A 1031 exchange is a tool taxpayers can use to defer their obligation to pay capital gains taxes when they sell an investment property and reinvest the proceeds. 1031 refers to the relevant section of the tax code, and exchange refers to the swap from one property to another. Regarding a 1031 exchange, it's crucial to understand that the rules surrounding domestic and foreign properties are distinct. While an investor can conduct a like-kind exchange of a U.S. property for another U.S. property, or a foreign property for another foreign property, it's important to note that exchanging a U.S. property for a foreign property is not permissible under Section 1031 of the Internal Revenue Code. Therefore, it's paramount that investors carefully consider their 1031 exchange strategies with this in mind to maintain tax deferment benefits.
The IRS carefully regulates 1031 exchanges. Taxpayers must follow strict timelines and ensure that the proceeds from the sale of the targeted property are held by a neutral party called a Qualified Intermediary during the transaction. However, almost any investment property is eligible for an exchange. Investors can sell a residential rental (not a personal residence) and replace it with an office building. Similarly, they can sell vacant land or farmland and use the proceeds to invest in retail space. All proceeds from the sale must be reinvested in the replacement, not just the gain.
In a 1031 exchange, the sold property is called the relinquished property, and the purchased property is referred to as the replacement. If the relinquished property is in the U.S., the replacement property must also be in the U.S. An investor cannot sell property in the U.S. and use a 1031 exchange to replace it with property in another country.
The converse is also true. An investor cannot sell property in another country and replace it with property in the U.S. using a 1031 exchange. The investor would likely pay U.S. capital gains tax on the sale. However, if they paid taxes on the transaction in another country, they are protected from a duplicate IRS levy by the U.S. Foreign Tax Credit. Furthermore, many countries apply lower taxes to these transactions, and some forego the levy entirely.
Yes. Investors can sell an investment property abroad, replace it with a property abroad, and use the 1031 exchange to defer capital gains taxes. This tactic is possible when the relinquished and replacement properties are in the same or even different countries. The qualifying consideration is that neither is in the U.S.
Whether swapping between two properties both located within the U.S. or between two properties both located in other countries, the U.S. taxpayer must carefully follow the IRS rules. These rules include matching or exceeding both the value and debt load of the relinquished asset and following the established timelines. Using a Qualified Intermediary is required and will also help ensure that the taxpayer doesn’t miss an important deadline or document.