Cross-Border Dimensions

And what happens when the taxpayer is a foreign person, which is answered by a withholding regime that operates on gross proceeds and cares very little about whether the exchange succeeds.

The second question is where transactions are lost, and it turns on a deadline that falls on the closing date itself.

48.1 Section 1031(h) and the domestic-foreign divide

Real property located in the United States and real property located outside the United States are not property of a like kind.¹

The rule is absolute and admits of no exception. It is not a presumption, not a facts and circumstances test, and not subject to a safe harbor. A taxpayer may exchange Maryland farmland for a California apartment building, and may exchange a building in Toronto for a building in Lisbon, but may not exchange the Maryland farmland for either of the latter.

The definition of the United States for this purpose is narrower than most clients assume. The term United States, when used in a geographical sense, includes only the States and the District of Columbia.²

Real property in Puerto Rico, Guam, the United States Virgin Islands, American Samoa, and the Northern Mariana Islands is therefore not United States real property for purposes of the divide, and it cannot be exchanged for property in the fifty States. That result surprises clients, and it should be confirmed before a client is encouraged to look at Caribbean replacement property that happens to fly a United States flag. The territorial question is developed at 48.4.

Two practical points follow.

Both sides of a foreign exchange must be foreign. The rule does not disqualify exchanges of foreign property. A taxpayer holding two properties abroad may exchange one for the other under section 1031, subject to every other requirement in this work, and a taxpayer holding foreign property who wants to reinvest in the United States must accept a taxable sale.

Check the location before the identification. A taxpayer whose relinquished property is domestic and who identifies a foreign property has identified something that cannot be like kind, and under Chapter 25 the identification is not amendable after the forty fifth day.

48.2 Foreign sellers and FIRPTA withholding

Where the taxpayer disposing of United States real property is a foreign person, an entirely separate regime applies and it operates before any exchange analysis is reached.

The substantive rule. Gain or loss of a nonresident alien individual or a foreign corporation from the disposition of a United States real property interest is taken into account as if the taxpayer were engaged in a United States trade or business and the gain were effectively connected with it.³ A United States real property interest means, in relevant part, an interest in real property located in the United States or the Virgin Islands.⁴

The coordination rule limits section 1031 for foreign persons in a way domestic taxpayers never encounter. Except as otherwise provided, a nonrecognition provision applies for purposes of the FIRPTA rules only in the case of an exchange of a United States real property interest for an interest the sale of which would be subject to taxation under chapter 1.⁵

Read with section 1031(h), the result is narrow and clean. A foreign person exchanging United States real property must acquire United States real property. Section 1031(h) already forbids exchanging domestic for foreign; the coordination rule independently denies nonrecognition for FIRPTA purposes unless the replacement interest remains within the United States taxing jurisdiction.

The withholding rule is where transactions actually fail. On any disposition of a United States real property interest by a foreign person, the transferee must deduct and withhold a tax equal to fifteen percent of the amount realized.⁶ The obligation falls on the buyer, it is measured against gross proceeds rather than gain, and it applies whether or not the seller ultimately owes any tax.

Statutory exemptions exist and two matter in residential practice. There is no withholding where the transferor furnishes an affidavit under penalty of perjury stating a United States taxpayer identification number and that the transferor is not a foreign person.⁷ And there is no withholding where the property is acquired by the transferee for use as a residence and the amount realized does not exceed $300,000.⁸ A reduced rate of ten percent applies where the property is acquired for use as a residence, the amount realized does not exceed $1,000,000, and the $300,000 exemption does not apply.⁹

The nonrecognition notice procedure, and why it does not help an exchange. A transferee is not required to withhold if the transferor notifies the transferee, in a prescribed manner, that by reason of a nonrecognition provision or the provisions of a United States treaty the transferor is not required to recognize any gain or loss, and if by the twentieth day after the transfer the transferee mails a copy of the notice to the Service with a cover letter.¹⁰

That procedure is closed to most exchanges by its own terms. A transferee may not rely on it, and must withhold, where the transferor qualifies for nonrecognition with respect to part but not all of the gain, or where the transferee knows or has reason to know the transferor is not entitled to the claimed treatment.¹¹

The regulation then states the exclusion expressly. The notice procedure does not apply to exclusions under section 121, to simultaneous like-kind exchanges that do not qualify for nonrecognition in their entirety, or to non-simultaneous like-kind exchanges where the transferee cannot determine that the exchange has been completed and all conditions for nonrecognition satisfied at the time it is otherwise required to pay the withholding tax and file Form 8288. In those cases the transferee is excused from withholding only upon the timely application for and receipt of a withholding certificate.¹²

An ordinary deferred exchange is a non-simultaneous exchange whose outcome cannot be known at the relinquished property closing. The notice procedure is therefore unavailable as a matter of course, and the withholding certificate is the only route.

The deadline falls on the closing date. A withholding certificate may be requested with respect to a like-kind exchange as a transaction subject to a nonrecognition provision, and the application must include information substantiating the requirements of section 1031. And then the sentence that governs the engagement: in the case of a deferred like-kind exchange, the withholding agent is excused from reporting and paying the withholding tax within twenty days after the transfer only if an application for a withholding certificate is submitted prior to or on the date of transfer.¹³

That is a one day deadline, and it is the second such deadline in this work, alongside the assignment notice of 24.3. An application submitted the week after closing does not preserve the deferral of the withholding obligation. The buyer must withhold fifteen percent of the gross price and remit it within twenty days, and the seller's exchange proceeds are reduced by that amount, which will usually mean the seller cannot acquire replacement property of equal value and will have boot in addition to a refund claim.

The practical sequence for a foreign seller.

Identify the seller's status before the contract is signed, not at the settlement table. A foreign seller changes the timeline for everyone.

Engage the intermediary and prepare the withholding certificate application in parallel, so the application is filed on or before the closing date.

Advise the buyer, in writing, of the withholding obligation and of the effect of the pending application. The obligation is the buyer's, the buyer's counsel will be cautious, and a buyer who withholds notwithstanding a pending application has not done anything wrong.

Where a certificate cannot be obtained in time, model the transaction with fifteen percent of the gross price removed from the exchange account, and tell the client the resulting boot figure before closing rather than after.

48.3 Treaty considerations

A treaty is expressly recognized as a basis for the nonrecognition notice examined at 48.2, which permits the transferor to certify that by reason of a nonrecognition provision or the provisions of any United States treaty no gain or loss is required to be recognized.¹⁴

That recognition should not be mistaken for an opportunity. United States income tax treaties conventionally preserve the taxing right of the country in which immovable property is situated, so a treaty rarely displaces the substantive tax on a direct disposition of United States real property by a resident of the other contracting state. The treaty questions that do arise in practice are generally about entity classification, about which contracting state a person is a resident of, and about the treatment of an interest in an entity holding real property rather than the property itself.

Three disciplines apply to any treaty position.

Read the treaty rather than the model. Provisions on gains from immovable property, on the definition of immovable property, and on interests in entities holding immovable property vary among United States treaties and among their protocols. A conclusion drawn from a model convention is a hypothesis.

Confirm residence and eligibility. Limitation on benefits provisions are a common obstacle, and eligibility is a separate question from residence.

Disclose the position. A taxpayer who takes the position that a treaty overrules or otherwise modifies an internal revenue law must disclose that position on the return, or in the prescribed form where no return is required.¹⁵ A treaty position taken to reduce or eliminate withholding is a treaty-based return position, and the disclosure obligation is separate from the withholding procedure.

The practical instruction is that a treaty claim in a section 1031 context should be developed with counsel experienced in the specific treaty, well before closing, and should not be improvised as an alternative to the withholding certificate application described at 48.2.

48.4 United States territories

The territorial question produces the most counterintuitive result in this chapter, and it arises from a definition rather than from any provision about exchanges.

For the domestic and foreign divide, the territories are foreign. Because the term United States in a geographical sense includes only the States and the District of Columbia,¹⁶ real property in Puerto Rico, Guam, the United States Virgin Islands, American Samoa, and the Northern Mariana Islands is real property located outside the United States for purposes of section 1031(h). It is not of a like kind to property in Maryland, and an exchange between the two fails on the like-kind requirement.

For FIRPTA, the Virgin Islands are inside. A United States real property interest expressly includes an interest in real property located in the United States or the Virgin Islands.¹⁷ That asymmetry is deliberate, it is confined to the FIRPTA definition, and it does not alter the section 1031(h) analysis.

The two rules can therefore operate on the same parcel in opposite directions. Real property in the Virgin Islands is foreign for purposes of what it may be exchanged for, and domestic for purposes of whether a foreign seller's disposition of it is subject to withholding.

Two further cautions.

Territories operate their own income tax systems, several of them mirroring the Internal Revenue Code and others enacting separate codes, and the treatment of an exchange under territorial law is a separate question governed by territorial law and the coordination provisions applicable to that possession. Nothing in this work addresses those systems, and a transaction involving territorial property requires local advice in addition to the federal analysis.

The Puerto Rico opportunity zone designation examined at 47.2 is repealed effective December 31, 2026,¹⁸ which removes what had been the principal federal deferral alternative for Puerto Rico property. A client who cannot exchange territorial property for mainland property, and who previously looked to that regime, should be told that the alternative is closing.

The counsel that closes Part IX. The location of both properties should be confirmed at the engagement, in writing, before any identification is made. It is the cheapest diligence item in an exchange and the only one whose failure cannot be cured by any provision examined in this work.