A 1031 Exchange (also referred to as a like-kind exchange) refers to IRC section 1031. It is a means of deferring the recognition and payment of capital gains taxes that would otherwise be due on the sale of real estate that a taxpayer holds for investment purposes. The taxpayer can accomplish this deferral by exchanging proceeds from the sale of the property into a "like-kind" property of the same or greater value.
If an investor sells a property they have owned for more than a year, the gain when the property is sold is taxed at the long-term capital gains rate, which is typically lower than the rate at which ordinary income like a salary and other wages is taxed. Keep in mind that a gain is only recognized if and when a property is sold. If the investor continues to hold it, the value growth is unrealized, and no taxes are owed. When the investor does sell, the taxes are due based on the difference between the basis (amount paid plus costs of acquisition) and sales price.
Using the 1031 exchange to continue reinvesting the proceeds from the sale can allow the taxpayer to continue deferring the realization of the gain if properly executed. Ultimately, if the taxpayer bequeaths the property to an heir in their will, that heir can receive a step-up in the basis to the value when they inherit it so that they wouldn't owe any capital gains tax to make up for what has been deferred.
How Are Properties in Other Countries Affected?
A 1031 exchange that starts with a property in the U.S. can't be exchanged for an asset in another country; the replacement property or properties must also be within the United States. However, an investor can use a 1031 exchange to defer the capital gains tax that would otherwise be due on the sale of real estate in a foreign country. In that case, the replacement property must also be in a foreign country.
Note: the relinquished and replacement properties do not need to be in the same foreign country, but neither may be in the United States. To clarify, consider these scenarios:
- The relinquished property is in the U.S. The replacement property must be in the U.S.
- The relinquished property is in the U.K. The replacement property can be in the U.K. or any other country except the U.S.
Will I Pay Taxes in the Country the Property Is Located in?
Many countries, like the U.S., impose a capital gains tax on the sale of investment property. If you pay a tax on a gain that you earn in another country, you will not also pay a U.S. tax on that gain due to the U.S. Foreign Tax Credit. In that case, using a 1031 exchange for a property in another country might not make the most sense, because you will need to pay the tax imposed in the country where the property is located.
Suppose the property is in a country with a low or no capital gains tax on real estate. In that case, it could be wise to use the 1031 exchange to defer the tax in the United States. New Zealand, Jamaica, and Singapore are among the countries reporting no capital gains tax.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits.