What is a “like-kind” Exchange
In the United States, there are many ways to defer taxes resulting from a property sale. A common method is to undertake what is generally referred to as a “like-kind” exchange or a 1031 exchange. In simple terms, under section 1031 of the American Internal Revenue Code (“IRC”), property owners may sell property such as investment property without paying capital gains. This type of exchange can only be made with like-kind property, hence the name. To benefit from this type of exchange, the proceeds from the sale of the property must be reinvested within a certain time frame in multiple or a single property of like-kind and equal or greater value.
Time frame and qualified intermediaries
Under Section 1031 of the IRC, the proceeds resulting from the sale of property such as investment property are taxable. Consequently, to defer the capital gains, the proceeds must be immediately transferred to a qualified intermediary. The latter then transfer the proceeds to the purchased property that is said to be replacing the sold property. In other words, the seller trying to benefit from the 1031 exchange will never possess the sale proceeds.
To benefit from the exchange, the delay in which you acquire the replacement property is significant. Firstly, the seller must identify a replacement property within 45 days of the sale. Secondly, the exchange must be concluded with 180 days of the sale. In the event replacement property is not found within the prescribed time limits, the seller is not penalized. However, he will have to pay the amount of capital gains attributed to the sale.
Reasons to undertake a like-kind exchange
There are numerous reasons to undertake a like-king exchange, notably:
I. The property you want to exchange for has better returns;
III. You want a property that is managed by a company.
The benefits of undertaking the exchange are evident; you can defer the capital gains tax resulting from the sale. In turn, this allows you to have more available capital for investment purposes. Thus, you can buy a better investment without having to pay taxes.
Consider the following example illustrating the benefits for an American citizen and resident
Marco owns a rental property in Fort-Lauderdale, Florida. He purchased the property for USD 400,000. He decided he wants to sell his condo and purchase another rental condo that will give him high monthly returns. . Using a Qualified Intermediary, he sells the Fort-Lauderdale property for USD 700,000. He begins his search for a new rental condo. During his search, the intermediary will keep the proceeds in an escrow account. After two weeks, Marco has found a replacement property valued at USD 1,000,000,
In this example, Marco will be able to defer the taxes attributed with the sale. As opposed to incurring approximately $150,000 of capital gains that he will have to add to his taxable income at the end of the year, he can defer it. Thus, by undertaking a like-kind exchange, he can use the otherwise taxable amount of $150,000 to invest in another property of equal or greater value.
Canadians selling U.S. property
If certain conditions are met, Canadians selling US real estate can benefit from a 1031 exchange. However, if not carefully planned, the incongruity between Canadian and American tax rules can create devastating tax consequences for such transactions.
The difference in rules
Under Section 1031 of the IRC, Canadians who own rental property in the U.S are entitled to defer the capitals gains associated with the replacement of like-kind property if the aforementioned conditions applicable to American citizens are met. However, because they are Canadians citizens, they must respect the rules prescribed in the Canadian Income tax Act (“ITA”) as well.
Canadian taxpayers may defer capital gains resulting from the replacement of property under section 44 of the ITA. Amongst other types of property, Section 44 applies to property that was real estate used by the taxpayer primarily for earning income from a business. However, rental property is specifically excluded. Furthermore, to defer the capitals gains resulting from a sale, the replacement property must:
be acquired in order to replace the previous property and be used for the same purpose; and
the purchase of the replacement property occurred within a delay of one year following the end of the tax year in which the first property was sold by the taxpayer.
As evidenced above, the Canadian property replacement rules are much stricter than their American counterparts. As a result, the Canadian citizens who own rental property in the United-States is in a very particular situation. Under Section 1031 of the IRC, they are entitled to benefit from the replacement property rules. However, the same cannot be said about their tax liability resulting from the sale in Canada. Because the property was a rental property, Section 44 of the ITA will not apply. Consequently, he will not be eligible to benefit from the Canadian replacement property rules.
Consequences of the transaction
The current foreign tax credit regime in Canada tries to protect its citizens from double taxation. The capital gains liability owed to the American tax authorities from most transactions can be claimed as a foreign tax credit in Canada. Consequently, Canadians may apply foreign tax credit towards their Canadian capital gains tax. Thus, the Canadian resident will end up paying the highest of the two capital gains taxes instead of the sum of both.
Unfortunately, the discrepancy between the Canadian and American replacement property rules make it impossible for a Canadian citizen to be exempt from being double taxes.
In our previous example, if Marco were a Canadian citizen and resident, the conditions of Section 1031 of the IRC would have been met. Thus, no tax attributed to the sale will be due in the US. However, Section 44 of the ITA would not have been met since rental property is not included in the definition of former business property. This would result in Marco’s ineligibility to claim foreign tax credit under Section 126 of the ITA. Thus, Marco would be subject to the full amount of Canadian tax on the transaction.
Furthermore, because Section 1031 is only a deferral of the taxes attributed to the sale, once Marco’s sells the replacement property, he will be subject to U.s tax.
Lastly, because Marco will not be granted a foreign tax credit under section 126 of the ITA, he will inevitably double taxed.
A 1031 exchange can be a viable and highly profitable transaction for Americans. It allows Americans to defer capital gains on the sale of U.S. real estate. Unfortunately, Canada's tax authorities have made it difficult for the same benefits to applying to Canadian residents. A Canadian selling US rental property will seldomly benefit from replacement property rules. Nevertheless, depending on the situation at hand, there can be other options to help limit a Canadian resident's tax liability selling U.S. real estate. At Meditax, our experienced lawyers and tax specialists can help evaluate your situations' particulars and assist you when selling U.S. real estate.