Can Foreign Investors Use a 1031 Exchange?

Yes. A foreign investor can generally use a Section 1031 exchange to defer gain when selling qualifying U.S. investment or business real estate and acquiring other qualifying U.S. real estate.

Citizenship and U.S. residency are not the deciding factors. The property, transaction structure, ownership, and deadlines are.

But a foreign investor has an additional problem that a domestic investor may not face: FIRPTA withholding. Unless that withholding is addressed before the sale, part of the exchange proceeds may be held back even when the transaction is intended to qualify for full tax deferral.

A successful exchange therefore requires more than selecting a replacement property. The qualified intermediary, FIRPTA strategy, entity structure, state filings, and home-country tax consequences must work together.

What a 1031 Exchange Actually Does

Section 1031 allows an investor to defer, not permanently eliminate, taxable gain when qualifying real property is exchanged for other qualifying real property.

The deferred gain generally carries into the replacement property through a reduced tax basis. When the replacement property is eventually sold in a taxable transaction, the deferred gain may become taxable unless another qualifying exchange or other tax provision applies.

The relinquished and replacement properties must be held for investment or productive use in a trade or business. Property held primarily for sale, such as dealer inventory, does not qualify. A personal residence also does not qualify merely because it is real estate, although mixed-use and converted properties require a separate analysis.

The Replacement Property Must Also Be in the United States

This is the first major limitation for an international investor.

U.S. real property is not like-kind to real property located outside the United States. A foreign investor cannot sell an apartment building in California and acquire property in Canada, the United Kingdom, France, or another foreign country through the same Section 1031 exchange.

The replacement property must generally be U.S. real property. Within the United States, the like-kind standard is broad. An apartment building may generally be exchanged for commercial property, undeveloped land, or another form of qualifying investment real estate.

The Exchange Must Be Established Before the Sale Closes

In a typical deferred exchange, the seller cannot receive or control the sale proceeds.

A qualified intermediary must be engaged before the relinquished property closes. The sale proceeds are transferred to the intermediary and later used to acquire the replacement property.

Hiring an intermediary after the seller has received the proceeds does not repair the transaction. By then, the sale generally has occurred and the opportunity for a conventional deferred exchange has been lost.

Foreign investors should also confirm which taxpayer owns the relinquished property. Generally, the taxpayer selling the old property must be the taxpayer acquiring the replacement property. Last-minute transfers between an individual, partnership, corporation, trust, or LLC can jeopardize the exchange.

Certain disregarded entities may provide flexibility, but ownership changes should be reviewed before signing closing documents.

The 45-Day and 180-Day Deadlines Are Firm

After the relinquished property is transferred, two deadlines begin running:

• The investor has 45 days to identify the potential replacement property in writing.
• The investor generally has 180 days to acquire the replacement property.

The 180-day deadline is actually the earlier of 180 days after the transfer or the due date, including extensions, of the investor’s federal income-tax return for the year of the sale. If the normal return deadline would arrive first, an extension may be necessary to preserve the full exchange period.

Weekends, holidays, travel, financing problems, and delays in moving money internationally do not ordinarily extend these deadlines.

The replacement-property identification must also satisfy specific rules. Merely discussing a property with a broker or intending to make an offer is not enough.

Full Deferral Requires More Than Meeting the Deadlines

Meeting the 45-day and 180-day requirements does not automatically mean that all gain is deferred.

For full deferral, the investor generally must:

• Acquire qualifying replacement real estate.
• Reinvest all net exchange proceeds.
• Acquire replacement property of equal or greater value.
• Address any reduction in debt with additional cash or other qualifying consideration.
• Avoid receiving cash or other nonqualifying property from the exchange.

Cash, debt relief, or other property received by the investor is commonly called “boot.” Boot may cause gain to be recognized even though the rest of the transaction qualifies under Section 1031.

This calculation should be completed before the replacement property is selected. Waiting until the closing statement is prepared can leave the investor with an unexpected taxable gain.

FIRPTA Does Not Automatically Disappear

When a foreign person sells a U.S. real property interest, FIRPTA generally requires the buyer to withhold 15% of the amount realized.

A planned 1031 exchange does not automatically turn off that withholding requirement.

If the transaction is expected to qualify for nonrecognition, the foreign seller may apply for an IRS withholding certificate using Form 8288-B. The application may request reduced or eliminated withholding based on the expected Section 1031 treatment or the seller’s maximum anticipated federal tax liability.

The application requires transaction-specific information, including the buyer’s name and taxpayer-identification number. It therefore generally cannot be filed simply because the property has been listed for sale.

The practical sequence is:

• Plan the exchange and FIRPTA position before accepting an offer.
• Engage the qualified intermediary before closing.
• Obtain the signed contract and required buyer information.
• Prepare and submit the withholding-certificate application as early as possible and no later than the transfer date.
• Notify the buyer in writing that the application has been submitted.
• Coordinate the pending application with the buyer, intermediary, and escrow company.

The IRS states that it will normally act within 90 days after receiving all information necessary to make a proper determination. That is not a guaranteed 90-day turnaround from the day an incomplete application is mailed.

If the IRS has not acted by closing, the buyer generally must still withhold the applicable amount. However, when the application was submitted by the transfer date, the withheld amount generally does not have to be remitted to the IRS until after the IRS issues its determination.

The funds may remain tied up while the application is pending. That can reduce the cash available for the replacement purchase and may create partial-recognition or financing problems if the exchange was not structured around it.

Do Not Rely on a Tax Treaty to Solve FIRPTA

Most U.S. income-tax treaties preserve the United States’ ability to tax gains from U.S. real estate. A treaty should not be assumed to eliminate FIRPTA or the underlying U.S. tax.

The more important treaty and foreign-tax question is whether the investor’s home country will also tax the sale, and whether it recognizes the U.S. Section 1031 deferral.

Some countries may treat the original sale as currently taxable even though the United States defers the gain. That can create:

• Tax due in the investor’s home country during the exchange year.
• A mismatch between U.S. and foreign tax basis.
• Foreign-tax-credit timing problems.
• Different taxable results when the replacement property is later sold.

The home-country treatment should be reviewed before the investor commits to the exchange.

California Continues Tracking Its Deferred Gain

California generally follows the federal Section 1031 rules for qualifying real-property exchanges. But California does not relinquish its claim to deferred gain merely because the replacement property is located in another state.

When California real estate is exchanged for out-of-state property, the taxpayer generally must report the exchange on Form FTB 3840. That form is normally required for the year of the exchange and every subsequent year until the deferred California-source gain or loss is recognized.

The filing obligation can continue even if:

• The investor lives outside California.
• The investor lives outside the United States.
• The out-of-state replacement property is later exchanged again.
• The investor otherwise has no California filing requirement.

When the replacement property is ultimately sold in a taxable transaction, California may tax the deferred California-source gain.

California real-estate withholding under Form 593 must also be coordinated separately. Federal FIRPTA planning does not automatically resolve California withholding.

The Ownership Structure Still Matters

Foreign investors commonly own U.S. real estate through an individual LLC, partnership, domestic corporation, foreign corporation, trust, or another structure.

That structure can affect:

• Which taxpayer must complete the exchange.
• Whether a proposed ownership change disrupts continuity.
• FIRPTA withholding and reporting.
• Federal and state tax rates.
• Partnership withholding.
• U.S. estate-tax exposure.
• Future distributions or property sales.
• The investor’s home-country tax treatment.

A 1031 exchange can defer income tax without solving, and sometimes while preserving, other structural problems. The exchange should therefore be reviewed as part of the investor’s broader U.S. ownership plan.

A Foreign Investor’s Pre-Closing Checklist

Before the relinquished property closes, confirm:

• The property was held for investment or business use.
• The replacement property will be located in the United States.
• A qualified intermediary has been engaged.
• The correct taxpayer will sell and acquire the properties.
• The 45-day and 180-day deadlines have been calendared.
• The replacement-property value, equity, and debt requirements have been modeled.
• FIRPTA withholding has been quantified.
• The Form 8288-B strategy and buyer-information requirements have been addressed.
• Federal and state taxpayer-identification numbers are available.
• California withholding and Form FTB 3840 obligations have been reviewed.
• The home country’s treatment of the sale and exchange has been analyzed.
• The replacement ownership structure has been evaluated for income and estate-tax consequences.

The Bottom Line

Foreign investors can use Section 1031, but eligibility is the easy part.

The harder task is coordinating the exchange before closing so that FIRPTA withholding, entity ownership, replacement financing, state reporting, and home-country taxation do not undermine the intended result.

If the sale closes before those issues are addressed, some of the best planning options may already be gone.

This article is for general informational purposes only and does not constitute tax, legal, or investment advice. Section 1031 eligibility and withholding requirements depend on the ownership, use, structure, and timing of each transaction.