Questions & answers

What is an I.R.C 1031 exchange? Can foreign institutional investors use it?

I’ve heard this term tossed around as a way to potentially avoid FIRPTA withholding and want to be sure we understand our options as we look to invest in U.S. residential properties.


Answers
  • Mark Drumm

    Managing Director, Regent Park Advisors
    December 13, 2017

    An IRC 1031 is often referred to as a "1031 Exchange." In this type of transaction, the seller designates that the property is being exchanged (rather than sold) for another "like-kind" property. In these transactions, there is typically a custodian (like a bank) that handles the exchange of capital between parties through an escrow arrangement established specifically for these types of transactions. Therefore, the exchanger (seller of old and buyer of new property) never has control, possession or use of the money during the interim period if the closings are spaced apart in time. There are specific time limits on how long a seller has to designate the property he is exchanging his property for and closing that new property. This allows for the seller/buyer to avoid paying any current capital gains taxes, but defers taxes for when they might sell the new property. I am not aware of restrictions placed on foreign owners of property in utilizing this tax structure.

  • Eric Ching

    Ching & Seto, APC
    December 13, 2017

    1031 exchange is a tax code provision that allows homeowners/investors to avoid capital gains taxes on the sale of the property if they buy another property within a specific timeframe. Foreign investors can use it but with the following conditions: There is a common misconception that foreign sellers can avoid FIRPTA withholding by participating in a 1031 exchange. Previously, foreign sellers in a 1031 exchange were only required to give notice of their intent to the buyer to relieve the buyer of the withholding requirements. In cases where the subsequent purchase of the replacement property did not occur, the IRS was disadvantaged in its ability to recover the tax that should have been withheld. In order for the sale of the relinquished property in a 1031 exchange to be exempt from FIRPTA: (1) the closing of the relinquished property must occur simultaneously with the purchase of the replacement property; (2) there can be no boot in the exchange; (3) the seller must notify the buyer that the seller is not required to recognize any gain or loss and; (4) the buyer must provide, within 20 days, a copy of the non-recognition notice to the IRS in which the buyer confirms that these requirements are satisfied.

  • Lucy Lee

    Akin Gump Strauss Hauer & Feld LLP
    December 13, 2017

    An exchange under section 1031 defers tax on a sale; it is an exchange of one investment property for another "like-kind" investment property and does not result in immediate gain upon the exchange. Thus, you can avoid FIRPTA withholding. It can be used by foreign institutional investors. Note that there are very specific procedures and a strict timing component which must be satisfied.

  • Daniel Lu

    Daniel Lu CPA
    December 12, 2017

    IRC means U.S. Tax Code. At Sec 1031 of the tax code, the code talks about "Like-Kind Exchange." In Terms of U.S. Real Properties, Like-Kind Exchange is simply a method to help investors defer paying Capital Gains Tax when: (1) an investor wants to purchase another Real Property (#B) using the funds from the sale of the Current Real Property (#A); (2) an investor does not want to pay a "Capital Gains Tax" when selling the current real Property (#A); and (3) the Real Property (#B) has higher value than Real Property (#A). Sec 1031 Exchange does not directly help Foreign Investors avoid the FIRPTA withholding. However, if the foreign investor meets all the requirements of the Sec 1031 and files a "Notice of Non-Recognition", FIRPTA withholding may be avoided. Keep in mind that an investor having a valid ITIN or Tax ID is important for the transaction to be processed smoothly and timely.

  • Dan Flanigan

    Chair, Real Estate and Financial Services Department, Polsinelli
    December 07, 2017

    A section 1031 exchange (also referred to as a "like-kind exchange") permits the owner of property to exchange such property for property of a like-kind without recognizing any United States Federal income tax on any gain derived from the disposition of the owner's current property. Thus, any taxpayer, including any foreign investor subject to United States income taxes is able to utilize Section 1031 to exclude such gain from their U.S. Federal taxable income. There are a significant number of rules that must be strictly followed in order for an exchange to qualify for non-recognition treatment under Section 1031. For real property, what is like kind is relatively broad. BOTH the current property and the new property must be EITHER (i) investment property or (ii) real property used in a trade or business. Investment real property can be exchanged for real property used in a trade or business and real property used in a trade or business can be exchanged for investment real property. Neither property, however, can be personal use property or inventory/property held primarily for sale to customers. Significantly, however, real property located in the United State IS NOT like-kind property as to property located outside the United States. Thus, U.S. real property must be exchanged for other U.S. real property and foreign real property must be exchanged for other foreign real property. Rarely is a like-kind exchange achieved by a simultaneous exchange (swapping property directly for another property or all transfers completed on the same day). Instead, like-kind exchanges are generally accomplished by way of a deferred exchange, where the current property is sold and then the replacement property is subsequently purchased with 180 days (Less common is the reverse exchange, where the new property is acquired before the old property is sold). There are a number of additional rules that must be strictly followed in order to achieve a deferred 1031 like kind exchange, most importantly is a use of a Qualified Intermediary to hold the proceeds from the sale of the current property. Assuming FIRPTA withholding would otherwise be required, a Section 1031 exchange will generally require withholding unless either (i) the exchange is quickly completed or (ii) a withholding certificate from the IRS is obtained. The exception for exchanges that are completed quickly creates an exemption from FIRPTA withholding ONLY if (i) the 1031 exchange is a simultaneous exchange or is completed within 20 days of the transfer (the due date of Form 8288) AND (ii) the transferor certifies in writing to the transferee that the exchange entirely qualifies for non-recognition treatment. If the previous exemption doesn’t apply, then a withholding certificate from the IRS must be received in order to be exempt from withholding and transferring the withheld funds to the IRS. Either the transferee or transferor my apply for the certificate by filing Form 8288-B. The IRS generally responds within 90 days after application is received. If a withholding certificate application has been filed and the sale occurs, the transferee doesn’t have to file the Form 8288 and transfer the withheld amounts until notice has been received from the IRS either granting or denying the certificate (amounts should still be withheld, they don’t need to be transferred to the IRS until a response is received).

  • Ben Briggs

    Briggs Freeman Sotheby's International Realty
    December 12, 2017

    Yes, 1031 exchanges can be very useful for foreign institutional investors. It is most helpful when you sell an asset; the 1031 exchange allows you to buy a new asset without realizing capital gains taxes on the first sale. But you might not want to count on 1031 as the central part of your investment strategy since Trump's 2017 tax reform might eliminate it. As always, this is very important to discuss with your tax advisor so they can ensure the optimal tax strategy for you. I'd be happy to introduce you to solid advisors.