SPECIAL UPDATE - SEE SHORT SALE AND FIRPTA TAX WITHHOLDING - IRS ISSUES PRIVATE GUIDANCE
It is critical for Realtors, Buyers, Closing Agents and Lenders to understand the important issues of the short sale when applied to the Internal Revenue Code's Foreign Investment in Real Property Tax Act of 1980 or FIRPTA transaction because disregard for following the FIRPTA rules will make the Buyer and Closing Agent and possibly the Lender liable to the IRS for the Seller's Tax Liability!!!!! The problem is that right now there is NO RULE by the Internal Revenue Service ("IRS") for FIRPTA Short Sales.
Recently a Realtor asked me if we handle short sale transactions for foreigners - meaning persons who would be subject to FIRPTA. Application of FIRPTA has been common in Florida real estate transactions for decades because of the large number of foreign buyers and investors. The difference here was that the Realtor was asking if we could handle the short sale transaction of his foreign client seller. This required some thought and it was enlightening to search for the answer. It is important to point out that there is no specific rule for a short sale, and thus this discussion required analysis and interpretation of the Regulations of the IRS. This article discusses in summary what must be done by a transferee (buyer) or closing agent regarding the short sale of a property owned by a foreigner in a transaction not exempt under FIRPTA, and is therefore not meant to be a complete and exhaustive discussion of FIRPTA.
I have jumped to the conclusion before even discussing the FIRPTA issues about short sales because the discussion below is frankly, daunting to any person with only basic knowledge about FIRPTA and about short sales. So this is a warning to the meek that this article requires a few readings to understand and you must use the hyperlinks to the IRS Regulations and Code that are provided in the text to fully comprehend the article.
Short Sales and FIRPTA seems to be a toxic combination fraught with potential liabilities to the buyer and closing agent and maybe even the lender, with any related interpretations and opinions potentially varying depending upon who your client may be. In the most common scenario, however, conservative thinking must be applied to these transactions to avoid having the buyer or closing agent pay the income tax of the seller.
The ultimate cost of a short sale vs. foreclosure must be examined by the lender. Published estimated cost of managing and selling an REO (WHAT IS AN REO?) is about $58,000 - and higher for larger mortgages (higher value properties). How a lender may calculate the benefit analysis of a foreclosure compared to a short sale when the transaction is not exempt under FIRPTA should govern whether or not the Realtor decides to take the listing since the lender may likely opt for the foreclosure route and not allow any short sale.
Closing agents are on the front line of the issue of FIRPTA and short sales and should be certain they are competent to handle the transaction without some professional assistance from tax counsel.
OK - Let's Get Into Short Sales and FIRPTA
What is FIRPTA?
In a nutshell, FIRPTA requires that the "buyer" (which term includes not only the actual buyer but the closing agent for the transaction as well), to withhold 10% of the "amount realized" (usually 10% of the selling price) from the property sold by a non-U.S. citizen / non-U.S. income tax resident (i.e., a "foreign seller") and remit it to the IRS shortly after the sale. The foreign seller can then request a refund of the withholding by filing a tax return with the IRS for the taxable year of the transaction.
Exceptions to FIRPTA
There are certain exceptions to the requirement of making the withholding, all of which are risky to the buyer and closing agent (with such risk being minimized through proper and timely documentation). This article is not a review of the full methods of dealing with FIRPTA, but only how it relates to a short sale. A person familiar with the FIRPTA requirements will be familiar with whether a buyer and closing agent can reasonably rely on the exceptions available in any particular transaction.
The key definition in the rule is the "amount realized". The IRS Regulations say, "The amount realized by the transferor (seller) for the transfer of a U.S. real property interest is the sum of:
(i) The cash paid, or to be paid; and
(ii) The fair market value of other property transferred, or to be transferred; and
(iii) The outstanding amount of any liability assumed by the transferee or to which the U.S. real property interest is subject immediately before and after the transfer."
Remember, the seller is not the lender - it is the owner of the real estate.
If the foreign seller transaction does not qualify under any exceptions, (likely the $300,000 maximum sale price coupled with the "qualified buyer" [IRS Regulation 1.1445-1(a)(4)], then barring an exception being applicable, the buyer or closing agent will remain liable to the IRS for 10% of the amount realized until such time as the foreign person pays his or her U.S. tax liability (in addition to possible penalties and interest relating to the failure to withhold). The prospect of being liable to the IRS for someone else's income taxes is obviously not a position for which any person wants to volunteer. Without an exception applying, this would likely kill the ability of the foreign seller to affect a short sale unless the lender agrees to taking its agreed amount less the amount of the required withholding.
Foreclosure and Deed in Lieu Under FIRPTA
There are special rules relating to the transferee (winning bidder) at a foreclosure sale and for a deed in lieu of foreclosure, all as set forth in IRS Regulation 1.1445-2(d)
As relevant to a foreclosure, IRS Regulation 1.1445-2(d)(3)(i)(A) generally provides that the "normal" 10% of the amount realized rule applies to a foreclosure sale; however, if certain special notice requirements are met, then the withholding will be reduced to the lesser of : (1) 10% of the "amount realized" or (2) an "alternative amount" equal to the entire amount determined by the court having jurisdiction over the real property that accrues to the debtor from the amount realized from the foreclosure sale (i.e., the surplus amount from a sale where the winning bid exceeds the amount of the foreclosure judgment - something that does not happen when the bid is less than the judgment amount). Importantly, if it is a foreclosure situation where the lien and debt is terminated, that amount shall not be treated as an amount that is reportable under IRS Regulation §1.1455-2(d)(3)(i)(A).
Furthermore, as relevant to a deed-in-lieu, IRS Regulation §1.1455-2(d)(3)(B) provides that the buyer or transferee (the lender taking back the property) must withhold 10% of the amount realized EXCEPT: (1) the transferee is the only person with a security interest; and (2) no cash or other property is paid to any person in respect to the transfer (except usual closing expenses); and (3) the related notice requirements for the transfer are satisfied.
FIRPTA and the Short Sale - the Dilemma - NO RULE FOR SHORT SALES
There is no rule for applying FIRPTA to a short sale as there is for a deed in lieu of foreclosure and foreclosure (discussed above); however, certain analogies could be drawn. In this regard, a short sale might be most analogous to a deed-in-lieu of foreclosure. Consider a foreign seller that, instead of short selling a property, deeds the property to the lender in a deed-in-lieu transaction. Assuming the above conditions are met, this transaction would not require FIRPTA withholding. Going one step further and assuming that the lender is a U.S. bank, a subsequent sale by the bank would not be subject to withholding.
In this context, it is important to understand that, as a general matter, the "other property paid" requirement would be satisfied in a short sale if the entire amount of the indebtedness either remains to be paid to the lender - in other words the foreigner is still liable to the lender for the unpaid balance of the loan (commonly known as the deficiency) - or if the indebtedness is simply forgiven. Thus by analogy, the short sale transaction would seemingly qualify for the exception under §1.1455-2(d)(3)(B) if it were re-characterized as a deed-in-lieu and a subsequent sale by the bank.
Regardless, of this logical analogy, the fact remains that a short sale is in fact, a sale by one party to another with the proceeds thereof going to the lender. In this regard, it would appear that 10% of the amount realized would need to be withheld on the sale. The relevant question then becomes: "What is the amount realized in a short sale?" Is it the amount paid by the buyer? Is it the amount paid by the buyer PLUS the amount of the debt that may or may not be forgiven by the lender? Does it matter if the debt is forgiven at closing or several years later (by letting enforcement of the debt lapse through the statute of limitations)?
One would think that, if there is NO forgiveness of debt and the foreign seller remains liable for the deficiency (whether or not such deficiency is collectable is another issue), then there is no additional "amount realized." The problem is that there is little, if any, IRS guidance on the issue, and in fact a "no-name", confidential non-binding discussion with the IRS did not clarify the issue (although certain follow-up may be forthcoming, and I will keep you posted if further guidance is provided).
Regardless, 10% of the "amount realized" will need to be submitted to the IRS, and without applying for a Withholding Certificate based on the maximum tax liability of the foreign seller it may not be possible to clearly determine how much should be withheld.
FIRPTA and the Lender
Lenders will not be happy with the conclusion that FIRPTA withholding is required on a short sale. As mentioned above, there is no question that 10% of the purchase price must be withheld on a FIRPTA sale. It is also possible that 10% of the forgiven debt also be withheld. Although there may be a U.S. income tax refund of part or all of the 10% withholding paid back to the foreign seller after he/she/it files the relevant U.S. income tax return, the filing of the tax return is not a procedure to be handled by the closing agent, buyer or lender and therefore there is no guarantee any money refunded will, in fact, be paid to the lender. Alternatively, the problem with not withholding the correct amount is liability of the buyer and the closing agent, and possibly the lender, for the amount that should have been withheld (along with penalties and interest). No party should put themselves in that position.
Here is an example:
Assume someone (a U.S. income tax non-resident alien or "NRA") bought a home for $500,000 cash and thereafter borrowed $800,000 when the value increased to $1,000,000 (80% LTV). Due to the changed market conditions, the NRA owner short sells the property and the sale is consummated for $750,000.
One theory is that withholding would be based on the $750,000 sale price, and therefore the HUD settlement statement is going to show a net amount to the lender that is LESS $75,000 being held by the closing agent or the IRS (see below). The ultimate receipt of that $75,000 or any portion of it by the lender will be dependent on the taxpayer's receipt of the Withholding Certificate from the IRS (or if the money was already sent to the IRS, the application for any relevant refund). In this situation, the Withholding Certificate could be obtained based on gain of $250,000 (i.e., $750,000 less the $500,000 purchase price), thereby reducing the withholding (in the case of an individual that has held the property long enough to qualify for the beneficial long-term capital gains rate) to $37,500 (i.e., 15% of $250,000, or the NRA seller's estimated maximum U.S. income tax liability). Under either scenario the lender will not receive the full $750,000.
The other theory is that the amount withheld should be based on $800,000 (i.e., the sale price of $750,000 PLUS the $50,000 of additional debt above and beyond that), thereby requiring $80,000) The question would then how to compute the NRA seller's gain for purposes of the Withholding Certificate, and a complex computation may be necessary in order to determine the amount of gain (this is because the amount of tax due would increase the amount of the debt forgiveness, which in turn could increase the gain, and so on, requiring a circular calculation to be run until the computation terminates). It is hard to imagine that this type of result was intended.
How To Handle the FIRPTA Short Sale
I am not an expert in tax law. For help in the answer I went to Shawn Wolf Esq. (email@example.com) at the tax law firm of Packman, Neuwahl & Rosenberg, P.A. (www.pnrlaw.com) in Coral Gables, Florida. Mr. Wolf and the law firm specialize in the area of tax law and specifically how foreigners are affected by US tax laws. Their expert opinions, including their discussion with the IRS (which, as mentioned above, was initially provided and then withdrawn), yielded results that are will not make the short sale process easy for any involved party. Here is what the consensus says:
A. FIRPTA regulations must be applied to a short sale.
B. Assuming that the NRA seller's maximum U.S. income tax liability is less than the 10% withholding (possibly computed with debt forgiveness to show the "maximum withholding), a "Withholding Certificate" application should be submitted to the IRS on or prior to the date of closing. The purpose of the Withholding Certificate would be to have the IRS determine the amount of funds to be remitted with Form 8288. The Withholding Certificate application is IRS Form 8288B. If the NRA seller's maximum U.S. income tax liability exceeds the 10% withholding amount (again, possibly computed with debt forgiveness to show the "maximum withholding) there is no benefit to applying for a Withholding Certificate.
More Specific Procedure - Dealing with Real Life
As an example of the procedure for a short sale with a foreign seller where the buyer / property does not qualify for the typical $300,000 residence exemption would go like this:
1. Determination by closing agent or buyer that the seller is a foreign person subject to FIRPTA and the transaction is not going to be exempt from FIRPTA reporting.
2. As soon as practicable after realization this is a FIRPTA reporting transaction, apply for the Withholding Certificate by submitting Form 8288B to the IRS (if beneficial). How practical this might be in a short sale scenario experienced closing agents can only roll their eyes - but must still comply.
3. Until receipt of the Withholding Certificate fixing the amount needed to submitted to the IRS, the amount to be withheld for eventual timely submittal to the should be held in escrow by the closing agent (conservatively speaking, this amount should be 10% of the purchase price and the amount of the debt above the sale price. The withholding should be a separate line item on the HUD-1).
4. Be sure the preliminary HUD-1 submitted to the lender for approval of the short sale includes the line item deduction.
5. The best practice is probably to have a written agreement between the lender and the seller and the buyer that any amount withheld under FIRPTA compliance that is not required to be submitted to the IRS under the Withholding Certificate is to be paid to the lender by the closing agent from funds withheld by the closing agent for that purpose. A similar agreement can be entered into with respect to any U.S. income tax refund received by the NRA seller, but the ability to collect those monies if they are paid by the IRS directly to the foreign seller may be an issue.
This is only what our consensus is regarding our interpretation of the current IRS Regulations applied to the short sale process. The IRS may eventually disagree or agree with these conclusions. In the meantime we think it best to be conservative in application since the liabilities to the buyer and closing agent are so drastic.
Copyright 2008 Richard P. Zaretsky, Esq.
Be sure to contact your own attorney for your state laws, and always consult your own attorney on any legal decision you need to make. This article is for information purposes and is not specific advice to any one reader.
Richard Zaretsky, Esq., RICHARD P. ZARETSKY P.A. ATTORNEYS AT LAW, 1655 PALM BEACH LAKES BLVD, SUITE 900, WEST PALM BEACH, FLORIDA 33401, PHONE 561 689 6660 RPZ99@Florida-Counsel.com - FLORIDA BAR BOARD CERTIFIED IN REAL ESTATE LAW - We assist Brokers and Sellers with Short Sales and Modifications and Consult with Brokers and Sellers Nationwide! Shortsales@Florida-Counsel.com New Website www.Florida-Counsel.com. See our easy to find articles at Need Short Sale Information? - These Articles Probably Answer Your Question