FIRPTA - Watch out for this one!

Foreign Investment Real Property Tax Act

We bought another property: a small rental house. Unlike the last one, this was not a foreclosure where we were buying from Freddie Mac. The sellers for this one were a married couple.

Good deal, good house. All seemed well. The HOA was slow responding but after a few weeks we were ready to close. The title company sent the paperwork.

First page...the numbers. Looks reasonable. Hummmm. No property tax adjustment. I guess they had paid their taxes up. Well, let me just check. Maricopy County makes that information available online. Ah, no...last year's taxes were not paid. Title Company: "Oh, thank you for noticing that: we missed it." !!!! But I digress. That is not the point of this post.

Second form to sign. A disclaimer saying the buyer (us) is acknowledging that the Title Company has no responsibility for FIRPTA. Huh?!?! I actually know what FIRPTA is, and this is an unacceptable risk.

FIRPTA is the IRS's way of not having to chase foreign sellers for Capital Gains taxes. FIRPTA puts the responsibility on the buyer to (a) determine whether the seller is a "foreigner"; and if so (b) the buyer is supposed to withhold 10% of the purchase price and send it to the IRS as a tax installment. The seller would then file their tax return to adjust to the correct amount and claim back any excess.

So how is this supposed to work if the Title Company has no responsibility? We, the buyers, have zero contact with the sellers. The consequence is that if the sellers are "foreigners" and they don't properly submit their tax return, we (the buyers) could be on the hook for whatever the IRS deems as the seller's tax liability. In this particular case, the sellers had not paid their HOA fees in over a year; nor had they paid their property taxes, so there was a significant risk that they also would not file their federal income taxes and/or clear up capital gains. In reality they probably did not make money on the house because they had spent a lot upgrading it. However, there was a significant difference between the current selling price and what they paid for it a few years earlier, so without a proper accounting of upgrade costs the IRS could easily assume there was a capital gain. Risky.

In our case, we had three choices: (1) unwind the whole deal; (2) disengage with the Title Company and engage with a new (and hopefully better) Title Company; or (3) deal with it ourselves. With the help of our excellent Real Estate Pro (yes Jeff...the same one) we solicited proof from the sellers that they were not "foreigners".

According to the IRS, "A person who meets the substantial presence test (183 day rule per IRC Section 7701) or is considered a resident alien for
income tax purposes is no longer considered to be a foreign person."

The sellers were able to produce a copy of a social security card and evidence that they were receiving social security income. So we felt that was solid proof that they were not "foreigners" for tax purposes, and closed the purchase. However, that is a personal judgement and we are still not satisfied that the Title Company has done their job and properly protected us. Still, the risk is pretty small with that evidence.

Be careful out there!

By the way, this all applies to us "foreigners" when we sell too. We should expect, notwithstanding Title Companies like this one, that we could have 10% of our sale price withheld when we sell. This is not a big deal if you are expecting it. There are ways to reduce or eliminate this requirement if there are good reasons why you really won't owe that much tax; or you just get the rest back when you file your next US tax form. So no need to panic on that count.