Legal Insights

FIRPTA: The Lurking Short Sale Killer

By: November 14, 2016

Short selling real estate is often complicated and time consuming. There are many moving parts and the deal can unravel for a variety of reasons. One hidden landmine in short sale transactions is the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”). FIRPTA requires that in real estate transactions where the seller is a foreign person (non-resident) the buyer must withhold 15% of the sales proceeds and pay it to the IRS. If the buyer fails to do so, the IRS can pursue the buyer for the seller’s tax liability. Although there are several exceptions to the tax withholding requirement, if none apply, the deal will fail. The most commonly used exception is the Certificate of Non-Foreign Status. As long as the seller represents that he or she is a U.S. resident, FIRPTA does not apply.  But if the seller is a foreign person the odds of the short sale falling apart increase exponentially. Why is that?

In a short sale transaction the bank approves the transaction based on it netting a certain amount of money. If the buyer withholds 15% of the sales price as required by law, the bank would receive much less than agreed. For example, if the house sold for $350,000, the buyer would be required to withhold $52,500 and pay it to the IRS. The reduced amount is generally unacceptable to the bank and the deal is rejected. Some sellers have even offered to pay the required FIRPTA withholding tax at close of escrow to make the short sale happen just to find out that the bank will not allow it. From the bank’s perspective, if the short selling property owner has access to that much additional cash, the bank should get it rather than the IRS and without bank approval the short sale will not happen.

There are two other potential exceptions that might allow the short sale to proceed. One is if the buyer intends to reside in the property for at least 50% of the time that the property will be in use during the first 24 months following closing and if the sales price is less than $300,000. If this is true, the transaction is exempt from the FIRPTA withholding requirements. But because many short sale buyers are investors this exemption is often unhelpful. The other exception is if the seller believes he or she will have no tax liability from the transaction, they may apply for a withholding certificate from the IRS which eliminates the FIRPTA tax withholding requirements. The IRS has 90 days to respond to the application and the short sale cannot close until the seller gets the certificate. But an additional 90 day delay can cause the buyer to walk away from the deal or it can cause the house to go to foreclosure.

So, prior to entering into a short sale transaction, it is important to know whether or not the seller is a U.S. resident. If not, the short sale will likely be more complicated, time consuming and difficult and there is a much greater chance that the deal will fall apart. It should be noted however, that even if the seller is a U.S. resident at the beginning of the transaction, his or her status may change before close of escrow. I am familiar with a short sale transaction where the seller had a green card and was a U.S. resident when the short sale started. But the transaction took over a year to complete and during this time period, the seller moved out of the United States and lost his green card. When it came time to close escrow he was unable to sign the Certificate of Non-Foreign Status and because none of the exceptions applied there was nothing that could be done to save the deal. No one had told the seller of the importance of maintaining his U.S. residency throughout the short sale process. He certainly did not think it would destroy his short sale transaction, but it did. The house went to foreclosure and the real estate agents that worked so diligently on the transaction for nearly a year did not get paid a dime. So, before you spend a significant amount of time on a short sale transaction, make sure you have thoroughly analyzed the requirements of FIRPTA and know how to step around this hidden landmine.