Section 1031 Like-Kind Exchanges for Canadian Residents
By Samantha Wu
January 25, 2017
When a Canadian-resident seller sells real property in the U.S., he is required to report the sale by filing a tax return (1040NR) to the IRS and paying capital gains tax. Many have heard of “Like-Kind Exchanges” under Section 1031 of the Internal Revenue Code (IRC) as a potential mechanism to defer capital gains tax. However, this mechanism may not be available or advantageous for Canadian taxpayers.
Section 1031 of the IRC provides that when a taxpayer sells U.S. real estate that is held for “productive use in a trade, business, or for investment”, he may exchange it, on a rollover basis, for similar U.S. real estate as long as it is for a productive use. The replacement property must be identified within 45 days of the sale, and the closing must occur within 180 days of the initial sale. For a qualifying transaction, any capital gain or loss on the first property is deferred (note: not avoided) until a future, non like-kind exchange disposition.
Canadian taxpayers must carefully consider the implications of such deferral even if their transactions qualify for a Like-Kind Exchange. As Canadian residents have the obligation to file and report their worldwide income to the CRA, they must report the sale of U.S. property on their Canadian tax returns. Generally, a taxpayer can claim any capital gains tax already paid to the IRS as a foreign tax credit on his Canadian return under the U.S.-Canada Tax Treaty. However, since there is no deferral equivalent to a Section 1031 Exchange under Canada’s Income Tax Act, a Canadian taxpayer must pay capital gains tax to the CRA even though the same tax is deferred on the U.S. side. Furthermore, on a future, non Like-Kind disposition of the U.S. property, capital gains tax becomes due to the IRS, and the Canadian seller is left without the ability to claim the treaty benefit, resulting in the dreaded double taxation.
While there are other methods to defer capital gains tax on the sale of U.S. real estate, they are very limited and complex for Canadian residents. It may be better to satisfy any capital gains tax you owe the IRS at the time of disposition.
If you own U.S. property and have questions about the Like-Kind Exchange or other tax deferral options, please contact us.
