The 1031 Exchange: Deferring Tax on a Sale and Reinvestment - Is It Relevant for an Israeli Resident?

1What is a 1031 Exchange?

A 1031 exchange is the swap of one investment property for another investment property, in which the capital gain on the sale of the first property is not subject to federal tax in that year but is deferred. The gain is not erased: it “moves” to the new property through its tax basis, and will be taxed when the new property is sold in a transaction that is not an exchange.

According to the instructions for Form 8824 of the US Internal Revenue Service (IRS), since 2018 the exchange applies only to real property held for use in a business or for investment, and not to property held primarily for sale - that is, not to a “buy-renovate-sell” project or to units that a developer builds for sale. The definition of “like-kind” is broad: a rental apartment can be exchanged for a commercial building or for investment land. But real property in the US and real property outside the US are not like-kind, so you cannot sell a property in Florida and acquire a property in Romania or Israel under Section 1031.

2What are the deadlines, and how do you identify a replacement property?

The deadlines are strict and cannot be extended: 45 days from the transfer of the property sold to identify the replacement property in writing, and 180 days to receive it - or the due date of the tax return for that year including extensions, whichever is earlier. A sale late in the year may shorten the actual period if you do not request an extension to file the return.

The identification must be in a signed document, with a clear description of the property - an address, a legal description or an identifying name. The regulations limit the number of properties that may be identified, so it is important to choose one of the following methods in advance:

3Why do you need a Qualified Intermediary?

Because if the sale proceeds reach your hands, or you have the right to receive them, the exchange fails and the gain is taxable. In a deferred exchange, the qualified intermediary holds the sale proceeds and uses them to acquire the replacement property, so that the transaction counts as an exchange and not as a separate sale and purchase.

A point that Israeli investors do not always know: under the 1031 regulations, anyone who served as your attorney, accountant, broker, investment banker or employee during the two years before the transfer of the property is a “disqualified person” and cannot serve as the qualified intermediary. The exception is someone who provided only services related to 1031 exchanges themselves, or routine escrow, trust and title insurance services of a financial institution or an insurance company. Related parties are also disqualified. In other words, your regular lawyer in Israel or in the US cannot hold the funds.

4What is Boot, and when do you still pay tax?

Boot is anything received in the transaction that is not like-kind real property - mainly cash. According to the instructions for Form 8824, gain is recognized for tax purposes up to the amount of the cash and other property received.

• Cash left aside - if the replacement property is cheaper than the property sold and the balance returns to you, the balance is taxed.
• Reduction in debt - if the mortgage on the new property is lower than the mortgage that was repaid and the gap was not made up with equity, the difference may be treated as Boot.
• Non-transaction expenses - some payments at closing that are not transaction costs may be treated as Boot.
• Related party - in an exchange with a related party, if either party sells the property it received within two years, the deferred gain may be recognized, subject to exceptions.

5Can a foreigner carry out a 1031 exchange, and what happens with FIRPTA?

Yes. Section 1031 is not limited to US citizens or residents. But in a sale by a foreign seller, the FIRPTA law comes into the picture: according to the IRS, the buyer is generally required to withhold 15% of the proceeds on a sale by a foreigner and remit it to the tax authority, even if the actual tax is much lower.

In a 1031 exchange this withholding can derail the plan, because 15% of the proceeds will not reach the qualified intermediary. The main options are an application for a withholding reduction certificate (Form 8288-B), which is filed before the sale or at the time of the sale, and, in limited cases, a notice of non-recognition (exempt transaction), which according to professional guides is suited mainly to a same-day exchange with no Boot received. When an application for a certificate is filed, the funds are usually held by the closing agent until a decision is issued. The technical details here should be checked with a US tax adviser before signing the sale contract.

6Does a 1031 Exchange save tax for an Israeli resident?

Not necessarily, and sometimes it may even create double taxation. An Israeli resident is subject to tax in Israel on capital gains from assets outside Israel. Real property abroad is not a “right in real property” under the Israeli Land Taxation Law, so its sale is taxed as the sale of an “asset” under the Israeli Income Tax Ordinance, at a rate of up to 25% of the real gain (with a linear calculation for the period before 2011), and a report to the assessing officer is required within 30 days of the date of sale.

As far as we are aware, Israeli law does not include a general provision recognizing tax deferral under Section 1031. If so, the sale of the first property will create a tax event in Israel, while in the US no tax will be paid that year - so there will be no foreign tax to credit against the Israeli tax. When the replacement property is sold years later, the US will tax the accumulated gain of both properties, while in Israel the gain at that time will be calculated according to the cost of the new property. A foreign tax credit in Israel is, as a rule, limited to the Israeli tax on the same income, so part of the US tax may go uncredited.

7When might 1031 still be relevant for an Israeli investor?

There are situations in which the calculation is different, and it is worth checking them with a tax adviser before ruling out the tool:

• New immigrants and long-term returning residents - Israeli law grants them, subject to conditions and for a limited period, an exemption from tax on income and gains arising outside Israel. During the exemption period Israeli tax does not apply to the sale, and the US tax deferral is a relatively clean advantage.
• Someone planning to sever Israeli tax residency - the analysis changes, but severing residency involves its own rules, and it is not a decision made for the sake of a single real estate transaction.
• US citizens living in Israel - they are taxed in the US in any case, and the considerations involve both tax systems at once.
• Holding through a corporation - when the property is held in an entity taxed as a company, the exchange is carried out at the entity level, and the consequences in Israel depend on the structure and on the rules that apply to holding a foreign company. This is an area that requires advance planning and not a decision on the day of the sale.

8The steps of a 1031 exchange for a foreign investor

1. Preliminary tax analysis in both countries: is the US deferral worth the mismatch in Israel.
2. Choosing a qualified intermediary who is not a disqualified person, and signing the exchange agreement before the sale closes.
3. Handling FIRPTA withholding: filing an application for a reduction or exemption certificate, and coordinating with the closing company on holding the funds.
4. Adding a 1031 cooperation clause to the sale contract and to the purchase contract.
5. Identifying the replacement property in writing within 45 days, under one of the identification rules.
6. Full due diligence on the replacement property - quickly, but without giving up the review of title, structure and tenants.
7. Completing the purchase within 180 days, by the same entity that sold, investing all of the proceeds and replacing the debt.
8. Reporting on Form 8824 in the US, and reporting the sale in Israel within 30 days, in accordance with advice.

9What to do before signing, and how we accompany you

A 1031 exchange sounds like an obvious solution, but for an Israeli resident it is a question of fit between two tax systems. The decision must be made before signing the sale contract, because after it most options are already closed: the intermediary, the handling of FIRPTA, and the identification dates. We bring together the full picture with tax advisers in Israel and in the US, manage the documents and the timetable, and examine the replacement property at a level of scrutiny that does not compromise because of the 45-day clock.

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The information in this guide is general in nature and does not constitute legal or tax advice on any specific transaction. Every transaction is assessed on its own facts.