Section 1031 Exchange: Tax Tips for Foreign Real Estate Sale

Welcome to another installment of the Practical Expat Tax Adviser. This series is designed to identify a common crossborder tax question and then provide the practical US tax considerations for the given situation that the standard human can understand. For those of us with less of a life who are more technically inclined, I end the article with a breakdown of the legal support and basis for the considerations provided. Enjoy!

This is not meant to be tax advice for YOUR situation. Find a qualified professional or reach out to me directly for more practical crossborder tax advice.

THE QUESTION: Can I minimize capital gains on my foreign real-estate sale

Taxpayer:
“I just got an offer on my Mexican rental property I cant refuse but selling it would trigger a sizable gain for me. Can you help me minimize the tax on this?”

That’s how most of the emails I get end, by the way - “Can we save taxes on this”. The topic of this article is looking at the general reporting requirements on the sale of foreign real estate and what we can do to minimize or at least defer the US tax on these transactions.

THE PRACTICAL

The general rule is that gain on the sale of a Mexican property is taxable in the US when the seller is a US citizen. If the sale is also taxable in Mexico, we would look to take a foreign tax credit in the US to avoid double taxation.

The real tax planning strategy on the US side is the Sec. 1031 exchange. This would allow the taxpayer to “defer” the gain on the property sale by rolling it into another foreign rental property. There are of course specific steps to follow and the replacement property also has to be outside the US but that is the best option for avoiding any tax today on the income from the sale of the property.

THE TECHNICAL

The first thing to be aware of when you are dealing with the sale of a foreign rental property is to confirm how that property is held. More specifically, is there a foreign legal entity involved or even a US legal entity? The ownership structure can have a significant impact on the reporting requirements as well as the overall taxation.

In the current case however, this individual owns the property in Mexico directly. So the operating income and an ultimate sale are picked up by his US return just like a US rental property would be. The difference of course is that Mexico will likely also want to tax the income from this property so our primary job is to avoid any double taxation scenario.

Foreign Tax Credit

When you are dealing with two countries taxing the same income, the tax compliance comes down to a coordination effort to ensure that the global reporting is done correctly. Often this requires looking at a relevant tax treaty to see who has the primary right to tax the income. However, in this case the general US tax code agrees with the primary taxing right going to Mexico.

Under Sec. 862(a)(5), gains from the sale of real property located outside the US are considered “foreign sourced”. That income is still reportable and taxable in the US to a US citizen, but it being foreign sourced means that you are allowed a

This means that you ultimately pay the higher of the two taxes.

Sec. 1031 Exchange: Deferring Gains

Not being double taxed is good, but it is even better if you can defer the tax on real estate gains to a future year. Especially where there may be no (or limited) tax in the foreign jurisdiction. In this case we don't know what the Mexican tax impact is on the sale but presumably there is some tax incentive there which lessens or eliminates the local tax.

A common strategy for US tax deferral on rental real estate gains is what’s called a “like-kind exchange” or a “1031 exchange” in reference to Section 1031 of the Internal Revenue Code.

In general, when property held for productive use in a trade or business or for investment is exchanged for like-kind property which is also to be held for productive use in a trade or business or held for investment,

As you can see in this simple example, the basis in the new property that was purchased is adjusted to account for the gain on the old property that is being deferred. So this gain is essentially rolled or “exchanged” into the new property and will be recognized later when that property is sold.

Like most things tax related, the devil is in the details and there are some nuances to this provision depending on the facts. But, more generally, when you are dealing with rental real estate the property will qualify for “investment property” for Sec. 1031 purposes.

The important rule here however comes in Sec. 1031(h).

(h)Special rules for foreign real property
Real property located in the United States and real property located outside the United States are not property of a like kind.

This is essentially saying that a foreign property can only be swapped for another foreign property. You cannot do a Section 1031 exchange on a foreign property sale for a US property.

How to perform the Section 1031 exchange: Step-by-step

In order to practically pull this off, you would want to engage an intermediary with experience in this type of transaction to make sure all the correct steps are followed and done on time. Below is a brief summary of the related steps.

1. Determine Eligibility

• Both the relinquished property (the one being sold) and the replacement property (the one being acquired) must be foreign real property as defined under IRC §1031(h).
• The properties must be held for investment or business use (not personal use).
• The exchange must follow like-kind rules (i.e., real estate for real estate).

2. Engage a Qualified Intermediary (QI)

• You must use a Qualified Intermediary (QI) to facilitate the exchange.
• The QI holds the proceeds from the sale of the relinquished property and ensures compliance with IRS rules.

3. Sell the Relinquished Foreign Property

• Enter into a sales contract for the relinquished property.
• At closing, the proceeds must go to the QI (not directly to you).
• You cannot have actual or constructive receipt of the funds.

4. Identify a Replacement Property

• You must identify a replacement property within 45 days of selling the relinquished property.
• You can identify:
  • Up to three potential properties (regardless of value), OR
  • Any number of properties as long as their total fair market value does not exceed 200% of the relinquished property’s value.

5. Acquire the Replacement Foreign Property

• You must acquire the replacement property within 180 days from the sale of the relinquished property.
• The replacement property must be in a foreign country (not the U.S.).
• The QI transfers the proceeds to purchase the replacement property.

6. Report the Exchange to the IRS

• File IRS Form 8824 with your tax return for the year of the exchange.
• Maintain detailed records of the exchange for tax compliance.

Closing remarks, before you close on your real estate sale

Real estate transactions have nuanced tax implications that are only amplified when dealing with property outside the US. There are tax savings to consider but, as always, it is much easier to get it right by planning ahead. Make sure you understand the rules and get the right people involved before you embark on a foreign real estate project so you don't miss out on tax planning opportunities, or worse, subject yourself to unnecessary tax and penalties.