respect to the income arising from the sale. In addition, any tax owing beyond the amount withheld must be paid by the filing deadline generally applicable to the foreign seller. Reg. Sec. 1.1445-1(f).
If the tax withheld exceeds the amount of tax owed as a result of the sale, the foreign seller may use the filing of the tax return to claim a refund of the overpayment.
[xx] Reg. Sec. 1.1445-3(c)(2). However, that amount must be adjusted to take into account certain other items, including, for example, any reduction of tax to which the transferor is entitled under the provisions of a U.S. income tax treaty, any amount that is required to be treated as ordinary income; and any other factor that may increase or reduce the tax upon the disposition.
[xxi] Reg. Sec. 1.1445-3(b)(4)(i).
[xxii] The IRS may deny a request for a withholding certificate where, after due notice, an applicant fails to provide information necessary for the IRS to make a determination. This was Taxpayer’s situation when we were brought in.
[xxiii] The Service will send a copy of the withholding certificate or copy of the notification denying the request for a withholding certificate to the transferee. For this purpose, the IRS’s final determination is deemed to occur on the day when the copy of the withholding certificate or the copy of the notification denying the request for a withholding certificate is mailed by the IRS to the purchaser.
[xxiv] By contrast, see Reg. Sec. 1.1445-2(i) which provides guidance on withholding in the context of a foreclosure action.