Section 1031 of the United States Tax Code establishes provisions that allow a taxpayer to defer capital gains taxes when he or she sells investment or business property in exchange for another “like-kind” property. Specifically, IRC Section 1031(a)(1) states:
“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”
To qualify for a 1031 Exchange tax deferral you must follow specific rules and meet certain time frames.
What is Considered “Like-Kind” Property?
First, only investment or business property is eligible under Section 1031, not a personal residence (with a few exceptions as noted below). The business property can be any tangible asset such as equipment or real estate, but the swap must involve the same type, nature, or character of property. For example, you can exchange a piece of equipment for a different piece of equipment, or an apartment building for a rental townhouse, but you cannot exchange equipment for real estate under Section 1031.
The Internal Revenue Code specifically notes that property located in the United States cannot be exchanged for property located outside the country under Section 1031. However, you can sell a foreign property and reinvest the proceeds in a new foreign property and defer all capital gain taxes.
For our readers, this article will focus on the exchange of one foreign property for another foreign property and discuss when a 1031 Exchange may be beneficial.
Is A 1031 Exchange A Good Option?
Before you arrange a 1031 Exchange, you need to consider if the tax deferral is worthwhile under the circumstances. As a U.S. citizen, you are obligated to report any worldwide capital gains on your U.S. tax return, and depending on your filing status, you may be required to pay substantial tax on those gains.
When you sell a property in a foreign country for a profit, you will probably have to pay tax on the capital gains from the sale in that country. A few countries do not assess capital gains tax so it’s important to ask a tax professional before starting the exchange process.
The IRS allows for a tax credit against capital gains taxes paid in another country to avoid double taxation. Depending on the amount of tax paid overseas, it may be more beneficial to use the IRS tax credit when you sell and avoid the tax altogether, rather than doing a 1031 Exchange and deferring the U.S. taxes to a future time. Again, a qualified tax professional can review your specific circumstances to help you make the best decision possible.
Also, you should consider the cost of doing a 1031 Exchange against your potential tax credit or deferral benefit. These transactions are fairly straightforward in the States, but when foreign properties are involved, you could pay US$1,500 or more to ensure it is done properly.
1031 Rules and Deadlines
The goal under a 1031 Exchange is to swap one investment with another similar investment of equal or greater value without receiving taxable cash or realizing capital gains. This allows your investments to grow tax-deferred until a time when you can reduce or eliminate your tax burden. Also, there is currently no limit on how many times you can do a 1031 Exchange and continue to defer your tax obligation.
First, you must find a suitable like-kind property that you want to purchase. Then you must retain a Qualified Intermediary to handle the funds and the exchange. You must have held the property you want to sell/exchange only for investment purposes (not for quick resale or personal use) and it’s recommended to own the property for at least two years before the sale.
The replacement property must be of equal or greater value than the property being sold and you must identify the replacement property subject to the 1031 Exchange within 45 days from the date you sell the first property. The purchase of the replacement property and the 1031 Exchange must be completed within 180 days of the first property’s sale date.
During the time between the sale of the first property and the purchase of the replacement property, you cannot take possession of the sale proceeds or control them in any way. The Qualified Intermediary must be in control of those proceeds and apply them to the purchase of the replacement property to qualify the funds for tax deferral under Section 1031.
Section 1031 Exceptions
Just like most provisions of the Internal Revenue Code, there are several exceptions to Section 1031. In certain circumstances you can use your primary residence for an exchange and a vacation home could qualify in special situations.
Your situation is unique and you don’t want to make a mistake when dealing with taxes and the IRS. Due to the complexity of these tax rules, you should consult a professional about your specific circumstances.