I hear from people every week who think their tax problem is the end of the world. It usually isn't. I'm Darrin Mish. I've resolved over $100 million in tax debt for clients. Here's what you should know.
The Sale Is Just the Start of the U.S. Tax Process
A foreign person sells U.S. real estate. The closing happens. Money changes hands. The buyer takes possession. As far as the foreign seller is concerned, the transaction is over. As far as the IRS is concerned, the U.S. tax obligations have just begun.
A foreign sale of U.S. real property triggers FIRPTA withholding, a U.S. nonresident tax return, potential state tax filings, and reporting on income earned from the property in prior years. Each piece has its own timing, forms, and deadlines.
The Income Tax Obligation
U.S. real estate is U.S.-source property. Gain from the sale of U.S. real estate is U.S.-source income, taxable to a nonresident alien under IRC Section 871(b) at graduated U.S. rates.
This is true regardless of the seller’s country of residence, regardless of any tax treaty (real estate is generally excluded from treaty protections), and regardless of whether the seller has any other U.S. tax filing obligations.
The mechanism: file Form 1040-NR, “U.S. Nonresident Alien Income Tax Return,” for the year of sale. The return reports the gain (or loss) on the sale and calculates the actual tax owed.
The FIRPTA withholding (typically 15 percent of gross sales price) is claimed as a payment on the return. If the withholding exceeds the actual tax, the foreign seller receives a refund. If the actual tax exceeds the withholding, the foreign seller owes the difference.
The Gain Calculation
Gain is sales price minus selling expenses minus adjusted basis.
Sales price is the gross amount paid by the buyer.
Selling expenses include broker commission, attorney fees, transfer taxes paid by seller, and other costs of sale. These reduce the gain.
Adjusted basis is the original cost (purchase price plus closing costs at acquisition) plus capital improvements made over the years minus any depreciation taken (or that should have been taken) on rental periods.
For a property held many years, the basis calculation can be substantial work. Old closing statements, improvement receipts, depreciation schedules from prior year returns – all of it matters.
Capital Gains Tax Rates for Foreign Sellers
Long-term capital gains (assets held more than one year) are taxed at the preferential capital gains rates that apply to U.S. taxpayers: 0 percent, 15 percent, or 20 percent depending on the income level.
Short-term capital gains (assets held one year or less) are taxed as ordinary income at graduated rates.
For a foreign seller with no other U.S.-source income in the year of sale, the gain is typically taxed at 15 percent if it falls within the 15 percent bracket. For very large gains pushing into the 20 percent bracket, the higher rate applies on the excess.
The net investment income tax (NIIT) of 3.8 percent under IRC Section 1411 generally does not apply to nonresident aliens. This is a meaningful break – the NIIT can add significantly to the tax bill for U.S. residents.
Depreciation Recapture
If the property was rented at any point during the foreign seller’s ownership, depreciation should have been taken on the prior year tax returns. Even if it was not taken, the IRS requires recapture as if it had been.
Section 1250 depreciation recapture on real property is taxed at up to 25 percent. This is a higher rate than the long-term capital gains rate and applies to the depreciation portion of the gain.
For foreign sellers who never reported the rental years (or reported them incorrectly), the recapture issue becomes complicated. The IRS may assess the recapture even on depreciation never actually claimed. This is a common audit issue.
State Tax Filing
Real estate is taxed at the state level in addition to the federal level. The state where the property is located has jurisdiction to tax the gain.
Most states tax real estate gains as ordinary income at state rates. California’s top rate is 13.3 percent; New York’s is 10.9 percent; Hawaii’s is 11 percent. Florida, Texas, Tennessee, Nevada, and several other states have no state income tax, so no state-level tax applies.
Many states also impose their own withholding on foreign sellers, separate from federal FIRPTA. The state withholding is recovered through a state nonresident return.
The federal and state returns are filed separately. Both should report the sale consistently to avoid inconsistency issues.
Prior-Year Rental Income Issues
If the property was rented at any point and the rental income was not reported on U.S. returns, the sale creates an exposure point. The IRS reviewing the sale return may notice the property was rented and look for prior-year filings.
Foreign owners of U.S. rental real estate are required to file annual Form 1040-NR reporting the rental income. The default treatment is 30 percent withholding on gross rent under IRC Section 1441. The alternative is the IRC Section 871(d) election to treat the rental income as effectively connected with a U.S. trade or business, which allows deduction of expenses and taxation on net income at graduated rates.
Without proper filings, the IRS can assess tax on the gross rent at 30 percent for prior years. The amounts add up quickly.
If you have a rental history that was not reported, the sale year is the moment to evaluate cleanup. Filing the sale return without addressing the rental years can invite scrutiny.
The Estate Tax Wrinkle
This is a parallel issue, not a sale issue, but it matters for planning. Foreign individuals owning U.S. real estate at death face U.S. estate tax under IRC Section 2103 on the value of U.S. property.
The federal estate tax exemption for nonresident aliens is only $60,000, not the multi-million dollar exemption that applies to U.S. citizens and residents. A foreign person dying with a $400,000 U.S. property faces estate tax on $340,000 of value at rates up to 40 percent.
This is why many foreign owners hold U.S. real estate through entities (foreign corporations, U.S. corporations, LLCs) that change the tax classification of what is held at death. The structures have their own complications, but the planning is important.
Timeline for the Year of Sale
The 1040-NR for the year of sale is due June 15 of the following year (the standard nonresident due date). Extensions are available to October 15 via Form 4868.
FIRPTA withholding remits to the IRS by the buyer within 20 days of closing. The seller’s stamped Form 8288-A copy B typically arrives within 30 to 60 days of closing.
For a closing in any given calendar year, the seller files the 1040-NR by June 15 of the next year (or October 15 with extension). The refund is processed 6 to 18 months after the IRS receives the return.
Three Steps After Closing
First, get the Form 8288-A copy B from the title company. Without it, the refund claim cannot be substantiated.
Second, gather basis records. Original purchase, improvements, depreciation taken. The gain calculation depends on this.
Third, evaluate prior-year rental issues. If the property was rented and the income was not reported, address that as part of the sale-year cleanup.
Get the U.S. Returns Filed Correctly
After 32 years of working with foreign sellers of U.S. real estate, the cleanest outcomes come from filing the right return with the right documentation the first time. Contact the Law Offices of Darrin T. Mish, P.A. at (813) 229-7100. We handle the 1040-NR, claim the FIRPTA refund, address any prior-year rental issues, and coordinate with state filings where they apply.