1031 Exchange Rules for Foreign Properties
A 1031 exchange allows investors to defer capital gains taxes by reinvesting the proceeds from selling an investment or business-use property into another like-kind property inside the US. Unbeknown to many investors foreign properties too qualifies in a 1031 exchange.
Understanding 1031 exchange rules between US vs foreign property ownership;
Domestic Properties: A U.S. property can only be exchanged for another U.S. property.
Foreign Properties: A foreign property can only be exchanged for another foreign property.
No Cross-Border Exchanges: Exchanging a U.S. property for a foreign property, or vice versa, is not permissible under Section 1031 of the Internal Revenue Code.
International to International Real Property Only –
Internal Revenue Code (IRC) Section 1031 applies to all citizens or residents of the United States (US) or non-resident aliens subject to US federal income taxes. Many Exchangors are not aware that international property is eligible for 1031 exchange tax treatment when international property is acquired as replacement property. Though it can be complex, it is possible to execute an international property exchange.
When selling real property held for productive use in a trade, business or for investment, a 1031 exchange allows individuals, partnerships, corporations, limited liability companies and trusts to defer the federal capital gain and recaptured depreciation taxes when selling property held for the proper intent, regardless of where the property is located. Property used predominantly in the US is eligible as replacement for property held in the US, while property located outside the US is eligible for 1031 consideration with property held internationally.
International 1031 Exchange Rules
The 1031 exchange rules for property held internationally are the same as for property located predominantly in the United States. Foreign property is not considered like kind with property held in the US or vice versa. A brief review of the primary exchange rules follows.
Exchange value – to defer the entire gain, the net replacement property purchase price must be equal to or greater than the net relinquished property selling price.
Partial exchanges are acceptable.
Timeline – the exchange must be completed within 180 calendar days of the initial closing.
The replacement property must be identified, preferably to the Qualified Intermediary, no later than the 45th calendar day post-closing.
Same taxpayer – the taxpayer who sells must be the taxpayer who buys with the exception of a disregarded entity, such as a single member limited liability company.
Challenges in an International exchange –
1 – When foreign currencies are wired into the US, the issue becomes the exchange rate gain/loss when converting to the US Dollar and back to the country where the replacement property is acquired.
2 – The second set of issues impacting the 1031 exchange is the socially accepted norms when buying and selling property. Sometimes, Buyer will want to pay the Seller directly. There is no closing or escrow company orchestrating the transaction. If the Buyer were to receive the funds from the Seller, then the constructive receipt regulation of the 1031 code would be violated and the exchange fails. Plenty of time is required to understand and work through issues with advance planning.
3 – Constructive Receipt; The closing process is different in every country. What we consider standard procedure in the US cannot be assumed in other countries. In a 1031 exchange, if the Seller receives a check, the exchange would be invalidated because the taxpayer has access to the cash, violating the (g)(6) constructive receipt requirement. It is critical for the taxpayer to provide the qualified intermediary access to their financial and legal counsel to discuss sovereign closing procedures.
A 1031 exchange can be beneficial for owners of foreign real estate, just as it is for domestic property owners. Here’s why:
• Tax Deferral: Exchanging one foreign property for another defers capital gains taxes for U.S. tax reporting purposes.
• Foreign Tax Credit: If the foreign country imposes its own taxes on the sale, the U.S. Foreign Tax Credit may provide some tax liability protection, offsetting U.S. taxes with taxes paid in the foreign country.
A 1031 exchange provides significant tax deferral benefits for both domestic and foreign property owners. However, understanding the specific rules and regulations regarding foreign and domestic properties is vital to avoid pitfalls.
Wai-Yew Lam (Trec instructor) @ wlam@adelphiretirement.com
Adelphi Retirement Inc
Texas Real Estate Commissioner Department
www.AdelphiRetirement.com