Have you experienced a surprised non-resident seller in South Carolina who was unaware of the non-resident withholding provisions? Common wisdom might lead a nonresident seller to assume that if they are treating the sale as relinquished property in a 1031 exchange, the nonresident withholding would not apply. Beware! This assumption may catch a nonresident seller unaware. South Carolina Code Section 12-8-580 requires any person who purchases real property from a nonresident seller to withhold South Carolina income taxes from the seller. South Carolina Revenue Advisory Bulletin #02-6 (hereinafter referred to as the “Advisory Bulletin”) provides guidance on how to apply this law.
Who is a Non-Resident Seller?
A nonresident seller is:
2. A corporation incorporated outside of South Carolina.
3. A partnership whose principal place of business is located outside of South Carolina.
4. A trust administered outside of South Carolina.
5. An estate of a decedent whose permanent home was outside of South Carolina at the time of death.
A nonresident seller may be deemed a SC resident if the qualifying conditions stipulated in Q&A Number 3 of the Advisory Bulletin apply. If the taxpayer meets the deemed resident requirements, they will not be subject to the withholding.
What Sales are Subject to Withholding?
The sale of any interest in real estate, including the sale of time shares, leases and minerals in place, is subject to withholding, as is the sale of tangible personal property sold as part of a real estate transaction.
Sales do not include tax exempt or tax deferred transactions, other than installment sales. So, why do we need to consider non-resident withholding requirements in a 1031 exchange? If the exchange is non-simultaneous, then it cannot be known with certainty that it will be a tax-deferred transaction until the exchange has been completed. Because the withholding typically occurs at closing, special attention must be paid to withholding issues early in the closing process.
How Does the Taxpayer Fill Out Forms I-290 and I-295?
A buyer from a nonresident seller must have proof that the correct amount was withheld. Form I-295, the Seller’s Affidavit, is one form of such proof. This affidavit is completed by the nonresident seller and may relieve the buyer from withholding if the seller is a resident, a deemed resident or if the sale is tax exempt. It may also allow the buyer to withhold on the gain stated by the seller instead of the higher amount realized.
Form I-290 is used to determine the amount to be withheld. It will be based on either the gain provided by seller on the Form I-295 affidavit, or on the amount realized, if Form I-295 is not provided. The amount withheld is 7% if the seller is not a corporation and 5% if the seller is a corporation.
The buyer must remit the withholding amount on or before the fifteenth day of the month following the month in which the sale takes place. As we will see, this requirement may be extended if the seller is effecting a 1031 exchange. The seller will report the sale or the exchange on its South Carolina income tax return.
What Are the Special Rules for Like-Kind Exchanges?
The rules set out above are the general rules for nonresident withholding. It becomes much more confusing when the nonresident seller is selling its property as part of a 1031 like-kind exchange. Common questions arise, such as who is responsible for remitting the withholding payment, how and when do we determine gain, what if the seller does not use all of its proceeds and what if the stated amount of gain on the I-295 affidavit changes? These special rules are addressed in Q&A Numbers 9 and 22 of the Advisory Bulletin, but not all of the questions are clearly answered.
If the exchange is simultaneous, which is the exception rather than the norm, the seller will complete Form I-290 stating that the transaction is a nontaxable Section 1031 like-kind exchange and whether the entire gain is deferred or the amount of gain that will be partially recognized. If there is gain to be recognized, withholding will be required based on this amount.
In a non-simultaneous exchange, the nonresident seller taxpayer has two options:
Option 1: The seller can choose to remit the required withholding out of his own personal funds, instead of using a portion of the sales proceeds. This option prevents using exchange proceeds for the non-exchange expense imposed by the withholding requirement. If the taxpayer completes the exchange successfully, he can file for an immediate refund of the withholding previously paid. However, if this withholding had been paid out of the exchange proceeds, it would now be “boot” to the taxpayer. The purchaser will prefer option number one, since the withholding requirement has definitely been met. If the taxpayer chooses this option, he should notify the qualified intermediary of this choice and provide the qualified intermediary with copies of Forms I-290 and I -295, and a copy of the settlement statement that reflects incoming funds from the taxpayer, used to pay withholding to the SC Revenue Department.
Option 2: The seller and buyer can agree to shift the withholding responsibility to the qualified intermediary at a later date, by entering into a contract with the QI as set forth in the Advisory Bulletin. Although the responsibility may be shifted, the liability for the withholding remains with the buyer. The exchanger will prefer this option, because he will not have to come out of pocket to provide the required withholding, but the buyer may be unwilling to cooperate in this option. The Seller will fill out Form I-295 stating that it is intended that the transfer qualify as a nontaxable like-kind exchange under IRC Section 1031. The seller must also fill out Form I-290 as if the sale were taxable. The qualified intermediary will hold the Form I-290 in escrow until the exchange is complete. The seller will need to provide the realized gain on Form I-295 in order to avoid calculating the withholding amount based on the sales price. It will be tempting for the seller to fill in “zero” gain, since he is doing an exchange, but the Advisory Bulletin clearly states that the I-290 must be completed as if the transaction were taxable. Once it appears that the transaction will not “qualify” (i.e., be fully tax-deferred), the qualified intermediary is required, under the contract with Buyer, to withhold money from the seller’s exchange funds to meet the withholding requirements. Withholding may be required, for instance, if the seller is not trading up or equal in value from the relinquished property to the replacement property, or if it appears that the seller will not use all of the exchange funds for the acquisition of the replacement property. The QI must remit the I-290 and withholding amount by the 15th day of the month following the month it becomes apparent that the exchange will not qualify. If it appears that the transaction will fully qualify as a nontaxable like-kind exchange, I-290 will not be filed and no withholding payment will be made.
What If the Seller Does Not Use All of Its Proceeds?
It is a common occurrence where the seller will use some, but not all, of the exchange funds to purchase replacement property. At the end of the exchange period, the qualified intermediary will return the balance of exchange funds to the seller, but must deduct the withholding amount from the exchange funds prior to returning them to the seller. It is important to note that if the seller does not provide the qualified intermediary with a completed I-295, the qualified intermediary has no choice but to withhold based on the gain realized. If the taxpayer originally completed a Form I-295 reporting the realized gain, as if it were a taxable sale, and now realizes that he will only recognize a partial gain, most Qualified Intermediaries will accept a revised I-295 to show the actual recognized gain. The QI will submit withholding based on the revised affidavit. This is one scenario not fully anticipated or addressed in the Advisory Bulletin.
What If the Amount of Gain Changes?
Sometimes the gain calculated on Form I-290 will change after the withholding amount has been submitted, which will result in a refund of all or a portion of the withholding to the seller. This typically happens when “Option 1” above has been utilized, but the taxpayer is successful in either partially or fully deferring gain recognition. In this case, the seller may submit Form I-290X to amend the withholding due and apply for a refund, but only for the following reasons:
1. The seller did not provide Form I-295 to the buyer and the amount withheld was based on the amount realized, but now the seller wants to state the amount of gain recognized on the sale.
2. There was an error in computing the withholding amount.
3. The parties were unaware of the exceptions to withholding at the time of sale.
Please note that Form I-290X can only be used to request a refund prior to the filing period for the individual income tax return. Once a tax return can be filed, it is too late to receive a refund unless an amended return is filed.
All the rules and exceptions described above show how cumbersome the nonresident withholding requirement can be when the nonresident seller is effecting a 1031 exchange. Only a handful of states have state nonresident withholding requirements for real estate sales, and South Carolina’s requirements are more exacting than most. In some states there is either a waiver process to avoid nonresident withholding in a 1031 exchange, or an exception to withholding if there is a 1031 exchange. For example, California simply puts the burden on the qualified intermediary to withhold a certain percentage of any cash boot paid to the taxpayer. Because South Carolina has a unique method of dealing with non-resident withholding when a 1031 exchange is involved, it is incumbent upon the closing attorney to guide the buyer, seller, realtor, and qualified intermediary through the requirements. Early communication to all the parties of these special rules will help eliminate confusion and misunderstanding in a transaction that is already stressful.