Exchanging Foreign Properties Under Code Section 1031

Code section 1031 has long since been the best kept secret of savvy real estate investors who are buying and selling investment properties. Today, this extremely advantageous tax benefit is used by beginners as well as the most seasoned real estate investors alike. Section 1031 of the Internal Revenue Code allows the taxpayer to defer capital gains tax on all property held for trade, business or investment. Furthermore, Section 1031 allows a real estate investor to defer capital gains taxes due on an otherwise taxable sale of appreciated real estate when that investment property is replaced with a "like-kind" investment property.

Foreign Property and "like-kind" Requirements
Section 1031 specifically provides that real property located in the United States is not "like-kind" to real property located outside of the United States. Section 7701 goes on to define the borders of the United States to being all fifty states and the District of Columbia. This means that a 1031 exchange involving a parcel of real property located within the United States and a parcel of real property not located within one of the fifty states, or the District of Columbia, is a sale, thus making it a taxable event. Any gain realized by such a transaction is fully liable to taxation as income.

Territories of the United States, such as the U.S. Virgin Islands, Guam and Puerto Rico enjoy a quasi status in regard to 1031 exchanges. Normally, U.S. territories are defined as not being in the United States under Section 7701. Therefore, any 1031 exchange between real property located within the defined United States and real property located within one of the U.S. territories is not a valid "like-kind" exchange. However, the IRS has stated that the definition of the borders of the United States may be enlarged in very specific circumstances. In Private Letter Rulings 9038030 and 200040017, the IRS stated that the definition of the borders of the United States can be expanded to include the U.S. Virgin Islands so long as the taxpayer is: (1) A citizen or resident of the United States and (2) Has income derived from sources within the U.S. Virgin Islands, is effectively connected to the performance of a trade or business in the U.S. Virgin Island or files a joint tax return with an individual who derives sources of income or is connected to a trade or business within the U.S. Virgin Islands. Both requirements must be fulfilled in order for an exchange between real property located within the 50 states and real property located within the U.S. Virgin Islands to be valid as a 1031 exchange. There exists no Private Letter Rulings regarding the other U.S. territories, but there is no territorial difference between the U.S. Virgin Islands, Guam and Puerto Rico. Therefore, it is intuitive that meeting the same two requirements would make a 1031 exchange between real property in the 50 states and real property in either Guam or Puerto Rico valid.

Other Considerations Regarding 1031 Exchanges and Foreign Property
There are other considerations that must be taken into account when utilizing 1031 exchanges of real property located on foreign soil. While it is true that foreign property is considered to be "like-kind" to other foreign property to be held for trade, business, or investment purposes; 1031 exchanges are tax deferring tools for U.S. income taxes. While Section 1031 allows tax deferment of U.S. income taxes for exchanges of foreign real property (ie. Real property in Canada exchanged for other real property in Canada), there may also be additional taxes associated with the foreign nation that derive from a 1031 exchange. You should consult your tax and legal experts to determine if the foreign nation has a tax treaty with the United States and what foreign tax implications will arise from a 1031 exchange.

FIRPTA (FOREIGN INVESTMENT IN REAL PROPERTY TAX ACT OF 1980)
Prior to 1981, foreign investors could sell their real estate without incurring a U.S. tax on the gain, provided the property was not used in conducting a business in the U.S. In 1981, however, "FIRPTA," was adopted to impose a tax on capital gains derived by foreign persons from the sale of their U.S. property.

FIRPTA imposes an income tax on the sale of what is termed a U.S. real property interest ("USRPI") on all nonresident alien individuals and foreign corporations. A USRPI includes U.S. real estate owned directly by the foreign investor, as well as, shares owned by a foreign person in a U.S. corporation that owns substantial real estate. To ensure collection of U.S. taxes that are due on the sale by a foreign investor, FIRPTA also provides a withholding mechanism under which the buyer, who is the transferee of a USRPI, is obligated to withhold 10% of the purchase price at closing and send it directly to the IRS instead of paying the full amount to the foreign seller. Some states, such as, Hawaii, California and Colorado, may also require the withholding of taxes on sales of U.S. real estate located within their borders.

It is possible for a foreign seller to avoid recognizing gain on the sale of its property by "exchanging" it for a similar, or "like-kind," property. If the exchange qualifies under U.S. law, recognition of gain for the foreign seller will be deferred and no FIRPTA income or withholding tax will be currently due on the transaction. However, should the foreign seller receive any property in the exchange that is not "like-kind," such as cash, the entire transaction is disqualified and all gain must be recognized. Note that real property located in the United States cannot be exchanged for real property located outside the United States.

One of the many requirements for a qualified like-kind exchange is that the transferee receive from the foreign seller either: (1) a Withholding Certificate issued by the Internal Revenue Service ("IRS") that sanctions the particular exchange and allows the transferee to avoid withholding any tax, or (2) a Notice of Nonrecognition Transfer from the foreign seller that certifies that the transaction qualifies entirely under law for nonrecognition of gain and this Notice is forwarded to the IRS by the transferee within twenty (20) days of receiving the seller's property. Since a Withholding Certificate is applied for by the seller in advance of closing, it is often used with a Simultaneous Exchange, where the facts of the entire transaction are known by the time for closing. With a Deferred Exchange, where details about the replacement property are not often known by the time for closing, a Notice of Nonrecognition is usually involved.