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Could a question over taxes sink a complicated real estate transaction with a foreign investment company? When taxpayers Eric and Audra Gilbert asked the Arizona courts to weigh in on their right to withhold taxes under the Foreign Investment in Real Property Tax Act (FIRTPA) and the Fixed, Determinable, Annual, or Periodic (FDAP) income rules, the courts fell back on the old adage: “pay first, litigate later.”
Eric and Audra Gilbert were interested in buying a home in Arizona. They entered into a real estate contract with Philip K. Leopard, trustee for Namaca Management Limited (Namaca), a foreign entity. The deal included an initial down payment in July 2014, a lump sum payment in 2015, two years of monthly payments, and a final balloon payment in August 2019. Altogether, they planned to pay Namaca more than $260,000.
As part of the contract, Namaca guaranteed that the property was unencumbered and that it wouldn’t do anything to create encumbrances that would prevent the sale. However, the title search leading up to the closing revealed a federal tax lien for $416,372.05 had been recorded against the property earlier that year. The parties agreed that Namaca would resolve the title issues “as quickly as possible” and at least “prior to or at the time of final conveyance of the Property” in 2019. However, in November 2015, the IRS added another layer, recording a second tax lien on the property for $283.007.48. Together, the liens were more than the Gilberts were planning to pay.
The issue here was that Namaca was a foreign entity. When taxpayers enter into a taxable real estate deal with a foreign entity, the FIRTPA and FDAP require the buyer to deduct, withhold, and pay a set amount from that transaction to the IRS. This is intended to prevent foreign real estate investors from buying and selling property without paying property taxes by ensuring the funds are collected up front. The law puts the obligation to ensure taxes are paid on the buyer, holding them responsible for any miscalculation.
When the Gilberts learned about the second tax lien, in August 2017, they notified Namaca’s trustee that they planned to follow the FIRPTA and FDAP rules by withholding part of their agreed purchase price. However, Leopard objected to the plan, claiming he (as trustee) and Namaca were “non-resident non-persons” exempt from tax withholdings. If the Gilberts didn’t pay in full, Leopard threatened to sue them for breach of contract.
The Gilberts didn’t want to cross the IRS, but they also didn’t want to get sued, so they went to court first. They filed a complaint seeking a declaratory judgment, asking the Arizona federal district court to declare that withholding money from the purchase price to pay federal taxes under FIRPTA and the FDAP rules would not breach their real estate contract with Namaca. However, the district court quickly dismissed the complaint, saying it lacked jurisdiction to make such a ruling.
Federal courts are usually reactive -- responding after one party’s rights or interests have been affected to make that party whole. However, the Declaratory Judgment Act (DJA) gives federal courts to proactively resolve conflicts between parties’ legal rights before the violation occurs. The Gilberts wanted to do what was right for both the IRS and Namaco, so they used the Declaratory Judgment Act to ask the court to sort out the legal interests of all the parties.
However, the DJA doesn’t apply to the IRS. The law carves out an exception for cases “with respect to Federal taxes.” In other words, the federal courts can’t tell the IRS what to do ahead of time. When the Gilberts appealed the dismissal to the Ninth Circuit Court of Appeals, that higher court said that the DJA does not allow jurisdiction over any claim that would “restrain the assessment or collection of any tax” even if the IRS has not made a final determination on the plaintiff’s tax liability.
The IRS doesn’t wait for the courts before collecting taxes owed. Instead, the courts must wait until after a payment is made and then refund any errors to the taxpayer. Even though the Gilberts planned to pay the taxes, the Ninth Circuit said the Supreme Court’s “pay-first, litigate-later” approach to tax law meant the courts could not get involved in their real estate transaction until after the property transfer taxes had been paid, even if it meant Namaca sued them for breach of contract.
Attorney Joseph R. Viola is a tax attorney in Philadelphia, Pennsylvania with over 30 years experience. If you or your clients have questions about the FIRTPA, FDAP, or their obligations to withhold taxes in a real estate transaction, contact Joe Viola to schedule a free consultation.