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Are Canadians Eligible To Exchange US Real Estate in a Tax Free Transaction (a Section 1031 Transaction)?

We’ve been on a little bit of a break for the busy “season” of February, March and into April. Let’s also take a break from talking about the FBAR amnesty program (we will return to this topic shortly).

A question we frequently get comes from a Canadian snowbird who owns (for example) a house in La Quinta. The Canadian then wants to sell the La Quinta property, and purchase a Palm Desert property to take its place. Let’s assume, for the sake of discussion, that the La Quinta home the Canadian snowbird is selling has appreciated in value by $500,000 since the snowbird bought the house in 1997 (we will think optimistically).

Question #1- Can our Canadian citizen sell the house in La Quinta (for $500k more than he bought it for) and buy the Palm Desert replacement property without paying any US tax?

The general answer is yes. The nonrecognition provisions of Internal Revenue Code Section 1031 apply to the disposition of a United States real property only if the United States real property is exchanged for other United States real property. But real property located in the United States and foreign real property are not property of like-kind, and therefore do not qualify for Section 1031. So our Canadian snowbird cannot sell the La Quinta house and purchase a Vancouver house and receive Section 1031 nonrecognition treatment.

Question #2- What are the general requirements for a Section 1031 exchange?

In order for a taxpayer (whether American, Canadian, or from any other country) to exchange their property in the US for another property in the US, and not pay tax:

A) The Property must be exchanged for “like-kind” property. “Like-kind” simply means that real property must be exchanged for real property. But Section 1031 also mandates both the relinquished property and the replacement property must be held for productive use in a trade or business or for investment. Thus, the taxpayer cannot exchange into or out of the taxpayer’s own personal residence. Vacation homes may qualify if they are rented out by the taxpayer to unrelated persons, or held primarily for investment rather than personal use. The Canadian snowbird needs to watch this requirement carefully. For example, in the 2007 case of Moore v. CIR, the Tax Court held that an exchange of vacation homes did not qualify for nonrecognition under § 1031(a)(1) because neither home was held for investment: “the mere hope or expectation that property may be sold at a gain cannot establish an investment intent if the taxpayer uses the property as a residence.” Subsequent to the Moore case, the IRS issued Rev. Proc. 2008-16, which provides vacation properties may qualify for a 1031 if:

(a) The dwelling unit is owned by the taxpayer for at least 24 months immediately before the exchange; and
(b) Within the qualifying use period, in each of the two 12-month periods immediately preceding the exchange,
(i) The taxpayer rents the dwelling unit to another person or persons at a fair rental for 14 days or more, and
(ii) The period of the taxpayer’s personal use of the dwelling unit does not exceed the greater of 14 days or 10 percent of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.
In addition, the replacement property must meet the same requirements for the two years after the exchange (i.e., must be rented out and not used too much for personal use). So Canadian snowbirds with a vacation home for(primarily) personal use will have a difficult time taking advantage of Section1031 tax free exchange treatment.

B) It’s not as simple as selling your property one day (let’s assume for a gain), and buying a replacement property down the road, and not paying tax on the gain. First, the replacement property must be identified not later than 45 days after the sale of the first property. What does it mean to indentify a property? You identify a property in writing, giving the writing to an independent party (a qualified intermediary). Second, the replacement property must be received not later than 180 days after the sale.

We’ll pick it up here in our next post, reviewing some examples of how the tax treatment works….

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Sanger & Manes offers world class expertise in estate planning and tax management for international clients who own US assets, with an emphasis on Canadians purchasing vacation homes. Learn more at our website: www.calresidencytaxattorney.com.