FIRPTA Tax Blog
By Michael W. Brooks, Esq.
As with US persons, non-US persons and parties (“Foreign Investors”) are allowed to enter into Internal Revenue Code Section 1031 (like-kind exchange) transactions. Foreign Investor exchanges allow owners of investment and business real estate to delay paying income tax on the appreciation of the property being sold (the “relinquished property”), provided the owner identifies a “replacement property” within 45 days of the sale of the relinquished property, and completes the purchase of the replacement property within 180 days of the sale of the relinquished property. This allows the person (even a Foreign Investor) to avoid paying the US (and California) tax on the sale of the relinquished property, but the investor will carry a lower basis from the relinquished property into the replacement property.
Take the example of a Chinese person who purchases an investment property (used as a rental property) in Irvine for $1,000,000. Three years after the purchase, the value of the Irvine property rises, and the Chinese person receives an offer to purchase the Irvine property for $1.5M. If the Chinese investor were to sell the property and not enter into a 1031 transaction, the investor might owe around $60,000 in tax to the IRS ($500,000 gain minus (say) $100,000 in realtor fees= $400,000 gain; $400,000 x 15% (federal capital gains tax rate)= $60,000 in tax owed to the IRS). The investor might also owe a tax to the State of California under this scenario, perhaps around $36,000 ($400,000 x 9% (average California tax rate)= $36,000). So in this case, our Chinese person will owe around $96,000 in total taxes on the sale if he does not take some action. So what can he do to at least delay paying the $96,000 total tax on the sale? As long as he is willing to purchase another parcel of California real estate in the next 180 days the answer is simple- enter into a valid 1031 transaction. So to complete the example, let’s assume our Chinese person, within 45 days of the sale, identifies a Newport Beach property he wishes to buy (and again rent out) for $1.5M. Provided he completes the purchase of the Newport Beach property (the “replacement property”) within 180 days of the sale of the Irvine property (the “relinquished property”), our Chinese investor can delay paying any of the $96,000 in total tax pursuant to Internal Revenue Code Section 1031. In three years however, when our Chinese investor sells the Newport Beach property for $2M, he will owe probably $200,000 in total tax to the IRS and California (i.e., he must then pay the tax on the gain from the sale of both properties…but at least he was able to delay the tax on the sale of the Irvine property for three years because of Internal Revenue Code Section 1031).
Some final thoughts on Foreign Investors entering into like-kind exchange transactions: First, the properties involved (both the relinquished property and the replacement property) must be used for business or investment (so it will probably be impossible for the Chinese investor to enter into a valid like-kind exchange transaction if either of the properties are being used for the Chinese person’s daughter to go to college in the United States- that’s not used for business or investment). Second, the replacement property must be in the United States- purchasing a replacement property in Canada or China (or any other country other than the US) will not qualify under IRC Section 1031. Finally, the purchase of a business or investment property in a state other than California will qualify as a like-kind exchange transaction for both the IRS and State of California, but if the Foreign Investor purchases a replacement property in another state, the individual will have to file an annual informational return with California to keep them up to date on when the replacement property is sold (so California knows when to impose its tax on the sale of the relinquished property).
In Part 2, we will discuss what happens to the non-US seller IRS 15% withholding tax when a Foreign Investor enters into a like-kind exchange transaction.