Bon Voyage?

Over the last couple of years, several of my friends have become citizens of the country from which their parents emigrated to the U.S.[i]

Also during that period, some acquaintances took advantage of the so-called “golden visa” programs still being offered by a handful of European Union members.[ii]

A few clients gave up their U.S. citizenship, or their status as permanent residents of the U.S. (green card holders), and paid the resulting exit tax.[iii]

However, I have seen many more U.S. individuals acquiring real properties, usually residences, located overseas, often in places with which they have an ethnic or other personal connection, or in which they have conducted business, and which they believe are relatively stable from a political and economic perspective.[iv]

Worldwide Income

Many, if not most, of these folks are aware that, for U.S. tax purposes, a U.S. individual must include in their gross income for a tax year all items of income realized by them during the tax year “from whatever source derived,” which includes income and gain from foreign sources.[v]

For example, a U.S. individual who realizes interest income from obligations of foreign persons, dividends from foreign corporations, gains from the sale of stock of a foreign corporation, compensation for personal services performed overseas, or rents from real property located overseas, must report such foreign source income[vi] on their U.S. federal income tax return.

Real Property

In addition, any gain realized by a U.S. individual from the sale or exchange of real property located overseas must be reported to the IRS on the individual’s federal income tax return for the year in which the gain from the sale is recognized.[vii]

Such gain will likely also be taxable by the foreign jurisdiction in which the real property is located.[viii] In that case, for purposes of determining their U.S. tax liability attributable to such gain, the U.S. individual will generally be able to claim a credit for the foreign income tax paid on the sale.

Surprisingly, however, many U.S. persons who own real property overseas are unaware that the Code’s like kind exchange rules[ix] may afford them the ability to defer recognition of the gain realized on the sale of such foreign property.

Like Kind Exchange

The gain realized from the sale or conversion of property into cash, or from the exchange of property for other property differing materially in kind, is recognized and reported as income.[x]

There are circumstances, however, in which the gain realized from the exchange of real property (the “relinquished property”) for other real property (the “replacement property”) does not have to recognized; instead, the realized gain is preserved,[xi] and its recognition is deferred until such time as the replacement property is sold for cash or is exchanged for property that is not of like kind.

Real Property

For purposes of this rule, the term “real property” generally includes land and improvements to land, such as a building and other “inherently permanent structures.”[xii]

In order for a taxpayer to enjoy the nonrecognition and deferral of gain from the exchange of real properties, certain requirements must be satisfied.

Like Kind

For one thing, the relinquished real property must be of like kind to the replacement real property. Fortunately, the fact that any real estate involved in the exchange is improved or unimproved is not material.[xiii] Thus, an exchange of unimproved land for a building may qualify for the favorable tax treatment because both are treated as real property.

Held For

In addition, the exchanging taxpayer must have held[xiv] the relinquished real property for productive use in a trade or business or for investment, and they must also hold the replacement property for productive use in a trade or business or for investment.[xv]

That is not to say that investment property may only be exchanged for other investment property, and business property for other business property. Instead, real property held for productive use in a trade or business may be exchanged for real property to be held for investment without the recognition of gain; likewise in the case of an exchange of real property held for investment for real property to be held for productive use in a trade or business.[xvi]

It bears noting that the taxpayer who disposes of the relinquished property must also acquire the replacement property. A taxpayer’s acquisition of the replacement property shortly before the exchange, or a taxpayer’s disposition of the replacement property shortly after the exchange, may call into question the taxpayer’s satisfaction of the “held for” requirement.

Held for Sale

That said, not all real property may satisfy the above “held for” requirement. For example, real property that is held primarily for sale will not qualify as either relinquished property or as replacement property for purposes of the like kind exchange rules;[xvii] the exchange of such property will not qualify for like kind exchange treatment.

Indirect Interest

In addition, neither stock in a corporation, nor a partnership interest in a partnership,[xviii] that owns only real property is treated as property that is of like kind to real property for purposes of these rules.

Exchange of U.S. for Foreign

Most interesting for our purposes, real property located in the U.S. and real property located outside the U.S. are not property of a like kind to one another. In other words, a U.S. person cannot defer recognition of the gain realized on the exchange of a U.S. real property for real property located outside the U.S. regardless of whether or not the “held for” requirement was satisfied;[xix] likewise with respect to the exchange of foreign real property for U.S. real property.

Foreign Real Property

However, a U.S. individual may exchange foreign real property for other foreign real property without the recognition of gain, provided the above-described requirements for treatment as a like kind exchange are satisfied.

For example, if a U.S. individual relinquishes a foreign real property they have held for investment in exchange for another foreign real property which they will also hold for investment, the gain realized on the U.S. person’s disposition of the relinquished property will not be recognized for purposes of the U.S. income tax.

The fact that the relinquished and the replacement real properties are located in different countries is not material, as long as the U.S. is not one of those countries.[xx] Thus, a residential rental property on the Aegean (northern) coast of Crete may be exchanged for a residential rental property in the Dolomites of northeastern Italy in a tax-deferred like kind exchange.

However, if the foreign rental property is also used by the U.S. individual personally – for example, as an off-season vacation home – the property may not qualify for tax-deferred exchange treatment unless the taxpayer can establish that their principal purpose for owning the real property is for investment, and also demonstrate that their use of the property is incidental to such principal purpose.

Reality Check

For purposes of illustrating the application of the like kind exchange rules, the foregoing discussion assumed an actual exchange, or direct swap, of real properties of equal value between two parties, each of which owns a real property that is desired by the other.

Direct exchanges, however, rarely occur and the respective values[xxi] of the relinquished and replacement properties rarely line up with one another.

Boot

As a practical matter, the replacement property may reflect a trading up or down in the exchanging taxpayer’s value or equity vis-à-vis the relinquished property.

In order for the exchanging taxpayer to defer all of its realized gain from the sale of their relinquished property, the taxpayer must acquire a replacement property with a fair market value at least equal to the fair market value of the relinquished property, and with a net fair market value – i.e., equity, or fair market value over debt – at least equal to the taxpayer’s equity in the relinquished property.

Any situation in which the exchanging taxpayer ends up with a replacement property that has a lower fair market value than the relinquished property, or in which the taxpayer has less equity than they had in the relinquished real property, would indicate that the taxpayer retained some cash from the sale of the relinquished property or otherwise withdrew equity from the property.

In that case, the exchanging taxpayer is treated as having received not only the like kind replacement real property (which may be received without the recognition of gain), but also other property or money, the receipt of which causes the gain realized by the taxpayer to be recognized, but in an amount not in excess of the sum of such money and the fair market value of such other property.[xxii]

Deferred Exchanges

Most like kind exchanges are deferred exchanges, meaning that the exchanging taxpayer must first sell the relinquished property to generate the funds needed for the acquisition of the replacement property – the acquisition of the replacement property is deferred. Generally speaking, the taxpayer’s relinquished real property is sold by an independent intermediary[xxiii] to a buyer for money, which the intermediary retains[xxiv] until the exchanging taxpayer timely identifies the real property to be acquired as replacement property, at which point the intermediary uses the money in its possession[xxv] to timely purchase such replacement real property, which is then delivered to the exchanging taxpayer to close out the like kind exchange.[xxvi]

In order for the replacement real property to be treated as like kind to the relinquished real property, (a) the replacement property must be properly identified[xxvii] as such on or before the day which is 45 days after the date on which the taxpayer transfers the relinquished property, and (b) the replacement property must be received by the earlier of (i) the day which is 180 days after the date on which the taxpayer transfers the relinquished property, or (ii) the due date (determined with regard to extension) for the taxpayer’s income tax return for the taxable year in which the transfer of the relinquished property occurs.[xxviii]

Other Considerations

Even in a domestic setting, the application of the like kind exchange rules is not always as straightforward as taxpayers and their advisers would like.

The exchange of foreign properties introduces an additional layer of complexity to the transaction. For that reason, it behooves the exchanging taxpayer to retain the services of a reputable qualified intermediary that is experienced in the exchange of foreign properties.

Because the exchange will involve the law of at least one foreign country, perhaps two if the replacement property is in a second foreign country, local real estate counsel must be retained.[xxix]

The U.S. taxpayer may also require the assistance of local brokers and, perhaps, lenders.

What’s more, it may be that the sale of the relinquished foreign real property will generate an income tax liability, and perhaps a transfer tax, in the foreign jurisdiction in which the property is located. The U.S. taxpayer will have to determine how to report the sale to the foreign tax authority and how to fund the payment of any foreign taxes.

Additional U.S. Tax Concerns

If, in connection with the ownership and operation of the foreign investment or business property, the U.S. taxpayer opens an account at a foreign financial institution, they will have to consider their reporting obligations to the U.S.; for example, an annual FBAR filing may be required, as may an annual filing of IRS Form 8938, Statement of Specified Foreign Financial Assets. Other U.S. tax filings may be required if the U.S. taxpayer subsequently, with the assistance of local counsel, contributes their foreign real property to a corporate-like entity that provides a degree of limited liability protection.[xxx]

With the acquisition of one or more foreign real properties, the U.S. taxpayer will also have to consider their exposure to foreign estate taxes and the effect thereof upon the taxpayer’s overall testamentary plan.

I guess every rose has its thorn.[xxxi]

The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.

[i] Many, if not most, of them are either immigrants to the U.S. or only one generation removed from such status. I fall into the latter category.

I will let you speculate as to the reasons these folks and the others described here want to establish a foothold outside the U.S.

[ii] For example, Portugal, Spain, Italy, Greece – the Southern European countries to which the Northern Europeans disparagingly referred as the “PIGS” during the decade or so following the 2008 financial crisis. (I omitted Ireland, which no longer has a golden visa program; with Ireland, the group’s acronym was the PIIGS.)

[iii] IRC Sec. 877A. In general, a “covered expatriate” is treated as having sold all their property for an amount equal to their fair market value. The sale is treated as occurring on the day immediately preceding the expatriation date. Any gain arising from the deemed sale – the deemed realization of gain – is reported on the individual’s “final” U.S. tax return.

[iv] A favorable tax system is another consideration.

[v] IRC Sec. 61.

[vi] IRC Sec. 862.

[vii] In general, when the sale price is actually or constructively received.

[viii] Article 13 of the U.S. Model Treaty provides that gains derived by a resident of a Contracting State from the alienation of real property (immovable property) situated in the other Contracting State may be taxed in that other Contracting State.

[ix] IRC Sec. 1031. It should be noted that like kind exchange treatment is not “voluntary” in the sense that, if an exchange satisfies the requirements set forth in Sec. 1031, recognition of the gain realized in the exchange will be deferred.

[x] Reg. 1.1001-1(a).

[xi] The deferred gain is preserved for later recognition by assigning to the replacement property the same basis as that of the property exchanged (with certain adjustments). IRC Sec. 1031(d). Similarly, the holding period for the replacement property includes the period for which the relinquished property was held by the exchanging taxpayer. IRC Sec. 1223(1).

[xii] Reg. Sec. 1.1031(a)-3.

Certain intangible assets may be treated as real property for purposes of IRC Sec. 1031. Reg. Sec. 1.1031(a)-3(a)(5).

[xiii] Reg. Sec. 1.1031(a)-1(b).

[xiv] There is no prescribed holding period for which a real property must be held for the requisite business or investment purpose. Much depends upon the facts and circumstances; generally speaking, the longer the real property is held, the better. Of course, the taxpayer has the burden of establishing satisfaction of the “held for” requirement.

[xv] IRC Sec. 1031(a)(1).

Special rules apply for exchanges between “related persons,” including a special 2-year post-exchange holding period. IRC Sec. 1031(f).

[xvi] Reg. Sec. 1.1031(a)-1(a)(1).

[xvii] IRC Sec, 1031(a)(2).

[xviii] But see IRC Sec. 1031(e) and IRC Sec. 761(a).

[xix] IRC Sec. 1031(h).

The “United States” is defined to include the States and the District of Columbia. IRC Sec. 7701(a)(9). However, the IRS has also treated the term “United States” as including the U.S. Virgin Islands, under certain conditions, for purposes of the like kind exchange rules. (See IRC Sec. 932 and the regulations issued thereunder.) Interestingly, Puerto Rico is not included.

[xx] IRC Sec. 1031(h).

[xxi] Gross and net.

[xxii] IRC Sec. 1031(b).

[xxiii] A “qualified” intermediary, within the meaning of Reg. Sec. 1.1031(k)-1(g)(4), is not considered the taxpayer’s agent for purposes of IRC Sec. 1031. In this way, the taxpayer is not treated as having received the sale proceeds from the sale of the relinquished property.

[xxiv] In general, the seller must avoid the actual or constructive receipt of these funds until the expiration of the replacement period, failing which the transaction will be treated as a taxable sale. Reg. Sec. 1.1031(k)-1(g)(6).

As regards the issue of receipt of funds by the taxpayer, see Reg. Sec. 1.1031(k)-1(f) and the safe harbors described in Reg. Sec. 1.1031(k)-1(g).

[xxv] Query whether the funds will be held in the currency of the jurisdiction in which the sale occurred, or will be converted to U.S. dollars. This currency exchange may itself present the risk of gain or loss. IRC Sec. 988.

[xxvi] Reg. Sec. 1.1031(k)-1.

[xxvii] Reg. Sec. 1.1031(k)-1(c). Note that, regardless of the number of relinquished properties transferred by the taxpayer as part of the same deferred exchange, the taxpayer may identify up to three replacement properties without regard to their fair market values, or any number of replacement properties as long as their aggregate fair market value does not exceed 200 percent of the aggregate fair market value of all the relinquished properties. Reg. Sec. 1.1031(k)-1(c)(4).

[xxviii] IRC Sec. 1031(a)(3); Reg. Sec. 1.1031(k)-1.

[xxix] The laws of more than two foreign jurisdictions may be implicated if the exchange involves relinquished or replacement properties that are located across three or more foreign countries For example, a U.S. individual sells their London and Paris investment properties in order to acquire a single replacement investment property in Budapest. Alternatively, they sell their single Paris investment property and acquire three replacement investment properties in Prague, Vienna, and Bern. Western Europe isn’t what it used to be.

[xxx] For example, Form 926 in the year of the contribution and Form 5471 annually thereafter.

[xxxi] Or should I say “thorns”?