Planning considerations for Canadians selling U.S. real estate

The first time many Canadians hear the term “FIRPTA” is from their listing agent when they’re selling U.S. real estate.

Under the Foreign Investment in Real Property Tax Act (FIRPTA), “the disposition of a U.S. real property by a foreign person” is subject to the withholding rules under Section 1445 of the Internal Revenue Code (IRC). That is a whopping 15% of the sale price.

While many real estate agents, closing agents and advisors are aware of the FIRPTA legislation, the withholding rules and the various methods of complying can be complex.

Filing a U.S. tax return

Canadians who own property in the U.S. are not required to file U.S. tax returns unless the property generates rental income or they have other U.S.-sourced income in a given tax year. As a result, Canadians who have purchased U.S. properties as vacation homes are usually filing U.S. tax returns for the first time when they sell these properties, and potentially owe a capital gains tax to the IRS.

Under the IRC, there are various types of withholding taxes. The FIRPTA withholding is not a tax but a withholding against capital gains tax. When the Canadian seller files the U.S. tax return the following year to report the U.S. property sale, any actual capital gains tax is deducted from the FIRPTA withholding, and the balance is returned to the taxpayer.

As the FIRPTA withholding amount is assessed on the contract price (discussed in greater detail below), and the capital gains tax is assessed on the actual gain made on the transaction, the withholding will likely be much larger than the capital gains tax. Since the amount held back by the IRS is large, the foreign seller is therefore incentivized into complying with his or her U.S. tax reporting obligations in order to receive a refund.

Furthermore, the timing of the refund after the tax return is filed can be unpredictable. Some Canadians have reported waiting up to two years for a refund, while others wait six to eight months.

Withholding rules and withholding parties

When FIRPTA applies to a real estate sale, the IRS puts the responsibility of withholding in the hands of the transferee: the buyer. Therefore, if the transaction violates the FIRPTA rules, the IRS may assess penalties against the buyer.

In a typical U.S. real estate transaction, the parties will deal with a closing agent who acts as the escrow agent for the proceeds of the sale. Since the seller’s escrow agent is holding the funds at closing, it also has a part to play in FIRPTA compliance. As a result, the term “withholding agent” can be confusing but, essentially, the buyer is legally responsible for ensuring compliance.

The key here is that “ensuring compliance” does not necessarily mean remitting the 15% to the IRS at closing. Instead, there are three other ways for a transaction to comply.

The default: Remit funds to the IRS

Commonly viewed as the default way of complying with FIRPTA, the 15% withholding is remitted to the IRS at closing. The buyer will sign a Form 8288, and a Form 8288-A is completed for each seller.

When the funds are remitted with the required forms, the seller typically receives a stamped copy of Form 8288-A from the IRS eight to 10 weeks following closing. He or she will then include a copy of the stamped 8288-A when filing the U.S. tax return. As discussed, any capital gains tax will be paid to the IRS out of the amount withheld, and the balance returned to the taxpayer.

The transaction qualifies for an exemption from withholding

Transactions qualify for an exemption from withholding if the following criteria are met:

(1) the amount realized is US$300,000 or less;

(2) the transferee/buyer has definite plans to use the property as a residence; and

(3) the transferee/buyer is an individual (or multiple individuals).

The IRS has provided specific guidelines on what “definite plans to use the property as a residence” means. For the purpose of this exemption, the personal use requirement means that for 24 months immediately after the closing date, the buyer plans on using the property personally for 50% of the number of days that the property is in use. The days that the property is left vacant do not count.

It is good practice, if the transaction is eligible for this exemption, for the buyer to sign a personal use certification at closing attesting to the above requirements, so that both parties have written record that the rules of FIRPTA were contemplated and complied with.

Application of 8288-B withholding certificate

When the seller’s capital gains tax liability is significantly lower than the amount withheld, or when the property is being sold at a loss, the seller may elect to apply for an 8288-B withholding certificate. The application must be submitted to the IRS by the closing date.

The withholding certificate application includes a calculation of the seller’s expected capital gain tax, thus showing the IRS that the required withholding amount exceeds his or her tax liability. If the seller makes a timely application, the transferee and the escrow agent are then authorized to hold the 15% in escrow, post-closing, while the application is pending.

In general, the IRS processes the application in 90 days. Depending on the seller’s tax liability, a withholding certificate can either reduce the amount to be withheld or provide an exemption. Once the withholding certificate is issued and received by the seller, the escrow agent is authorized to release the withheld funds back to the seller directly out of escrow, minus the reduced amount required to be remitted to the IRS, if any.

It is important to remember that obtaining a withholding certificate does not exempt the seller from his or her U.S. tax filing obligations.

Withhold or remit at a reduced rate

The withholding rate increased from 10% to 15% in February 2016. However, when the amount realized on the transaction is less than US$1 million, there is still an opportunity to reduce the withholding rate to 10% if the buyer is able to sign a personal use certification (discussed above). This rate reduction can be implemented whether the seller decides to remit the funds to the IRS or apply for a withholding certificate.

Timing is key

When FIRPTA’s withholding rules apply to a real estate transaction, all the parties must be made aware. It is prudent for the Canadian seller to consider the pros and cons of the various methods of complying with FIRPTA in order to have a clear path ahead, especially when the cooperation of the buyer and the escrow agent is often required.

If the seller decides that it’s worthwhile to apply for a withholding certificate, the preparation takes time, and a variety of information regarding the property’s history as well as information from the buyer must be gathered. Therefore, let clients know to plan for FIRPTA in a timely manner.

David A. Altro, B.A., LL.L., J.D., D.D.N., FLC, TEP, is managing partner of ALTRO LLP, and a Florida attorney and Canadian legal advisor. Samantha Wu, B.A., J.D., is an Ontario and New York attorney at ALTRO LLP.