The 1031 exchange (like-kind exchange) is a widely used tax-deferral tool among U.S. real estate investors, and many people wonder whether it’s available to a nonresident alien, such as a Japanese resident. The short answer is yes, nonresident aliens can use a 1031 exchange — but there are a few pitfalls unique to nonresidents. We cover the basic mechanics of 1031 exchanges in a separate article; this one focuses specifically on the issues that come up for nonresidents.
Nonresidents Can Use a 1031 Exchange
Internal Revenue Code Section 1031 has no residency or citizenship requirement. As long as you sell U.S. investment or business real estate and replace it with like-kind U.S. real estate within the required timeframes, a Japanese-resident nonresident alien can defer tax on the gain just like a U.S. resident. The key issue is what counts as “like-kind”: U.S. real property is only considered like-kind to other U.S. real property — you cannot exchange into property located in Japan (Section 1031(h) explicitly provides that U.S. and foreign real property are not like-kind). In other words, a nonresident using a 1031 exchange is necessarily limited to replacement property within the U.S.
The Nonresident-Specific Obstacle: Conflict With FIRPTA Withholding
The biggest practical obstacle for a nonresident doing a 1031 exchange is FIRPTA withholding. Normally, when a nonresident sells U.S. real estate, 15% of the sale price is automatically withheld at closing. But in a 1031 exchange, the sale proceeds need to be held by a Qualified Intermediary (QI) and applied directly to the purchase of the replacement property — so withholding 15% of the proceeds at closing creates a shortfall in the funds needed to complete the exchange.
To address this, it’s standard practice to file Form 8288-B (Application for Withholding Certificate) with the IRS before closing, requesting that withholding be reduced to zero or a much smaller amount on the grounds that the 1031 exchange results in little or no currently recognized taxable gain. This application often takes weeks to months to process, so a nonresident considering a 1031 exchange needs to work backward not only from the standard 45-day identification period and 180-day completion deadline, but also from the Form 8288-B processing timeline, and get started early.
Tax Isn’t Eliminated — Only Deferred
A 1031 exchange only defers tax; it doesn’t eliminate it. The replacement property inherits the tax basis of the property you sold, so when you eventually sell the replacement property outright (without doing another exchange), all the deferred capital gain, plus depreciation recapture on the depreciation you’ve claimed along the way (taxed at up to 25%), comes due at once. And that final sale will also be subject to standard FIRPTA withholding (15%). Nonresidents should think through their long-term exit strategy with this in mind: the deferred tax burden surfaces all at once whenever you eventually cash out of U.S. real estate entirely and move the funds back to Japan.
Tax Return Treatment
Even in a year you complete a 1031 exchange, a nonresident must still file Form 1040NR. You’ll attach Form 8824 (Like-Kind Exchanges) reporting the details of the exchange — the property given up, the property received, and the calculation of deferred gain. Even if withholding was reduced through an approved Form 8288-B, you still need this filing to establish your final tax position for the year.
Frequently Asked Questions
Q: Can I keep doing 1031 exchanges between U.S. properties after I’ve moved back to Japan?
A: Yes. Eligibility for a 1031 exchange is determined by the property’s location (U.S.) and use (investment or business), not the owner’s residence, so living in Japan doesn’t prevent you from using it. That said, being based in Japan can make the paperwork for the FIRPTA withholding certificate and fund transfers more cumbersome, so it’s worth confirming the practical logistics — including moving funds through a Japanese financial institution — ahead of time.
Q: What if Form 8288-B approval doesn’t come through by closing?
A: If approval isn’t ready in time, escrow typically holds back the withholding amount and reconciles it once approval comes through and the actual withholding is determined. This can create a temporary shortfall in the funds needed for the exchange, so it’s worth arranging bridge financing as a backup.
This article is provided for general informational purposes only and is not a substitute for individualized tax advice. A 1031 exchange requires carefully managing both strict deadlines and the withholding certificate process, so we recommend consulting a professional before proceeding.
Summary
Nonresident aliens can defer tax through a 1031 exchange just like U.S. residents, but they face a practical hurdle residents don’t: reconciling the exchange with FIRPTA withholding. Getting a Form 8288-B withholding reduction approved alongside the standard exchange deadlines requires starting early and building in a real margin of time.
Related Articles
- FIRPTA Withholding Explained: The 15% Withholding on a Japanese Seller’s U.S. Real Estate Sale, and How to Get It Refunded
- Understanding the 1031 Exchange: Deferring Capital Gains on Real Estate Sales with Strict Deadlines
- Depreciation Recapture When Selling a US Rental Property: The Extra Tax Owners Often Overlook
- US Real Estate Investing While Living in Japan: Form 1040NR and the Net Election Under Section 871(d)