Internal Revenue Code (IRC) Section 1031 applies to the citizen or resident of the United States (US) or non-resident alien subject to US federal income taxes. When selling real and personal property held for productive use in a trade, business or for investment, a 1031 exchange allows individuals, partnerships, corporations, limited liability companies and trusts to defer the federal capital gain and recaptured depreciation taxes when selling property held for the proper intent, regardless of where the property is located. Property used predominantly in the US is eligible as replacement property held predominantly in the US, while property located outside the US is eligible for 1031 consideration with property held internationally.
Predominant Use
Examples of foreign 1031 property eligible for a 1031 exchange include aircraft, thoroughbred horses, vessels and ships, physical gold and silver bullion held in international depositories, artwork, collectibles and real property. Personal property used both in the US and outside the US are subject to predominant use rules to determine whether the property is held for productive use inside or outside the US. In the two-year period prior to the disposition and the two-year period post-acquisition, the physical asset’s location of more than 50 percent determines whether the asset is held in the US or outside the US.
IRC § 168(g)(4), which describes property such as aircraft and vessels that are eligible for accelerated depreciation, considers predominant use to be the US given (1) aircraft is registered with the Federal Aviation Administration and operated to and from the US (2) rolling stock, including vehicle, equipment, machinery and railroads that have frequent sales and purchases used both nationally and internationally and (3) vessels operated in foreign or domestic commerce of the US and documented under US laws.
Constructive Receipt
A Person of Indian Origin who either maintains US citizenship or is a non-resident alien and is subject to US federal income taxes can initiate a 1031 exchange to defer their US federal capital gain on investment property held in India. The replacement property can be in India or elsewhere, though not in the US.
The closing process is different in every country. What we consider standard procedure in the US cannot be assumed in other countries. For example, in India, the Buyer typically provides the Seller a check as part of the sale rather than working through escrow, closing attorney or title company. In a 1031 exchange, if the Seller receives a check, the exchange would be invalidated because the taxpayer has access to the cash, violating the (g)(6) constructive receipt requirement. It is critical for the taxpayer to provide the qualified intermediary access to their financial and legal counsel to discuss sovereign closing procedures.
Holding Exchange Funds Locally
Can funds be held locally in the domestic currency rather than holding in a US escrow account? This requires the exchange funds be converted to US Dollars and back to the local currency for the replacement property acquisition, risking loss in a currency exchange. Continuing with the Indian example, Indian banks generally do not have three party accounts between the taxpayer, bank and the qualified intermediary. Whose tax identification number is on the account? Stateside, the taxpayer’s tax identification number is a sub-account under the qualified intermediary’s account number. In India, the taxpayer’s Permanent Account Number, or PAN, is used to establish the account with the requirement that disbursement requires multiple signatures, including one from the taxpayer, qualified intermediary and bank. Once again, working with a Chartered Accountant in India familiar with the Central Bank and local officials is important to secure agreements between participating parties to the 1031 exchange.
Have you reviewed the tax consequences of selling property held abroad and need to engage a qualified intermediary to accommodate a 1031 exchange? Contact our office for a free consultation or to ask a question by clicking on the button below.
