The Foreign Investment in Real Property Tax Act (FIRPTA) is a federal law that requires a “foreign person” to pay tax on the gain realized upon the sale of real property owned by that person. However, the law does not make the seller responsible for paying this tax. Rather, the law requires the buyer to determine whether or not the seller is a “foreign person” (basically a non-resident alien).
If the seller is a “foreign person” as defined by the statute,then the buyer must withhold 10% of the sale proceeds at closing. These funds are to be forwarded to the IRS to insure that the foreign person pays tax on the gain realized from the transfer. If the buyer fails to determine that the seller is a foreign person and thus fails to withhold 10% of the proceeds, the buyer is liable for the 10%. WOW! That’s significant. If you just bought a $400,000 house from a foreigner and did not satisfy your obligations under this statute, you may be liable to the IRS for a cool 40 grand. Ouch.
The NWMLS, recognizing the serious risk to buyers, has included a “FIRPTA” provision in the standard Purchase and Sale Agreement (PSA):
j. FIRPTA – Tax Withholding at Closing. The Closing Agent is instructed to prepare a certification (NWMLS Form 22E or equivalent) that Seller is not a “foreign person” within the meaning of the Foreign Investment in Real Property Tax Act. Seller shall sign this certification. If Seller is a foreign person, and this transaction is not otherwise exempt from FIRPTA, Closing Agent is instructed to withhold and pay the required amount to the Internal Revenue Service.
So that’s good news! The PSA specifically instructs the closing agent, aka escrow, to make sure the buyer complies with this legal obligation. Whew!
Wait, there’s bad news? Yep. Virtually every escrow company has its own “escrow instructions” that elaborate on the terms of the PSA. And guess what? Those instructions relieve the escrow agent from taking any steps to make sure the buyer complies with FIRPTA. Here is the language from some commonly used escrow instructions:
Seller warrants to Escrowee [i.e., the Closing Agent] that if Seller is an individual, Seller is a non-resident alien for purposes of U.S. Income taxation, or if Seller is a corporation, partnership, trust or estate, Seller is not a foreign entity. The Foreign Investment in Real Property Tax Act of 1980 as amended by the Tax Reform Act of 1984 places special requirements for tax reporting and withholding on the parties to a real estate transaction where the transferor (seller) is a non-resident alien or non-domestic corporation or partnership or partnerships. It is understood and acknowledged by the undersigned that (a) Escrowee will not take an active role in either the determination of the non-alien status of the seller transferor or the withholding of any funds; and (b) Escrowee makes no representations and (c) Buyer and Seller are seeking an attorney’s, accountant’s, or other tax specialists opinion concerning the effect of this Act on this transaction and are not acting on the statements made or omitted by the Escrowee.
So what protection the PSA provides, the escrow instructions take away. “Whew!” is grossly premature.
Obviously, “consulting with an attorney or other specialist” is simply the escrow company engaging in a little CYA. The closing agent, and only the closing agent, is in a position to obtain the necessary signed certification. The PSA instructs the closing agent to do so. But the closing agent promptly tells the buyer that it will not do so. If you’re a buyer in this situation, watch out. You could get some exceptionally bad news from the IRS long after you’ve purchased the home.
Not convinced? Check out my follow-up post where I flesh out my opinion with those of several other residential real estate lawyers.
Finally, this is a fantastic illustration of how a buyer can benefit from having an attorney on board from the get-go. At Quill Realty, we provide every client with an attorney (and we pay the attorney’s fee). So if you’re a Quill client, you can rest assured that your attorney will identify and resolve this issue (usually by demanding that the closing agent comply with the terms of the PSA and not those of the escrow instructions, to which they usually agree). Not a Quill client? Well, good luck in seeking to eliminate this very substantial post-closing exposure to the IRS…
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