Expats and those who own property overseas have to worry about double taxation – but in some cases, U.S. taxes can be deferred on foreign exchanges.
In a previous post, we discussed state-to-state exchanges and how it’s possible to perform a 1031 exchange between U.S. states and select U.S. domestic territories. But what if you live abroad, or own property outside the U.S.? Do you have no choice but to pay capital gains taxes on your property sale?
It is possible to utilize Section 1031 for foreign assets, but only in certain situations. Understanding when a 1031 exchange with foreign property is allowed and why it may or may not be advantageous can be a crucial part of wealth and retirement planning for those who live overseas, own international businesses, or hold property in their countries of origin.
Foreign property and the definition of “like-kind”
One of the most useful aspects of IRC Section 1031 is the rather broad definition of like-kind property. While Section 1031 only applies to real property, any real property used in a productive trade or business or held for investment will likely qualify. As the IRS website states, “Most real estate will be like-kind to other real estate.” However, there is an important exception.
- 1031 Exchange of real property held for productive use or investment contains an important section titled, “Special rules for foreign real property,” which states:
Real property located in the United States and real property located outside the United States are not property of a like kind.
This means that you cannot perform a 1031 exchange between a U.S. property and a non-U.S. property. If your relinquished property is located within the United States, then your replacement property must also be located within the United States (or certain U.S. territories) to qualify for 1031 tax deferral. Rare exceptions include the territories of Guam, the Northern Mariana Islands, and the Virgin Islands, where property may be considered to be like-kind to property located within the United States (see Temp. Reg. Section 1.935-IT ( c) (ii)(E); TD 9194).
But that doesn’t mean an exchange with foreign property isn’t possible. While foreign property is not of a like kind with domestic property, foreign properties are considered like-kind with one another. You can perform a 1031 exchange with foreign properties, so long as your relinquished and replacement properties are both located outside the United States. For example, an investment property in the Cayman Islands can be exchanged for rental property in the Cayman Islands or for investment property in New Zealand.
What makes foreign exchanges complicated is that they require the exchanger to factor in the tax system of the country (or countries) where the properties are located, as well as that country’s banking laws and regulations. Exchanges with foreign property have the same IRS rules as standard U.S.-based exchanges, but compliance can be difficult depending on how different the banking system in question is from the U.S. system.
Challenges of 1031 exchanges with foreign property
One thing we pride ourselves on at JTC is our commitment to 1031 best practices. As a Qualified Intermediary (QI), we employ strict security measures regarding how exchange funds are handled. This gives our clients peace of mind that everything is being done by the book so they can successfully qualify for tax deferral.
A major component of 1031 best practices is the use of Qualified Escrow accounts to hold exchange funds. These funds are never commingled with operating funds, and any fund movement requires dual authorization from the exchanger and JTC. Unfortunately, some countries’ banking systems don’t utilize an escrow structure, making this impossible.
There may also be some limitations on the amount of money that non-citizens can transfer into and out of certain countries. For instance, several nations now have their own versions of the U.S. Patriot Act, which grants the power to restrict or prohibit the transfer of money into or out of the country and/or to set onerous requirements in order to do so. Similarly, financing an acquisition through a foreign lender may present difficulties and could take time.
Different QIs have different procedures when it comes to holding funds during a foreign exchange. It’s possible to transfer the sales proceeds to the United States, where they can be held in U.S. banks in American dollars, and then transferred to the country where the replacement property is being acquired. The problem with this is that some countries impose exit taxes or limit currency remittance, and currency conversion rates can affect the value of the funds as they are moved back and forth.
If the exchange is taking place entirely in one country (meaning the relinquished and replacement properties are located in the same country), it’s possible for exchange funds to be held in that country during the exchange. 1031 rules state the exchanger cannot take constructive receipt of funds, which is why a QI is necessary. In the event that the situation calls for it, the client might have to make plans to open an escrow or trust account with a foreign lawyer in the area or another qualified person who can manage the transaction (note: this party cannot represent the taxpayer as an “agent”). In countries without the types of accounts typically used for 1031, it’s still possible to hold funds in an account that abides by local rules and U.S. 1031 rules, but it needs to be done right. An experienced QI is crucial in these situations.
If your exchange involves properties in two different non-U.S. countries, you may not be able to avoid issues regarding the transfer of funds and currency conversion. To successfully execute a 1031 exchange involving multiple countries, you need to work with specialists who understand the laws in all jurisdictions involved. Depending on where you and your properties are located, you could also be at risk for double taxation.
1031 for non-residents – how to perform a like-kind exchange if you live abroad
Properties owned in other countries are subject to taxes in those countries, and U.S. citizens living abroad are subject to taxes in the countries where they live. If you’re paying U.S. taxes and taxes in your country of residence, how do you avoid being taxed twice on the same income?
U.S. citizens living abroad can take advantage of tax treaties that help them avoid double taxation. There are 66 such countries, and if you live in one of them, you won’t be taxed by the IRS on income for which you’ve already paid taxes in your country of residence. But if you live in a country without a U.S. income tax treaty, you may be subject to double taxation. Depending on the tax rate of the country in which you live, this could be a substantial burden.
The same is true of capital gains taxes on a property sale: if you paid taxes on the sale in the country where the property is located, you can receive a tax credit in the U.S. to avoid double taxation, so long as the country has a U.S. tax treaty. But because you have to pay those foreign taxes, you won’t be able to reinvest your full sales proceeds like you could with a properly-structured 1031 exchange. Losing out on this benefit may make your exchange no longer financially advantageous, depending on the taxes paid and the property you hoped to acquire.
What about if you live abroad and want to perform an exchange with property located in the U.S.? The key thing to consider is where the entity that owns the property is established. If you are the legal owner of the property, then the sale will be taxed based on where you live and where the property is located. If the property is located in the U.S., you can perform an exchange with another U.S. property, but you will also owe taxes in your country of residence, reducing the amount you have to reinvest.
Foreign investors also have to worry about the Foreign Investment in Real Property Tax Act (FIRPTA), which affects property sales when the seller is an international investor. The buyer/transferee or certain agents of the buyer may be required to withhold up to 15% of the gross sales price as withholding tax. If the buyer is purchasing the property as a personal residence and the sale price is between $300,001 and $1 million, just 10% of the gross sales price must be withheld. Otherwise, 15% of the gross sales price must be withheld. Within 20 days following the date of transfer, this sum needs to be sent to the IRS. Consequently, you will not be able to utilize that capital when acquiring your replacement property.
It is possible to obtain an exception so you can use the sales proceeds in a 1031 exchange, but this requires careful planning well in advance of the sale of the relinquished property. Furthermore, Treasury Decision 9082, which came into effect on November 4, 2003, mandates that all foreign sellers of U.S. real estate must possess a Taxpayer Identification Number (TIN) in order to fulfill the necessary withholding obligations or to apply for a reduced tax withholding rate. Individuals who are ineligible for Social Security Numbers (SSN) can obtain Individual Taxpayer Identification Numbers (ITINs) by submitting form W-7, thereby satisfying the requirement to provide a TIN.
Whether you live in the U.S. and want to exchange properties abroad, live abroad and want to exchange properties in the U.S., or you’re a U.S. citizen living abroad and want to exchange properties in other foreign countries, you have to worry about the tax systems in the countries where your properties are located, the country of your citizenship, and the country where you live.
Foreign domiciliation in 1031 tax deferral
Imagine you’re a U.S. citizen, live in the UK, own property in India, and want to exchange it for property in Egypt. That’s four different countries whose tax systems you need to worry about in order to successfully execute your exchange. An average QI that only has experience working in the U.S. won’t be able to get the job done right. You need more than just 1031 expertise – you need global business and tax expertise as well.
One thing that sets JTC apart from other Qualified Intermediaries is that we’re a global company that does so much more than just 1031. We have offices in jurisdictions around the world, with local staff that understand the laws and business culture in those areas. We also have a Private Client Services division that works with individuals and families with complex monetary and investment interests around the globe.
JTC specializes in foreign domiciliation, especially in tax-free jurisdictions. If you or your properties are located in a jurisdiction with no income tax, you could potentially execute a 1031 exchange without having to pay local taxes. By deferring U.S. taxes as you would with a U.S.-based like-kind exchange, you could reinvest your full sales proceeds in your replacement property. JTC has offices in several of these jurisdictions, and can work with our 1031 clients to take advantage of what they have to offer.
The biggest thing you should take away from this blog is that 1031 presents opportunities all over the world, and you have a lot of options when it comes to deferring taxes on property sales. JTC is unique in that we combine the power of our global reach, PCS division, and 1031 experts to develop tax deferral, domiciliation, and investing strategies for our clients that allow them to protect their assets and build wealth for the future.
To learn more about JTC’s 1031 exchange team, click here.
