US members of multinational groups frequently utilize Section 1031 tax-deferred like-kind exchanges when they dispose of real estate whose selling price is to be reinvested in qualifying replacement real estate. For example, in 2015, Hilton Worldwide Holdings Inc. disposed of the Waldorf Astoria New York for four hotels in Florida and one hotel in California in a Section 1031 exchange valued at approximately $1.9 billion.
Under many foreign corporate income tax laws applicable to fixed asset rollovers, foreign corporate income tax can likewise be deferred, without the need to interpose a qualified intermediary, when business real estate is sold, to the extent that the cash proceeds are timely reinvested in replacement business real estate.
In a US like-kind exchange or foreign rollover of equal value, the exchangor corporation’s replacement real estate generally takes the carried-over tax basis of the relinquished real estate. Thus, the deferred corporate income tax liability, equal to the corporate income tax rate times the deferred gain, is preserved in the replacement real estate.
This deferred corporate income tax liability with respect to a replacement building in effect is triggered over the depreciable life of the replacement building, through lower depreciation deductions than would have been available in a non-tax-deferred reinvestment. For example, in the US, the deferred tax liability with respect to the building is in effect triggered into corporate income tax ratably over the 39-year useful life of the replacement commercial building. When the replacement land and building are sold, it triggers the remaining deferred corporate income tax liabilities with respect to the building and with respect to the land.
Financial Accounting
For financial accounting purposes such as under GAAP, financial accounting gain, unlike taxable gain, may be immediately included upon a Section 1031 like-kind exchange or foreign rollover transaction. For example, the 2015 Hilton Worldwide Holdings Inc. annual report reported a financial accounting gain on its Section 1031 exchange of the Waldorf Astoria New York.
In the case of a GAAP-recognized but tax-unrecognized gain on a US Section 1031 or foreign rollover transaction, a deferred tax liability balance sheet account is established at the time of the transaction to reflect the financial accounting, but not tax reporting, corporate income tax liability. The deferred tax liability account with respect to the replacement building is in effect reversed to zero over time and triggered into after-tax financial accounting income periodically. This is as an offset to financial accounting income tax expense, as the replacement building is depreciated.
In foreign countries with a tax roll-over provision, similar carryover tax basis—and a corresponding immediate financial accounting gain recognition and deferred tax liability provision—may also be applicable. When the replacement land and building are sold and not replaced, it triggers any remaining deferred tax liability recorded with respect to the replacement building and any liability with respect to the replacement land.
For example, if the GAAP and tax depreciable life of a US Section 1031 exchangor’s replacement building is 39 years, then until the building is sold, about 1/39 of the portion of any deferred tax liability account attributable to the building would be reversed into the exchangor’s financial accounting income through a reduction in annual financial accounting income tax expense. When the replacement building is sold, the remaining deferred corporate income tax liabilities account with respect to the replacement building, and any with respect to the replacement land, is triggered into financial accounting income.
Part 2 of this article will look at how financial accounting immediate recognition and deferred tax accounting impacts the Pillar Two tax computation.
This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Author Information
Alan S. Lederman is a shareholder at Gunster, Yoakley & Stewart, P.A. in Fort Lauderdale, Fla.
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