Taxpayers subject to US federal capital gain taxes due upon sale of foreign property can defer the tax when initiating a 1031 exchange for like-kind property that has a productive use in a business or investment located predominantly outside the US. Traditionally, when real or personal property is sold, a federal capital gain tax is imposed, ranging from 0 to 28 percent for collectibles. A 1031 exchange allows the Taxpayer to defer the tax given strict rules defined in Internal Revenue Code Section 1031 are followed. The tax deferral represents additional working capital or an indefinite, interest free loan to be used towards acquiring the replacement property within 180 calendar days of the relinquished or old property closing.
Like-Kind Property
Property eligible for a 1031 exchange includes real, tangible and intangible personal property. Real property is any type of real estate, including land and improvements, water rights, oil and gas mineral interests, easements and lessee’s interest in a thirty plus year lease. Tangible property includes aircraft, collectibles, gold and silver bullion, numismatic coins, livestock, equipment, railroad cars and locomotives, ships, tugs and barges, trucks, buses and autos and furniture. Intangible personal property includes franchise and development rights, copyrights, patents, trademarks, aircraft landing rights, fishing permits and sports contracts.
Like-kind property must be held in the productive use of a business or for investment, implying limited personal use. In the case of a vacation rental property, the Taxpayer’s personal use is limited to 14 overnights per year or ten percent of the time rented over the twelve month period prior to the closing. Hold time is not defined in the IRC Section 1031; however, the IRS has stated that two years is sufficient. For vacation rental properties, the IRS will not challenge whether the property qualifies if the Taxpayer meets the test defined in Revenue Procedure 2008-16.
In Country Requirements
When selling property, each country has their set of procedures and taxes. Part of the foreign property 1031 exchange challenge is complying with both the sovereign requirements and those of the Internal Revenue Code Section 1031. It is imporant to understand the local procedures of title conveyance and how the exchange funds are held. 1031 exchanges in China and Israel follow the same 1031 exchange requirements, though both add a layer of country specific complexity. Working through a series of alternatives, the exchange proceeds can be held in the domestic currency, completing the 1031 exchange in accordance with 1031 requirements.
Suggested Steps to a Foreign Exchange
As with 1031 exchanges located in the US, the first step is to visit with your CPA to understand the tax consequence of the sale. The tax represents the reason to initiate the 1031 exchange. Next, search and engage a Qualified Intermediary (QI) who accommodates foreign property 1031 exchanges. Ask the QI how the 1031 exchange can be accomplished following the rules of the country where the property is located. The QI will prepare exchange agreements in accordance with the 1031 code and work to hold the exchange funds in a manner to preserve principal and liquidity. There are alternatives to exposing the exchange funds to exchange rate loss or expense of wiring the funds to the US and back to the country where the replacement property Seller is located. Exchange funds can be held within the country of origin given the bank account is structured to avoid violation of the (g)(6) constructive receipt requirements. In no event may the Taxpayer receive, pledge, borrow or otherwise obtain the benefits of the Exchange Account before or while held for the purpose of acquiring replacement property.
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