Commercial real estate investors often assume that a 1031 Exchange is for US-based properties only. While the law that permits them is a US law, it does not necessarily apply to only US properties.
In this article, we are going to describe the requirements needed to complete a foreign 1031 Exchange. In doing so, we will describe what a 1031 Exchange is, the requirements for completing them, and the benefits and risks of doing so. By the end, readers will have the information needed to determine if a foreign 1031 Exchange may be a good fit for their needs.
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What is a 1031 Exchange?
A 1031 Exchange, sometimes called a like kind exchange or delayed exchange, is a type of commercial real estate transaction that allows investors to defer capital gains taxes on the profitable sale of an investment property as long as they reinvest the sales proceeds into another like kind property.
Rules To Complete a 1031 Exchange
1031 Exchange rules are set forth by the IRS in section 1031 of the Internal Revenue Code (IRC). The rules are lengthy and complex, but the key elements are described below:
- Real estate investors have 45 days from the sale date of the relinquished property to identify a suitable replacement property and 180 days to complete the purchase of it.
- The replacement property must be “like kind” to the sold property and it must be “held for productive use in a trade or for business or investment purposes.” For this reason, a 1031 Exchange does not typically include someone’s primary residence or vacation home because they are neither held for investment or like kind to a commercial property. In general, most commercial properties in the US are like kind to other commercial rental properties in the US. FSo, for example, an apartment building is like kind to an office building.
- The fair market value of the new property must be equal to or greater than the value of the relinquished property.
- Both the relinquished property and the replacement property must be titled in the same way.
As long as these rules (and the others) are followed, real estate investors receive a “non-recognition of gain” which means that they are able to defer taxes until they decide to realize the gain.
Benefits of a 1031 Exchange
Aside from the obvious tax deferral benefit, there are several other benefits of a 1031 Exchange that investors may potentially realize. They include:
- Diversification: If they desire, investors can exchange one property for multiple as long as certain tests are met – allowing them to diversify their property portfolio.
- Tax Deferred Growth: A 1031 Exchange is not a one time event. They can be done over and over, which allows investors to grow their capital tax deferred over a long period of time – a significant benefit.
- Estate Planning: Finally, a 1031 Exchange can be beneficial to estate planning efforts because proper planning can allow heirs to inherit property interests at a stepped up cost basis – which can result in significant tax savings.
When used effectively, a 1031 Exchange can be an incredibly effective tax deferral/tax savings strategy.
Rules for Doing a 1031 Exchange in a Foreign Country
With regard to a potential international 1031 Exchange, the rules are clear:
- A US property can be exchanged for another property in the US
- A foreign property can be exchanged for another foreign property
- A US property cannot be exchanged for a foreign property
So, the key rule is that the property locations must line up. FSo, for example a property in Seattle could be exchanged for another property in Seattle. But, it could not be exchanged for a property across the border in Vancouver. But, if the property in Vancouver was already owned, it could be exchanged for another property in Vancouver.
For investors who already own foreign properties, a 1031 Exchangethis may sound enticing, but it can make the transaction much more complex, particularly with regard to paying taxes in the foreign country and exchanging currency from USD to the local currency.
Does an Investor Pay Taxes in the Country of an Exchanged Property?
It is very important to note that all real estate transactions are unique. Thus, it is difficult to make blanket statements about every situation. With regard to the payment of taxes on the profitable sale of a property, there are several factors for investors to keep in mind.
First, the US Foreign Tax Credit ensures that US- based investors are not double taxed on the profitable sale of an investment property – if taxes were paid in the local municipality. FSo, for example, a Florida based investor would not be double taxed in the US for a property sold in France.
Second, the 1031 Exchange itself allows investors to defer taxes on the profitable sale of a property – as long as they go through the exchange process.
These two points are relevant for the deferral of US taxes. Depending on local rules, it is possible that some taxes may be due in the local municipality upon property sale – based on the sale price, local capital gains tax rate and/or income tax rate.
Challenges For Performing a 1031 Exchange With a Foreign Property
For taxpayers, there are two primary challenges to completing a 1031the Eexchange of property in a foreign country.
Again, local rules and customs for completing the sale of a property may differ. In some cases, money may be paid directly to a seller. In others, it may go through a third party or title company.
Real estate iInvestors should be careful that they do not receive a constructive receipt of funds directly or it may invalidate the exchange, causing a taxable gain.
Holding Exchange Funds
This challenge is where currency exchange risk is introduced.
Some countriesplaces may require that exchange funds be held in the local currency rather than a US based escrow account. When this is the case, funds may need to be converted from USD to the local currency for the transaction and then back to USD when it is complete. These steps introduce additional currency risk that can make a foreign exchange more challenging and, potentially, less profitable.
Summary of 1031 Exchanges on Foreign Property
A 1031 Exchange is a real estate transaction that allows individual investors to defer long term capital gains taxes on the profitable sale of a real estate investment property as long as the sales proceeds are reinvested into another, like kind property.
The rules and timelines for completing a 1031 Exchange are outlined in IRC Section 1031. Among the most important is that the exchange property must be “held for productive use in a trade or for business or investment.” It cannot be held for personal use or it cannot involve a personal residence.
With regard to a foreign 1031 Eexchange, investors can exchange a US property for a US property or a foreign property for a foreign property, but cannot exchange a US property for a foreign property.
In a foreign property to foreign property exchange, investors may encounter several challenges including managing through local customs regarding the receipt of funds and the currency exchange risk of converting the exchange proceeds from USD to the local currency and back.
Given the complexity of a foreign exchange, it is always a best practice to work with the experts like Qualified Intermediaries, CPAs, and/or tax attorneys with specific expertise in this space.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We utilize our liquidity and decades of experience to find multi-tenanted, world-class investment opportunities for our partners.
If you are an Accredited Investor and want to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.