Under the provisions of Code Section 1031, a taxpayer may sell U.S. real estate at a profit and defer paying tax on that profit by replacing it with the purchase of another property. There are specific provisions which must be met in order for the transaction to qualify for tax-deferred treatment that are beyond the scope of this article.
Many foreign nationals own U.S. real estate. Assuming they meet all the provisions to qualify for the deferral of tax under the like-kind exchange rules, there is nothing in the code that disqualifies foreign nationals from taking advantage of this provision simply because they are taxed as nonresidents in the U.S.
U.S. income tax residents are generally only subject to U.S. tax on the sale of U.S. real estate. Therefore, under the proper circumstances, deferral of U.S. income tax on the sale of appreciated real estate could be a significant tax benefit.
Nonresidents of the U.S. may be subject to reporting the sale of the U.S. property not only in the U.S., but also in their home countries, as many countries tax their residents based on a worldwide income basis. The ability to defer paying tax in the U.S. may not benefit nonresidents if they are unable to also defer paying the tax on the sale in their home country.
Under the section 1031 like-kind exchange rules, if a taxpayer sells appreciated property and then replaces it with property of a higher value, the entire tax on the profit on sale can be deferred until the sale of the replacement property. While nonresidents could defer paying U.S. income tax on the sale, it is unlikely that their home country would afford them this benefit. They could have a deferral of income tax in the U.S., but no deferral of income tax in their home country. They would lose the benefit of taking a tax credit for U.S. taxes paid to reduce the taxes payable in their home country. At the subsequent sale of the replacement property, U.S. tax would no longer be deferred and tax would be due on the profit on the first property and the replacement property, if applicable. The home country would only tax the sale of the replacement property, as the tax on the sale of the first property would have already been subjected to tax in the year of sale. While the U.S. income tax rates are frequently lower than the tax rates in other countries, deferring the tax until the replacement property is sold could result in a higher tax than the tax payable in the home country and the nonresident might not be able to take full advantage of the tax credit provisions.
Another consideration of nonresidents in reporting the sale of U.S. property in their home country is the difference in exchange rates of the U.S. dollar and the currency of their home country at the times of purchase and sale of the property. The fluctuations in the exchange rate could result in a significant difference in the profit reported for U.S. purposes and for home country purposes.
Nonresidents should weigh all the factors in deciding whether or not the like-kind exchange provisions would provide a benefit to them, not just from a U.S. tax standpoint, but also from a home country tax standpoint.