If you were raised on American TV and are now approaching middle age, you may recall watching the Warner Brothers cartoons featuring characters like Bugs Bunny, Daffy Duck, and Elmer J. Fudd. An oft-featured plot line involved Fudd hunting down rabbits or ducks. He would speak to the audience while on the hunt stating that everyone should be quiet because he was hunting. Bugs and Daffy would argue over the appropriate hunting season in front of Fudd in order to save their respective lives. Bugs affirmed it was duck season whilst Daffy declared it to be rabbit season. In the end, neither one of them won the argument. Annoyed by their constant bickering and running out of patience, Fudd would just hunt both of them down, no matter the season. 

Unbelievably, Fudd and the IRS have something in common. The IRS too has become annoyed and has run out of patience. It has declared open season against taxpayers affected by international matters. Its declaration included a notification to the public about 60 campaigns specifically intended to deal with these problems. These matters fall under the jurisdiction of a specialized division within the IRS called the Large Business and International Division (LB&I). By implementing a targeted campaign on international tax matters, the Service is shoring up its efforts to collect revenue. With a rampant pandemic resulting in the creation of several stimulus programs in addition to the pre-existing tax cuts mandated by the 2017 Tax Cuts and Jobs Act, the federal government needs to come up with the cash to foot the bill for these programs. In an effort to maximize limited human resources at the IRS, they have moved away from a taxpayer-based audit approach to an audit approach that has a more targeted issue-based objective. Taxing authorities have engaged the Foreign Investment in Real Property Tax Act (FIRPTA) as one of their weapons of choice for enforcement.    

FIRPTA’s main two prongs for attack confront the gain derived upon the exchange and disposition of real property by non-resident aliens (NRAs) and further, the income derived from the ownership of such properties prior to disposition. In a sale, the transferee or buyer becomes the withholding agent on the exchange of property by remitting 15% of the gross proceeds with the relevant and necessary forms to the IRS. Upon reporting this gain to the IRS, the NRA declares a credit of 15% on the taxable income. The campaign now under way is intended to increase voluntary compliance of these measures. Although other capital gains are not taxed to NRAs because such gains are unrelated to the conduct of a U.S. business, a capital gain on the disposition of real property is taxable.                                                                                                         

NRAs are subject to a 30% withholding tax on the gross income derived from rent paid. Tenants bear the burden of holding back the 30% tax and complying with the associated filing requirements. Frequently, tenants are not exercising due diligence in completing their filings because they do not investigate the identities of their landlords. Barring presentation by the NRA of any evidence of exemption from this withholding requirement, a tenant can face potential personal liability for failure to file and/or obtaining proper documentation as proof of exemption. Moreover, without proper planning and the structuring of real estate investments, the NRA will miss out on an opportunity to take advantage of certain tax favorable elections. These elections allow for the taxation of the net income (and not the gross, which comes before the deduction of expenses, etc.) of the rental. Foreign property owners will find themselves with a payment of 30% tax as the final tax which, in many instances, offsets the entire net profit from the U.S. real property.

The new campaign would focus on the ownership by foreign corporations and trusts of U.S. income producing properties. Further, the IRS will better monitor tenants’ (whether residential or commercial) due diligence in determining the citizenship and/or residency status of their landlords. These landlords can include foreign corporations, NRAs, or other investors who have either a direct or indirect ownership interest in these investments. By the IRS issuing proper guidance to taxpayers and administering associated compliance obligations such as tax reporting, it ensures better collections efforts for this revenue source. Better enforcement represents a break from the history of non-compliance in this area.

The laws associated with the revenue derived from rental income or from the disposition of properties by foreign persons and entities can be complex. The complexity lends itself to errors and omissions by all parties to the transactions.  An issue-based audit campaign effectively focuses on these problems and makes the greatest use of limited resources at the IRS. The new campaign takes on a cooperative approach at enforcement by the issuance of “soft letters” that not only educate and encourage compliance by taxpayers about their reporting obligations—they also promote voluntary self-correction.

The Bugs Bunny cartoons are as far removed as possible from any semblance of reality—yet, these cartoons bear some resonance to real-life problems. With the economic situation being what it is today, the IRS has had to become creative in its collection efforts. The IRS response stands in opposition to a reactive comeback solely motivated by frustration and impatience. By remaining introspective and by laying out a blueprint for the future, the IRS devised a novel approach to its enforcement capability. Unlike Elmer J. Fudd, who simply declared all-out war against his antagonists, the IRS recognizes that a cooperative approach produces significant results. This position especially holds true when reaching out to foreigners who are subject to U.S. tax, as well as their domestic counterparts who are required to withhold and report those very same taxes.

Alicea Castellanos, CPA, is the CEO and Founder of Global Taxes LLC. Alicea provides personalized U.S. tax advisory and compliance services to high net worth families and their advisors. She has more than 17 years of experience in U.S. taxation of individuals from around the world. Prior to forming Global Taxes, she founded and oversaw operations at a boutique tax firm and worked at a prestigious global law firm and CPA firm. Ms. Castellanos specializes in U.S. tax planning and compliance for non-U.S. families with global wealth and asset protection structures that include non-U.S. trusts, estates and foundations that have a U.S. connection, as well as foreign investment in U.S. real estate property.

Please note: This content is intended for informational purposes only and is not a replacement for professional accounting or tax preparatory services. Consult your own accounting, tax, and legal professionals for advice related to your individual situation. Any copy or reproduction of our presentation is expressly prohibited. Any names or situations have been made up for illustrative purposes — any similarities found in real life are purely coincidental.