How does withholding work at a US closing when the seller is foreign?

When a foreign person sells real estate in the United States, the buyer must hold back a percentage of the sale price at closing, generally 15%, and send it to the Internal Revenue Service instead of paying it to the seller. The settlement agent or closing attorney usually does the work, but the legal duty sits with the buyer, and the money is a prepayment of the seller's income tax, not the tax itself.

This article covers the federal rules that apply in the United States, with amounts in US dollars. It is general information, not legal or tax advice.

The rule comes from the Foreign Investment in Real Property Tax Act, known as FIRPTA. The mechanics are simple once each person at the table knows which part belongs to them, which form carries the money, and when the seller sees the difference again.

Who has to withhold when a foreign person sells US real estate?

The buyer has to withhold. The IRS calls the buyer the transferee and states that, in most cases, the transferee is the withholding agent for a sale of a US real property interest by a foreign person.

The rule comes from the Foreign Investment in Real Property Tax Act, known as FIRPTA. The tax belongs to the seller, but the collection duty is placed on the person handing over the money. The IRS says that the transferee must find out whether the transferor is a foreign person, and that if the transferor is foreign and the transferee fails to withhold, the transferee may be held liable for the tax.

A foreign person, in the IRS's definition, is a nonresident alien individual or a foreign corporation that has not elected to be treated as a domestic one, and the definition extends to other foreign entities. It does not include a resident alien individual. Citizenship is therefore not the test: a foreign national who is a US resident for tax purposes is not a foreign person under this rule, and a US citizen living abroad is not one either. The test is the seller's tax status, which is why the question is settled with a signed statement and a taxpayer identification number, not with a passport or a mailing address.

In practice the buyer rarely touches the forms. The settlement agent, title company or closing attorney who runs the closing collects the seller's status, computes the amount, shows it on the settlement statement, holds it and sends it to the IRS with the return. That is a service performed for the buyer. The return is filed in the buyer's name, with the buyer's own taxpayer identification number, and the liability stays with the buyer if the step is missed.

How much is withheld, and on what amount?

The general rate is 15% of the amount realized, which on an ordinary cash sale is the contract price. The percentage is applied to the price, not to the seller's gain, and that is why the figure looks so large.

The IRS defines the amount realized as the sum of three things: the cash paid or to be paid, counting principal only; the fair market value of any other property transferred; and any liability of the seller that the buyer assumes or that the property remains subject to. Three consequences follow.

• The seller's mortgage does not reduce the base. A property sold for $800,000 with $300,000 still owed to a lender is withheld on $800,000.
• The seller's profit does not matter at this stage. A seller who is selling at a loss is withheld on the full price all the same, unless a withholding certificate says otherwise.
• Commissions, transfer taxes and closing costs do not reduce the base either. They come out of the seller's proceeds separately.

When a property is owned jointly by a foreign person and a US person, the IRS instructs the buyer to allocate the amount realized among the sellers according to their capital contributions, treating spouses as having contributed 50% each, and to withhold only on the share allocated to the foreign seller. A married couple where one spouse is a foreign person is therefore withheld on half the price, not on all of it.

When does the rate drop to 10% or to zero?

The rate drops only when the buyer is an individual acquiring the property to live in: to zero when the amount realized is $300,000 or less, and to 10% when it is above $300,000 and not more than $1,000,000. Above $1,000,000, or when the buyer will not live there, the rate is 15% whatever the price.

Both reductions rest on the same test, set out by the IRS. The buyer, or a member of the buyer's family, must have definite plans to reside at the property for at least 50% of the number of days the property is used by any person during each of the first two 12-month periods following the date of transfer. Days when the property stands vacant are not counted. The buyer must be an individual, so a purchase through a company does not qualify.

The bands are not marginal. The rate that applies is charged on the whole amount realized, so the thresholds are cliffs. A residence bought for exactly $1,000,000 carries $100,000 of withholding at 10%; the same residence bought for one dollar more carries just over $150,000 at 15%. The IRS also applies the $300,000 test to the total amount realized on the sale, not to each seller's share of it.

The residence exemption is the buyer's statement about the buyer's own future. If the buyer signs it and then does not live in the property as required, the IRS holds the buyer liable for the failure to withhold, unless the plans changed because of circumstances that could not reasonably have been anticipated at the time of the transfer.

What is a non-foreign affidavit, and why does every seller sign one?

A non-foreign affidavit is a certification by the seller, signed under penalties of perjury, that the seller is not a foreign person. When the buyer holds one, the IRS lists it among the exceptions under which no FIRPTA withholding is required.

This is why the document appears in closings that have nothing foreign about them. The buyer cannot know a seller's tax status by looking, the liability for guessing wrong is the buyer's, and the certification is the buyer's protection. The IRS says the certification should give the seller's name, US taxpayer identification number and home address, or office address for an entity. The instructions for Form 8288 tell the buyer to keep it for five years after the year of the transfer.

The seller may also hand the certification to what the IRS calls a qualified substitute, which is the person responsible for closing the transaction, such as an attorney or a title company, other than the seller's own agent. The qualified substitute then gives the buyer a statement, also under penalties of perjury, that it holds the seller's certification.

A certification does not protect a buyer who knows better. The IRS states that it is not effective if the buyer or the qualified substitute has actual knowledge that it is false, or receives notice that it is false from an agent. A seller who cannot truthfully sign is a foreign seller for the purposes of the closing, and the file moves to withholding.

Who is liable if nothing is withheld?

The buyer is liable. The IRS states that a withholding agent is personally liable for the full amount of FIRPTA withholding tax required to be withheld, plus penalties and interest.

The instructions for Form 8288 spell out what that means: if the buyer was required to withhold and did not, the tax and interest may be collected from the buyer, penalties for late filing and late payment apply, and a willful failure to collect and pay over the tax can carry a separate penalty.

Real estate agents and closing professionals carry a narrower exposure, and it is worth stating exactly. Under the IRS's rules, an agent of either party, or a qualified substitute, who has actual knowledge that a certification is false must notify the buyer. An agent who does not is liable for the tax, with the liability limited to the compensation the agent received from the transaction. The IRS defines an agent for this purpose as a person who represents a party in the negotiation or the settlement, and says that handling the consideration, recording documents, clerical work, obtaining title or property condition reports and transmitting documents do not by themselves make a person an agent.

What does the settlement agent file, and by when?

The withholding is reported on Form 8288 and paid to the IRS by the 20th day after the date of transfer, together with a Form 8288-A for each foreign seller. The date of transfer is in practice the closing date.

Form 8288 is the buyer's withholding tax return. Form 8288-A is the statement of what was withheld from one seller, and it is the seller's future receipt. The instructions for Form 8288 say that Copies A and B of Form 8288-A are attached to the return and Copy C is kept for the buyer's records. The IRS then stamps Copy B and sends it to the foreign seller, who generally attaches it to a US income tax return to get credit for the amount withheld.

Taxpayer identification numbers run through all of it. The return asks for the buyer's number: a Social Security number for an individual, an employer identification number for an entity, or an individual taxpayer identification number for a foreign buyer who cannot get a Social Security number. The statement asks for the seller's. If the seller's number is missing, the instructions say the buyer must still file both forms on time, but the IRS will not send the stamped Copy B to the seller; it writes to the seller asking for a number and releases the stamped copy once one is supplied.

A foreign seller with no US number applies for an individual taxpayer identification number on Form W-7. The IRS will generally not issue one before a binding contract of sale exists, so the application cannot be made years ahead, but it can and should be made as soon as the contract is signed.

Where does the withholding sit on the settlement statement and in the order of payments?

The withholding sits on the seller's side of the settlement statement, as a charge that reduces the seller's net proceeds, alongside the mortgage payoff, the commissions and the seller's closing costs. The buyer's side does not change: the buyer brings the same funds as on any other purchase.

In the order of disbursement, the withholding does not jump ahead of the claims that must be paid for title to pass clean. The seller's lender is paid off, the liens and taxes shown on the title commitment are cleared, and the commissions and closing costs are paid as agreed. What changes is the last line. The seller's net proceeds are split in two: one part is wired to the seller, the other stays in the settlement agent's account and goes to the IRS with the return.

One situation needs attention before the closing date, not on it. Because the base is the price and not the equity, a heavily mortgaged property can produce a withholding figure larger than the seller's net proceeds. A sale at $800,000 with $700,000 owed to the lender leaves less than $100,000 after the payoff, against $120,000 of withholding at 15%. The obligation does not shrink to fit the cash available. The seller either brings funds to closing or obtains a withholding certificate that reduces the amount, and the second route takes time.

How can a withholding certificate reduce the amount?

A withholding certificate is a document issued by the IRS that reduces or eliminates the withholding on a specific sale. It is applied for on Form 8288-B, and the IRS says the buyer, the buyer's agent or the seller may make the request.

The IRS lists the grounds on which it may issue one. Reduced withholding is appropriate because the standard amount would exceed the seller's maximum tax liability on the sale. The seller's gain is exempt from US tax. Or the buyer or the seller enters into an agreement with the IRS for payment of the tax and provides security for it. The first ground is the common one at a residential closing: a seller with a small gain, or a loss, shows the IRS the purchase price, the improvements and the selling costs, and asks that the withholding be cut down to the tax that could actually be due.

A complete application must include the taxpayer identification numbers of all the parties to the transaction, according to the IRS, which is another reason the seller's number cannot wait. A seller without one can send Form W-7 together with the Form 8288-B application.

The timing rule is what makes the certificate useful even when it arrives after closing. The IRS says it will generally act on a request within 90 days after it receives a complete application. Most contracts close sooner than that. The instructions for Form 8288 deal with the gap directly: if an application for a withholding certificate is pending on the date of transfer, the buyer must still withhold the full amount, but need not file Form 8288 or send the money to the IRS until the 20th day after the day the IRS mails the certificate or a notice of denial.

The IRS also warns that if the principal purpose of an application was to delay paying the withholding, interest and penalties are assessed from the 21st day after the date of transfer.

What does this look like on an $800,000 sale?

On an $800,000 sale to a buyer who will not live in the property, the withholding is $120,000, which is 15% of the price. The worked example below shows how that figure moves through the closing and back to the seller.

The assumptions are illustrative. A nonresident alien sells a rental condominium for $800,000 in cash. The buyer is an investor, so no residence reduction applies. The seller owes $300,000 on a mortgage. Total commissions are 5% of the price, a rate chosen for the example. The seller's other closing costs are $6,000. No withholding certificate has been requested.

Without the withholding, the seller would have received $454,000. The $120,000 difference is not a cost of the sale. It is a deposit against a tax that has not been computed yet.

The actual tax is worked out on the seller's US income tax return for the year of the sale, which for a nonresident alien individual is Form 1040-NR. The return reports the gain, meaning the price less the seller's cost in the property and the costs of selling it, and applies the rates that fit the seller's situation. Suppose, purely for illustration, that the return shows $18,000 of tax on this sale. The seller claims the $120,000 as a credit by attaching the stamped Copy B of Form 8288-A, and the IRS refunds the excess of $102,000.

How long that takes depends on two things the seller cannot speed up much: the calendar, since the return for the year of the sale is filed after that year ends, and the IRS's processing of the return. A sale early in the year therefore leaves the excess with the IRS for longer than a sale late in the year. The instructions for Form 8288 also refer to an application for early refund filed with the IRS, to which the stamped Copy B can be attached, for a seller who qualifies and does not want to wait for the return.

Compare the same sale with a certificate. If the seller had applied before closing on the ground of maximum tax liability, and the IRS had agreed to $18,000, the $120,000 would still have been held back at closing, but it would have stayed with the settlement agent. After the IRS's answer, $18,000 would have gone to the IRS with Form 8288 and $102,000 would have been released to the seller, without waiting for a tax return to be processed.

Do states withhold on top of the federal amount?

Some states run their own withholding on real estate sales, separate from the federal rule and with their own forms, rates and exemptions. Whether one applies depends on the state where the property is located, and in several states it turns on whether the seller is a resident of that state, not on whether the seller is foreign.

The two systems are independent. A state's regime can apply to a seller from another US state who is in no way a foreign person, and a foreign seller can face both. California is an example of a state whose regime is not limited to foreign sellers: its Franchise Tax Board describes real estate withholding as a prepayment of income tax due from the sale of California real property, reported on its Form 593, with an exemption for property valued at $100,000 or less among others. The state amount is likewise a prepayment, credited on a state return.

What mistakes cause trouble at a foreign-seller closing?

Most problems at a foreign-seller closing come from a wrong assumption about who is responsible, a missing taxpayer identification number, or an exemption signed without being met. Each can be avoided in the first week of the contract.

• Assuming the seller or the agent is responsible. The seller owes the tax, but the buyer owes the withholding. A buyer who relies on the seller's promise to pay later, or on an agent's remark that the seller "is basically a resident", carries the liability alone.
• Leaving the taxpayer identification number until after closing. Without the seller's number, the IRS does not send the stamped Copy B of Form 8288-A, and a withholding certificate application is not complete. The number can be applied for once a binding contract exists.
• Signing the residence statement to help the deal. The exemption at $300,000 or less and the 10% rate up to $1,000,000 require definite plans to live in the property for at least half the days it is used in each of the first two 12-month periods. A buyer who signs without those plans takes on the liability for the amount not withheld.
• Computing the amount on equity or on gain. The base is the amount realized. A net sheet that applies 15% to the seller's profit understates the withholding, sometimes by most of it.
• Applying for a certificate after the transfer. The rule that lets the money wait in escrow applies to an application pending on the date of transfer. Filed later, the application no longer keeps the funds out of the IRS's hands on the normal deadline.
• Treating the withholding as the final tax. A seller who never files a return leaves any excess with the IRS, and a seller whose tax is higher than the withholding still owes the balance.