Qualified Opportunity Zones/Funds and FIRPTA
The interaction of the qualified opportunity zone (“QOZ”) and FIRPTA tax regimes was not addressed in the proposed regulations issued to date on QOZs by the IRS. The QOZ regime may provide a significant benefit to nonresidents that have either invested in U.S. real estate or plan to do so. As will be noted, there are several issues that need to be addressed by the IRS.
What is a QOZ?
- The QOZ regime contained in the Tax Cuts and Jobs Act (“TCJA”) allows taxpayers to defer tax on capital gains from the sale of investments if the capital gain is invested within 180 days in a qualified opportunity fund (“QOF”).
- The deferral of the capital gains invested may last until December 31, 2026 and may also allow the taxpayer to exclude up to 15% of the deferred gain completely.
- More importantly, the TCJA allows for a permanent exclusion (through a basis step-up) of capital gains derived from the later sale of the investment in a QOF provided that is held for at least ten years.
- Proposed regulations permit an investor to hold its investment in a QOF until December 31, 2047 and still receive the benefit of capital gain exclusion.
The “no tax on future appreciation” benefit only applies to the portion of the future gain attributable to “eligible gain” rolled into a QOF for which a gain deferral election was made, in accordance with the QOZ statute and regulations. Eligible gain is gain that (1) is treated as capital gain for federal income tax purposes, (2) arises from a sale to an unrelated person and (3) would be recognized for federal income tax purposes before January 1, 2027 absent the QOZ regime.
What is FIRPTA?
Nonresidents of the U.S. are generally only taxed in the U.S. on effectively connected income (“ECI”) and U.S.-source income that is fixed and determinable – example: interest, dividends and royalties.
Congress enacted the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”) to impose a tax on foreign persons when they sell a U.S. real property interest. A “foreign person” includes a nonresident alien, foreign partnerships, trusts, estates and corporations which have not elected to be treated as a domestic corporation under IRC Sec. 897(i). For U.S. real property dispositions subject to FIRPTA, the transferee (purchaser) is required to withhold and remit to the IRS 15% of the gross sales price to ensure that any taxable gain realized by the seller is actually paid.
Three Exceptions to FIRPTA
- If property becomes buyer’s personal residence, IRC Sec.1445(b)(5) provides an exemption for property acquired by a transferee that will be used as the transferee’s personal residence. To qualify for the exemption, the transferee must sign an affidavit stating that the amount realized (generally sales price) is not more than $300,000.
- The second exception to the FIRPTA withholding requirements is the simultaneous IRC Sec. 1031 exchange. The transferee is not required to withhold if “the transferor gives written notice that no recognition of any gain or loss on the transfer is required because of a non-recognition provision in the Internal Revenue Code.” Such notice is called a “Declaration and Notice to Complete an Exchange” (“1031 Declaration and Notice”). A transferee can rely on a 1031 Declaration and Notice only if: (1) the foreign person completes a simultaneous exchange (i.e., the same day); and (2) the foreign person receives no cash or mortgage boot.
- The third exception is for a transaction in which the IRS has issued a withholding certificate to the foreign seller. The amount which must be withheld by a buyer can be reduced or eliminated pursuant to a withholding certificate. A withholding certificate may be issued due to: (i) a determination by the IRS that reduced withholding is appropriate because either the amount that must be withheld would be more than the transferor’s maximum tax liability or withholding of the reduced amount would not jeopardize collection of the tax; (ii) the exemption from U.S. tax of all gain realized by the transferor; or (iii) an agreement for the payment of tax providing security for the tax liability, entered into by the transferee or transferor. The transferee, the transferee’s agent or the transferor may request a withholding certificate. The IRS will generally grant or deny an application for a withholding certificate within 90 days after its receipt of a completed IRS Form 8288-B application.
Issues to be addressed regarding the interplay of FIRPTA and QOZs
- In general, nonresidents are only taxed on ECI, fixed and determinable income, and sales of a U.S. real property interest. In order for gain to be eligible for the QOZ regime, the IRS should clarify that gain recognized by a nonresident is considered eligible gain for purposes of the QOZ regime whether or not the gain would be subject to U.S. taxation. There is nothing in the legislative history of the QOZ regime that would appear to deny the ability of nonresidents to benefit from the QOZ regime.
- As noted previously, when a nonresident sells a U.S. real property interest, it may be possible to obtain a withholding certificate from the IRS to reduce the amount of withholding. It can take the IRS several months to issue a certificate. During this period, funds are usually held in escrow until the IRS issues a withholding certificate. The TCJA requires that a taxpayer invest gain into a QOF within 180 days of the sale or exchange that generated the gain. Will a withholding certificate be obtained in a timely fashion? The IRS has been asked to issue guidance that allows taxpayers to elect to treat the 180-day period from the date of sale or exchange or the date they receive a FIRPTA withholding certificate.
The QOZ regime potentially offers significant benefits to nonresidents, potentially offering exemption from gain on the sale of U.S. real estate. There are several issues which need to be addressed by the IRS. However, this is an area that should be closely monitored by nonresidents investing in U.S. real estate.