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1031 Exchanges Involving Foreign Property 

Accruit
05/31/24
Are 1031 Exchanges only available to domestic real property within the United States? Can a United States taxpayer that owns real estate used in a trade or business or held for investment outside of the United States utilize a 1031 Exchange? Learn more about the considerations and regulations for 1031 Exchanges involving foreign properties in this article.
Foreign Property 1031 Exchanges

1031 Exchange s enable Exchangers to defer Capital Gains taxes by reinvesting the proceeds from selling an investment or business use property into another. It's important to understand the distinct rules for domestic and foreign properties: you can exchange a U.S. property for another U.S. property or a foreign property for another foreign property, but you cannot exchange a U.S. property for a foreign property, or visa versa. Exchangers should carefully plan and educate themselves on the rules and regulations of 1031 Exchange s to ensure they will retain tax deferral benefits. 

 

Do US Taxes Apply to Foreign Real Estate?

Prior to discussing the considerations for 1031 Exchange s involving foreign property, it is important to understand how United States taxes apply to foreign property. If a US taxpayer, or taxpaying entity, owes property outside of the United States, the property or income generated from the property is treated largely the same as domestic property, including: 

  • Profits from the sale of property for a profit those proceeds would be subject to taxation
  • Income generated from the ownership or operation of foreign real estate is taxable income 
  • Property owners can deduct qualifying expenses for foreign properties to lower their taxable income
  • Property is eligible for depreciation, although foreign commercial property is depreciated over 40 years and foreign residential property is depreciated over 30 years, versus the 39 years and 27.5 years respectively for domestic properties

In summary, foreign property owned by a taxpaying citizen of the United States is essentially treated the same as domestic property in regard to annual taxes. 

Do 1031 Exchanges Apply to Property Outside the United States? 

In a 1031 Exchange , both the Relinquished and Replacement Properties must be like-kind. Like-kind means that any real estate property held for use in a trade or business or for investment is like-kind to any other real estate property held for use in a trade or business or for investment, i.e. they do not need to be same kind. For example, a multi-family property can be exchanged for an office building. The historical reference to like-kind was much more relevant prior to 2018 when various types of personal and intangible property was often exchanged.  Since that time, only real property can be exchanged.   

This requirement establishes that properties located within the continental United States are considered like-kind other continental U.S. properties.  For example, properties in Puerto Rico are considered outside of the U.S. However, properties located in the Virgin Islands may be treated as like-kind to domestic property under certain circumstances. There is also some authority that properties in Guam or the Northern Mariana Islands may qualify for a 1031 exchange for U.S. property. What is clear within the Regulations is that foreign property is considered like-kind to other foreign property.  

Relinquished and Replacement Properties in a 1031 Exchange involved must be domestic or foreign, there cannot be a mix. In the United States, properties can only be exchanged for others within the United States. Foreign properties can be exchanged for other properties in any country, as they are all foreign. Exchanges between different foreign countries are valid, as the qualifying consideration is that they are both foreign to the U.S. 

Therefore, Exchangers can exchange foreign property for other foreign property because it is like-kind. Foreign property is not like-kind to domestic property, so a 1031 Exchange is not permissible between domestic and foreign properties.  

 

1031 Exchange Scenarios

When considering a 1031 Exchange , it is important to keep in mind specific rules regarding foreign and domestic properties: 

  1. U.S. Property to U.S. Property: An investor can conduct a like-kind exchange of a U.S. property for another U.S. property. For instance, selling a multi-family rental property in San Francisco, California and exchanging it for an office building in Nashville, Tennessee qualifies for a 1031 exchange. 

  1. Foreign Property to Foreign Property: An investor can exchange a foreign property for another foreign property. With this, both properties must be located outside the U.S. to be considered like-kind.  

  1. U.S. Property to Foreign Property: Exchanging a U.S. property for a foreign property is not permissible under Section 1031 of the Internal Revenue Code. If an investor attempts this, their 1031 Exchange  would likely be nullified and they could have to pay associated taxes on the real estate transaction. 

 

Does a 1031 Exchange Make Sense for Foreign Property? 

Any sale of foreign property held for investment should undergo the same evaluation as a domestic property being sold. A 1031 exchange of one foreign property for another would result in tax deferral for U.S. tax reporting purposes. Hence, a 1031 Exchange for foreign property would still be beneficial for a property owner even if the country in which the property is not located does not impose its own taxation.

If the foreign country does impose its’ own taxes on the sale, an investor might be afforded some tax liability protection from a duplicate tax levy by the U.S. Foreign Tax Credit. In some cases, an owner of foreign property can take credit on their tax return for some taxes paid in the foreign country and use it to offset United States taxes.

 

A 1031 Exchange can be as beneficial for owners of foreign real estate as those owning US property. It is important to remember that US real property and foreign real estate are not like-kind to one another for 1031 Exchange purposes. As always, when contemplating a 1031 Exchange it is crucial to involve a Qualified Intermediary (QI) skilled to facilitate all types of 1031 exchanges, including those for foreign real estate holdings. 

 

The material in this blog is presented for informational purposes only. The information presented is not investment, legal, tax or compliance advice. Accruit performs the duties of a Qualified Intermediary , and as such does not offer or sell investments or provide investment, legal, or tax advice.