Published on:

Let’s See Some 1031 Tax-Free Exchange Examples for Canadians Swapping Palm Springs Real Estate. Oh Wait, Canadians Can’t Use IRC Section 1031…

So we’re still on a parallel track with our main blog (these will separate again after we complete the FBAR amnesty discussion). We’re talking about when a Canadian snowbird can sell an appreciated property (like a property in Indian Wells that has increased in value) and close to simultaneously buy a new property (our Canadian purchases a Palm Desert property), and not pay any tax on the first sale. This is done under IRC Section 1031. What Canadians should take away from this discussion (and the 2 previous blog entries) is its very unlikely Canadians can use 1031 and get the tax free treatment on the sale of the first property. Why so unlikely? Because Canada does not have a tax provision like 1031. So while the Canadian might be able to exchange a US property he or she is using as a rental property (remember, a vacation house won’t work probably unless the Canadian snowbird uses it no more than 14 days a year) for another US rental property (must be US, can’t be exchanged for a property in another country), and qualify for 1031 on their US tax return, Canada will still tax them immediately upon the sale of the first property. What good are nonrecognition provisions in one country if they are not observed in the other country (and the treaty doesn’t mandate Canada honor US Section 1031)? The answer is: no good at all. Canadians buying property in the US must worry about both how the US and Canada taxes the transaction. Canadians, until your government adopts 1031 (or a provision like it), you cannot utilize the favorable treatment of the IRC Section 1031, even for property exchanges in the US.

The remainder of this entry is copied from our general blog on 1031 examples.

Let’s do some basic (and not so basic) 1031 examples. Again, before we start, remember that in addition to a rising real estate market (no sure thing the last few years, although in the Palm Springs area we might finally be turning the corner), in order to qualify for 1031 you need property either: held for (a) investment or (b) productive use in a trade or business.
Also remember vacation homes are unlikely to qualify as either: held for (a) investment or (b) productive use in a trade or business, unless the owner or the owner’s family uses the vacation house not more than 14 days a year. A property used as rental property will qualify for Section 1031 because the IRS deems rental properties as held for productive use in a trade or business.

Basic 1031 Examples
Here’s a basic example (1): Tom purchases a Palm Desert house in 2001 for $500k. Tom sells it in 2006 for $1,000,000. Shortly thereafter in 2006, Tom purchases an Indian Wells home for $1,000.000. In 2012, Tom sells the Indian Wells home for $1,250,000. Assuming the Section 1031 requirements met, Tom’s taxable income in 2006 is $0, and Tom’s taxable income in 2012 is $750,000.

When the taxpayer receives cash in the transaction, the taxpayer must recognize gain (at least to the extent of the cash received).

Basic example (2): Tom exchanges real estate held for investment (i.e., the general rule is he or his family uses it not more than 2 weeks a year), which he purchased in 2000 for $500,000 which now (in 2012) has a fair market value of $800,000, for other real estate (to be held for productive use in a trade or business) worth $600,000, and $200,000 in cash. The gain from the transaction is $300,000 (Tom bought a property for $500,000 and is now exchanging it for a new property worth $600,000 plus $200,000 in cash), but the $300,000 gain is only recognized to the extent of the cash received: $200,000. Tom must recognize $200,000 in 2012 when he engages in the exchange.

And let’s do one more example (with a little more complexity, including two assets transferred (only one of which qualifies under 1031)), plus the question of what is the basis in the new property:

Basic example (3): In 2007, Tom transfers real estate he used exclusively as a rental property which he purchased in 2002 for $1,000,000 in exchange for other real estate (to be held as rental property) which has a fair market value of $900,000, an automobile which has a fair market value of $200,000, and $150,000 in cash. Tom realizes a gain of $250,000 (bought property in 2002 for $1,000,000 and sold it in 2007 for property plus a car plus cash all worth $1,250,000). Tom must recognize (ie pay tax on) the entire $250,000 gain because he received items other than another real property (the car plus the cash) worth a total of $350,000. The basis of the new rental property received in exchange is the basis of the transferred real estate ($1,000,000) decreased by the amount of money received ($150,000) and increased in the amount of gain that was recognized ($250,000), which results in a basis for the property received of $1,100,000. This basis of $1,100,000 is allocated between the automobile and the real estate received by Tom. The basis of the automobile must remain its fair market value at the date of the exchange- $200,000, with the basis of the real estate received being the remainder: $900,000. So at the end of the transaction, the basis in new property is only $900,000 ($100,000 less than the basis in the old property).

Contact Information