When foreign persons or companies purchase real estate in the U.S., they are generally subject to the same state and federal taxes as citizens. In order to ensure that appropriate tax is paid when a foreign-owned property eventually sells, the law requires a certain percentage of the purchase price to be withheld at closing and deposited with the government. The withholding is currently 10 percent under federal law and 2 percent under Colorado law. The government will apply the withheld funds to the ultimate tax liability and return any excess amount to the foreign seller upon appropriate tax filings. The 12 percent withholding can often come as a surprise to foreign sellers, particularly because it’s not referenced in many real estate contracts. This column is about nasty surprises that can also occur to a buyer dealing with a foreign seller due to improper withholding.
Preliminarily, a foreign seller has the obligation to pay any taxes, but the buyer has the obligation to make sure that the proper amount is withheld at closing. So, if proper withholding does not occur, the buyer could potentially be on the hook for paying 12 percent of the purchase price plus applicable penalties and interest. Here are some considerations for buyers:
First, withholding is not required if the seller provides an affidavit signed under penalty of perjury saying that the seller is not foreign. Title companies routinely require such affidavits when they handle closings, but it’s never a bad idea to check that the affidavit is part of the closing paperwork, particularly if a title company is not handling the closing. In many routine transactions, it’s appropriate for the buyer to rely on such an affidavit.
Second, it may go without saying, but helping a seller avoid paying tax could be criminal tax fraud and should be avoided. Buyers should be on the lookout for evidence that a purportedly U.S. seller is really foreign in the interest of avoiding any association with fraudulent activity and because, as noted, buyers remain fully liable for any nonwithheld amount, together with penalties and interest for noncompliance, no matter what the seller does. Potential red flags that tax evasion is occurring include a transfer from a foreign corporation to a U.S. citizen or company shortly before closing, a request that proceeds be paid to someone other than the foreign seller, gifts of U.S. real estate by foreign owners, sales of stock in foreign companies that own U.S. real estate, and the seller does not have a U.S. tax identification number.
Third, and finally, withholding is not required if the purchase price is $300,000 or less and the buyer intends to use the property as a personal residence. A potential issue can occur if the buyer represents to the foreign seller that the buyer intends to use the property as a personal residence (which is a fairly standard representation in many real estate contracts), but the buyer actually does not use the property as a primary residence. In that case, if withholding did not occur because of the exception, the buyer could be inadvertently liable for improper withholding.
In sum, withholding issues often catch buyers and sellers by surprise. A buyer’s safest approach when dealing with a foreign seller is to require withholding in the contract even if the seller might otherwise claim an exception. Otherwise, the buyer may end up liable for the amount that should have been withheld. Because the buyer is still on the hook even if the seller commits fraud, buyers (and their advisors) should look for evidence that a purportedly U.S. seller is really foreign and seek appropriate legal advice as needed.
Noah Klug is owner of The Klug Law Firm, LLC, in Summit County, Colorado. He may be reached at 970-468-4953 or Noah@TheKlugLawFirm.com.