Section 1031 Exchanges: Potentially Great for Americans, Not So Much for Canadians When Selling US Real Estate

What is a 1031 or “Like-Kind” Exchange

A Section 1031 Exchange—named after the Internal Revenue Code section that established it—is a way in which the owner of US real estate can defer the capital gains tax owed on the sale of the property. Almost any type of real property, other than a person’s primary residence, can qualify for this tax-deferred exchange. A 1031 Exchange is accomplished when a property owner sells his or her US real estate through a Qualified Intermediary and purchases a replacement property through that QI within 180 days of closing.

An Example of a 1031 Exchange

Alice owns a rental property in Hallandale, Florida that she purchased in 2009 for $1,000,000 USD. She wants to sell and invest in a new rental condo that is right on the beach. Using a Qualified Intermediary, she sells the Hallandale property for $1,330,000 USD and begins her search for a new rental condo. The Qualified Intermediary will keep those sale proceeds in an escrow account to be used on the new purchase—it is important that Alice never handles this money. Within forty-five days, Alice has identified the perfect new condo listed at $1,500,000 USD; she completes her purchase within just a few months.

In this example, Alice will have effectively deferred approximately $50,000 in capital gains taxes just by using a 1031 exchange!

A Few Points

It is worth highlighting that if Alice is unable to find an adequate replacement property or do so within the time restrictions of a 1031 Exchange, there is no additional penalty. Alice will only be liable for the capital gains taxes just as if she had not used a Qualified Intermediary from the beginning.

Of course it is important to note too that there are a few additional rules along the way about how and when to identify replacement property and what property will qualify with which your Qualified Intermediary will be able to assist you. It is valuable to find a Qualified Intermediary who is experienced and communicative. When searching for the right Qualified Intermediary, a prospective seller should look at whether the company has been in business for a long time, has a good reputation, and has any additional intangibles (such as having an experienced attorney on staff).

It Is Hard for Canadians to Make a Section 1031 Exchange

1031 Exchanges are not restricted to US sellers. Canadians who sell US real estate can under certain conditions make a 1031 Exchange. However, these conditions are exceedingly restrictive due to requirements imposed by Canadian tax law.

When a Canadian realizes a capital gain on the sale of US real estate, this gain is subject to tax in both the United States and Canada. Tax paid in the US on a capital gain can be claimed as foreign tax credit in Canada to be applied against Canadian capital gains tax. The net result is that a Canadian seller pays the highest of US and Canadian tax instead of paying the sum of the US tax and the Canadian tax.

One of the difficulties of the foreign tax credit system is that a foreign tax credit can only be claimed when the sale of US real estate is recognized in Canada and the US at the same time. In most instances, a deferral of capital gains tax in a 1031 Exchange only occurs in the US. Canada will not recognize the deferral unless the exchange meets the conditions of Section 44 of the Canadian Income Tax Act (“ITA”).

Section 44 of the ITA provides for an election for the deferral of capital gains on the sale of a “former business property”: capital property that was primarily used to earn business income. There are three (3) requirements for a sale of US real estate to meet the conditions of Section 44 of the ITA:

1.  The sold property must be former business property. Rental property is excluded from the definition of former business property.
2. It must be reasonable to conclude that the replacement property will be acquired to replace the old property for the same purpose.
3. The purchase of the replacement occurs within one year after the end of the tax year in which the old property was sold.

In our previous example, if Alice was a Canadian citizen and resident, she would not have met the conditions of Section 44 of the ITA because rental property does not fall within the definition of former business property. It therefore does not qualify for a deferral of tax in Canada.

Alice will be required to pay tax multiple times. She will first pay tax in Canada on the sale of her old rental property, but no tax will be due in the US. Since no US tax was paid, Alice cannot claim any foreign tax credits in Canada on the sale of the property. Upon the later sale of the replacement rental property, Alice will pay tax in both the US and in Canada, and she cannot claim a foreign tax credit for the Canadian tax paid on the sale of the old rental property.

Conclusion

A 1031 Exchange can be a great way for Americans to defer capital gains tax on the sale of US real estate. It is however not usually so great for Canadians selling US real estate. A Canadian selling US real estate can only fully benefit from a 1031 Exchange in rare circumstances. If you own a US vacation property or rental property and are thinking of selling it, our team can advise and assist you with all components of the sale of your property.