Tax & Accounting September 08, 2017

Canadians should think twice before using U.S. 1031 exchanges

Just about everyone who deals with U.S. real estate investments hears about “1031 exchanges” at one time or another. For the few who have not, it is, essentially, a mechanism whereby a gain on the sale of real estate may be deferred for tax purposes by acquiring a new property. Canadians investing in U.S. real estate are often intrigued by this concept. The closest thing we have to it would be “replacement property” rollovers[1]. Although the mechanics of a Canadian “replacement property” rollover are far simpler than a 1031 exchange[2], the circumstances under which they are available are far more limited. In general, a “replacement property” rollover is only available with respect to properties that are used in a (non-rental) business or properties that have been the subject of an “involuntary” type disposition, such as an expropriation. The wider scope of 1031 exchanges makes Canadians quite envious! Often Canadians facing a big gain on U.S. real estate will structure a 1031 exchange and just assume that the Canadian tax authorities will respect the deferral of the gain, just like the IRS. Not true! Canada will want tax on the gain when the property is sold, since it would be very rare for a U.S. 1031 exchange to qualify as a “replacement property” rollover in Canada. Furthermore if the gain is ultimately taxed in the U.S. years later when the newly acquired property is sold, it is quite possible that the U.S. taxes payable then will not be fully creditable in Canada because of the fact that the gain for Canadian tax purposes will be much lower than it will be for U.S. tax purposes. Hence, there is potentially an element of double taxation. In contrast, if the property were sold without the 1031 exchange, it would be quite possible that the U.S. taxes would be a “wash” in Canada because they would be fully creditable against the Canadian taxes. Hence the 1031 exchange would achieve nothing. An exception might be where the property is held by a Canadian corporation. Because of the fact that capital gains of a corporation are fully taxed in the U.S., the U.S. tax rate could be much higher than the Canadian tax rate and there would be some substantial (net) tax savings achieved from a global perspective. In an extreme case, the U.S. federal tax rate on the gain could be as high as 35%[3], whereas the rate in Canada could be as low as 12.5%[4].  However, one would have to consider what would happen when the new property is sold in the future. The gain for U.S. tax purposes will be higher than for Canadian tax purposes and the potential for foreign tax credit will thereby be reduced. The tax deferral may not be worth the potential for double tax. On the other hand, if corporate tax rates in the U.S. really are substantially reduced in the future, as a result of Trump’s proposals or otherwise, the 1031 exchange could still turn out to be a winning strategy. What about a situation where the U.S. real estate is held in a controlled U.S. corporation? Here again, I find Canadian shareholders often fail to “look before they leap” and use a 1031 exchange when selling corporate property. If the capital gain resulting from the sale results in “foreign accrual property income” (“FAPI”), the tax deferral in the U.S. will come, to a certain extent, at the expense of higher Canadian taxes at the shareholder level. This is because there will be no “foreign accrual tax” available to offset the inclusion in income of FAPI. (This article was originally posted in Michael Atlas’ Canadian International Tax Blog) [1] Under section 44 of the Income Tax Act (“the Act”) [2] In Canada no actual “exchange” is required. There is only a requirement to acquire a replacement within a certain period of time. [3] Plus, potentially “branch profits tax”, under section 884(a) of the IRC, of 5% of the remaining 65%, bringing total to 38.25%. In addition, state taxes could also apply. [4] If earned by a corporation that is not a “Canadian-controlled private corporation”.
Michael Atlas
Toronto -based Chartered Professional Accountant
Michael Atlas is a Toronto-based CPA who is an independent consultant on high-level Canadian tax matters, with particular emphasis on international tax issues. 
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