Navigating U.S. Withholding Tax Rules on Sale of Principal Residence by Nonresident Taxpayers

by Joan Smyth, KPMG LLP's Washington National Tax practice, Washington, D.C.
(KPMG LLP in the United States is a KPMG International member firm)

In the current U.S. real estate market, foreign nationals who have invested in U.S. real property may envision reaping substantial profits from the sale of their properties. While foreign sellers may be poised to enjoy the economic benefit of their real estate investments, oftentimes sellers are not prepared to deal with the income tax withholding mechanism the United States government has in place to ensure collection of foreign sellers' U.S. income taxes on any sales gains.

This article will focus on a common real estate transaction, the sale of a principal residence by a nonresident, and will provide a general overview to guide a nonresident selling a home in the United States through the U.S. income tax withholding and reporting requirements. Any foreign national who anticipates selling an interest in U.S. real property should consult with a U.S. tax advisor about the application of these rules to a specific transaction.

U.S. Income Tax on Sale of U.S. Real Property Interest

In general, when a foreign person sells an interest in U.S. real property the seller is subject to U.S. income tax on any gain realized from the property sale.¹ A U.S. property interest includes any interest in real property located in the United States or the U.S. Virgin Islands, or any interest (other than as a creditor) in a domestic corporation, if the corporation was a U.S. real property holding corporation² during the five-year period preceding the disposition of the transferor's interest (or during the period in which the transferor held the interest, if shorter). The following discussion, however, will focus solely on the sale of a personal residence that is directly owned by a nonresident and located in the United States.

Generally, gain realized from a property sale is equal to all money received in the transaction plus the fair market value of any property or services received, less the seller's adjusted basis in the property. Adjusted basis is generally the seller's original cost of the property plus the cost of any improvements.³

Gain from the sale of property used by the seller as a personal residence is characterized as capital gain. Depending on how long the seller held the property, the gain is either short-term (property held for one year or less) or long-term (property held for more than one year). Net long-term capital gain is subject to tax at a maximum rate of 15 percent (reduced to 5 percent for taxpayers in the 10 or 15 percent marginal tax brackets).⁴

Returning to our example, assuming no other capital gain or loss transactions for Michel during the year, the $325,000 is long-term capital gain subject to U.S. tax at the maximum capital gain rate. Thus, U.S. income tax of $48,750 would be due on the gain realized from the sale of his principal residence (ignoring for now certain U.S. tax benefits available to taxpayers who sell a principal residence).

Withholding on Amount Realized from Disposition of U.S. Real Property

When a nonresident individual disposes of a U.S. real property interest, the sales proceeds are generally subject to U.S. income tax withholding. The withholding rules were enacted to collect any U.S. tax owed by foreign sellers.

In general, the buyer of the property must determine if the seller is a foreign person, and if so, the buyer must deduct and withhold 10 percent of the amount realized by the seller (generally this is the sales or contract price for withholding purposes). The buyer must remit the tax to the Internal Revenue Service (IRS) by the 20th day after the transfer date.

To report and transmit the amount withheld to the IRS, the buyer files Form 8288, U.S. Withholding Tax Return for Dispositions by Foreign Persons of U.S. Real Property Interests.⁵ The buyer must also prepare Form 8288-A, Statement of Withholding on Dispositions by Foreign Persons of U.S. Real Property Interests, for each foreign person subject to withholding. Copies A and B of the form are attached to the Form 8288 submitted to the IRS, and the buyer retains Copy C. The buyer is not required to furnish a copy of these forms to the seller. Upon receipt of the withheld funds and the forms, Copy B of Form 8822-A is stamped by the IRS and forwarded to the seller.

Subsequently, the seller must file a U.S. tax return to report the property sale or disposition even if the seller's U.S. tax liability has been fully satisfied through withholding. The tax return must be filed and any tax due must be paid by the filing deadline applicable to nonresidents. To receive credit for the U.S. federal income tax withheld by the buyer, the seller must attach to the tax return the stamped copy of Form 8288-A that the seller received from the IRS.

In our example, assume the transfer date is March 1, 2005. The buyer must withhold $70,000 ($700,000 x 10 percent) from the sales proceeds. The buyer completes Forms 8288 and 8288-A and sends the forms and the amount withheld ($70,000) to the IRS by March 21, 2005. Upon receipt, the IRS stamps Copy B of Form 8288-A to acknowledge receipt of the $70,000 and forwards the stamped copy to Michel at the address shown on the form. In 2006, when Michel files his U.S. tax return, he will attach the stamped copy of Form 8288-A to his U.S. tax return to receive credit for the U.S. taxes paid and, if applicable, a refund for any overpayment of tax.

A common misconception is that withholding is imposed on a seller's gain from the transaction. Since the buyer is required to withhold on the amount realized, the withholding may exceed the seller's maximum U.S. tax liability with respect to the sale, as illustrated by the preceding example. It's easy to see how these withholding rules can tie up an individual's cash resources for a period of time, which can be particularly difficult for a seller who intends to use the gross proceeds to purchase a new home. However, some relief may be available in certain situations. If an exception to withholding applies, or if the seller obtains a withholding certificate from the IRS, the withholding may be reduced or eliminated.

Exceptions to Withholding

In certain circumstances, the buyer is not required to withhold any U.S. income tax from the sales proceeds. Although there are a number of exceptions to withholding that may apply when a foreign person sells an interest in U.S. real property, the following exceptions are the most common in the context of the sale of a principal residence.

First, if the seller provides the buyer with a certification stating, under penalties of perjury, that the seller is not a foreign person, no withholding is required. The certification must contain the seller's name, U.S. taxpayer identification number, and home address. Form W-9, Request for Taxpayer Identification Number and Certification, may be used for this purpose.

Similarly, withholding is not required if the buyer acquires the property for use as a home and the sales price is $300,000 or less.

Further, if the buyer receives written notice that no gain or loss will be recognized currently on the transaction because a nonrecognition provision in the Internal Revenue Code, or a provision in a U.S. income tax treaty applies, no withholding is required. In a nonrecognition transaction (i.e., a transaction in which U.S. tax is deferred until a later date) the seller must provide the buyer with written notice that no gain or loss will be recognized. The buyer must file a copy of the notice with the IRS by the 20th day after the transfer date. No IRS pre-approval is required for this, or the prior exceptions to withholding, to apply.

Finally, no withholding is required if a buyer receives a withholding certificate from the IRS that eliminates withholding.

Withholding Certificates

A withholding certificate serves to adjust the withholding obligation to correspond as closely as possible to the seller's U.S. tax liability arising out of the property transfer. The buyer, the buyer's agent (with a power of attorney), or the seller may request a withholding certificate from the IRS.

A withholding certificate may be issued because:

A withholding certificate obtained before the transfer notifies the buyer that either reduced withholding or no withholding is required. A withholding certificate obtained after the transfer may authorize a normal refund or an early refund.

The following discussion assumes that the seller is applying to the IRS for the withholding certificate.

Withholding Certificate Obtained before Property Transfer

If the seller intends to obtain a withholding certificate prior to the property transfer, the buyer must be notified in writing that the seller has or will apply for the withholding certificate. Generally, the IRS will act on requests within 90 days of receiving a complete application (which must include the taxpayer identification numbers of all the parties to the transaction).

On the transfer date, the buyer must withhold tax even if the seller has an application for a withholding certificate pending with the IRS. However, the buyer is not required to file Forms 8288 or 8822-A or remit the tax withheld to the IRS until the 20th day after the IRS mails the buyer a copy of the withholding certificate or notice of denial.

Referring to the previous example, assume Michel qualifies to exclude $250,000 of gain on the sale of his principal residence. For tax year 2005, Michel has no other U.S.-source income. After the exclusion, Michel has taxable income equal to $75,000 of long-term capital gain.

Applying the applicable tax rate for long-term capital gains (15 percent), Michel's U.S. tax liability is $11,250. Michel decides to apply for a withholding certificate since the amount required to be withheld (absent a withholding certificate) of $70,000 exceeds his maximum tax liability of $11,250. Prior to the transfer date, Michel notifies the buyer in writing that he is applying for a withholding certificate. Following the application procedures, he provides the IRS with the information necessary to establish his maximum U.S. tax liability.

If, on March 1st (the transfer date) his application is still pending, the buyer must withhold $70,000 from the sales proceeds. However, because the buyer has been notified in writing that Michel is applying for a withholding certificate, the buyer is not required to report or pay over the funds to the IRS immediately. Within 20 days after the IRS has mailed a copy of the withholding certificate to the buyer indicating that withholding has been reduced to $11,250, the buyer must file Forms 8288 and 8288-A and remit the funds to the IRS. Amounts in excess of the withholding indicated on the withholding certificate (in this case, $58,750) may be released to Michel.

The IRS will stamp Copy B of Form 8288-A acknowledging receipt of the $11,250, and will forward the stamped Form 8288-A to Michel at the address indicated on the form.

Usual Compliance Procedure

As explained above, the withholding of tax does not excuse a foreign seller from filing a U.S. tax return to report income from a property disposition. For nonresident individuals, Form 1040NR, U.S. Nonresident Alien Income Tax Return, must be filed and any tax due paid by the applicable filing deadline.

Thus, Michel must file a Form 1040NR to report the income from the property sale although his full U.S. tax liability has been paid through withholding. In 2006, when Michel files his 2005 U.S. tax return, he will attach the stamped copy of Form 8288-A to his tax return to claim credit for the $11,250 withheld.

Withholding Certificate Obtained after Property Transfer

In some circumstances, the seller may not be aware that withholding can be reduced, or eliminated, by applying for a withholding certificate from the IRS. In other cases, the seller may not have collected all the information required to file the application prior to the transfer date. If a seller does not want to wait until his or her U.S. tax return is filed to report the income from the property transaction and claim a refund, the seller may apply for an early refund (without interest). No specific form has been developed for the early refund application.

The IRS will process an application for early refund only if the required copy of Form 8822-A is attached to the early refund application. If an application for a withholding certificate based on the seller's maximum tax liability is submitted after the transfer takes place, the application may be combined with the application for early refund. Similar to a withholding certificate application, the IRS will act upon an application for early refund within 90 days of receipt.

Once again returning to our example, the transfer date of Michel's home was March 1, 2005. Assume that due to the upheaval surrounding both his work and household relocation, Michel failed to apply for a withholding certificate prior to the property transfer. Absent the early refund procedure, Michel would be required to wait until 2006 to file his U.S. tax return and claim a refund of his $58,750 overpayment ($70,000 withheld on the transfer date less Michel's maximum tax liability of $11,250).

Under the early refund procedure, Michel may submit to the IRS a withholding certificate application and an application for early refund (with a copy of Form 8822-A attached) after the property transfer. If Michel were to submit his applications by April 1, 2005, for example, the IRS would act within 90 days of receipt. Thus, Michel could receive his tax refund in mid-2005 rather than waiting until 2006 to file his U.S. tax return and claim a refund of his $58,750 overpayment. However, receipt of an early refund does not otherwise eliminate Michel's 2005 U.S. tax return filing requirement.

Conclusion

Although the sale of a U.S. real property interest can be relatively uncomplicated, many foreign sellers are stymied by the U.S. tax withholding rules designed to guarantee collection of a foreign seller's U.S. tax obligation. When the required withholding amount exceeds the foreign seller's U.S. tax liability arising from the transaction, the foreign seller may lose the use of the overwithheld funds until a U.S. tax return has been filed and the overwithheld amounts are refunded. With proper planning, and in some cases by taking the appropriate steps after the property sale, a foreign seller can more closely match the amount that is required to be withheld to his or her U.S. tax liability arising from the property transfer, thus releasing funds for investment or other purposes.

Footnotes:

1. U.S. Internal Revenue Code (I.R.C.) sections 897, 871 (b) (1).

2. A U.S. real property holding corporation is any corporation in which the fair market value of the corporation's U.S. real property interests equals or exceeds 50 percent of the fair market value of its (i) U.S. real property interests, (ii) interests in real property located outside the United States, plus any other assets used or held for use in a trade or business. (I.R.C. section 897 (c) (2).)

3. See I.R.C. sections 1001, 1011, 1016.

4. For this paragraph, see I.R.C. sections 1221, 1222, 1 (h) (1).

5. This form — and all forms referenced in this article — is available from the IRS Web site at: www.irs.gov.

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