Can Foreign Investors Use 1031 Exchanges?

The Big Picture

Because Section 1031 of the U.S. Tax Code qualifies the property, not the person, foreign investors are not disqualified from using this section of the tax code. In other words, neither the statute nor the attendant regulations restrict eligibility based on citizenship or residence.

Why This Matters

A 1031 exchange is available to foreign sellers of real property held for productive use in a trade or business, or held for investment purposes, as long as the relinquished and replacement properties are located in the United States. IRC §897(e). The foreign exchanger must provide the qualified intermediary (QI) with an IRS Form W8-BEN (in lieu of a Form W-9) that discloses the exchanger’s Individual Tax Identification Number (ITIN). An ITIN can be applied for on IRS Form W-7.

Withholding Requirement. The Foreign Investment in Real Property Tax Act (FIRPTA) requires withholding on dispositions of U.S. real estate by “foreign persons,” defined as non-resident foreign individuals or foreign partnerships, corporations, trusts or estates. (IRC §§861, 871, 882, 897, 6039C, 6652). In accordance with these sections, the buyer must (1) withhold fifteen percent (15%) from the proceeds of the sale of real property if the seller is a foreign person and (2) send the withholding directly to the Internal Revenue Service (IRS) within 20 days of the transaction closing to ensure any taxable gain realized by the foreign seller is paid.

Strategy No. 1: Evaluating Exceptions to the Withholding Requirement

In order to take full advantage of Section 1031, foreign sellers should plan in advance of their sale, and consult with tax, legal, and financial advisors to determine whether they qualify for an exception to the withholding requirement. If the foreign seller waits until the sale is imminent, the ability to defer the tax on the FIRPTA escrowed amount is put at risk. All of the rules of a typical 1031 exchange apply to executing a tax deferred exchange for a foreign seller (i.e. use of a qualified intermediary, complying with the 45-day identification rule, closing on the replacement property within 180 days, applying all proceeds from the sale to the purchase of the replacement property, etc.).

These exceptions include:

1) If the sales price is under $300,000 and the transferee intends to reside in the property, then no withholding is required.

2)  When the foreign seller is executing a simultaneous exchange, then the foreign seller must file a “Declaration and Notice to Complete an Exchange” (1031 Declaration and Notice) which puts the buyer on notice that no withholding will be required. This exception also requires the exchange to be a complete deferral, meaning the foreign entity would receive like-kind property, reinvest all proceeds from the sale, and obtain a mortgage of equal or greater value as to the amount which was paid off on the relinquished property.  The buyer may rely upon the notice unless it has actual knowledge that the facts stated are untrue.  The buyer should check the closing statement to verify that no boot is being received by the seller.

3)  Once the foreign seller has obtained a tax identification number, it can apply for a withholding certificate from the IRS.  If the withholding certificate (IRS Form 8288-B) has been received before the sale of the relinquished property, withholding can be avoided.

Strategy No. 2. Deposit into Exchange Account 

If the foreign seller has not timely obtained a withholding certificate, it can nevertheless replace the escrowed FIRPTA funds with cash from outside of the transaction.  This would allow the exchange to proceed without any tax ramifications.

The Takeaway

While a foreign investor can execute a 1031 exchange of real property, careful tax planning is essential.  Consultation with tax, legal, and financial advisors, along with a qualified intermediary, should be commenced as soon as possible prior to the sale of the property.