At the Live and Invest in Belize Conference this week, several attendees asked about using a 1031 like-kind exchange to move capital overseas. Specifically, they wanted to sell investment property in the United States and use the proceeds to invest offshore.
A 1031 like-kind exchange is an IRS mechanism that allows an investor to exchange productive property and defer capital gains taxes. It can be used with many business assets but really only makes sense with assets that appreciate… essentially, real estate.
Here’s the most important thing to understand about the 1031 like-kind exchange rule: The IRS doesn’t allow you to use it for an exchange between U.S. investment property and non-U.S. investment property. You can only exchange U.S. for U.S. or foreign for foreign property to benefit from the tax deferral.
As a quick aside, you don’t actually directly exchange one property for another. It’s not that you have to find someone who has a piece of property you want who also wants your property so the two of you can swap. You simply follow the IRS rules when selling and use the proceeds from a sale to purchase a replacement property.
The obvious advantage of doing an exchange is that you can reinvest the capital from the sale of one property into a new property, allowing you to compound your returns without taking an immediate tax hit. If you continue to exchange investment properties up to the point of your passing, your heirs get a stepped-up basis from your estate and the capital gains taxes disappear altogether (although estate taxes may take over at that point, if the estate is big enough).
It sure would be nice if an investor looking to diversify into offshore real estate could take advantage of the 1031 like-kind exchange, but you can’t. You have to make your first investment outside the United States with taxed cash. If you want to use capital from the sale of a U.S. property, you have to sell it outright and pay any associated capital gains tax. Then you can move the after-tax capital offshore.
Having made that first foreign property purchase, you then can use proceeds from the sale of that property for a next foreign property purchase… deferring the U.S. capital gains.
The question you have to ask at that point, however, is should you do a 1031 like-kind exchange with your foreign property?
If you’re selling property in Belize, which imposes no capital gains tax, to buy another property in Belize or some other country (for 1031 purposes the IRS only differentiates between domestic and foreign property; you can move among foreign countries as you like, without restriction), then you probably want to consider an exchange to defer U.S. capital gains taxes.
However, if you’re selling property in a country where you’re liable for as much or more in capital gains tax locally as you would be in the United States, then you shouldn’t bother doing an exchange. You can take a credit on your U.S. tax return for the foreign taxes paid to offset tax in the United States. Do an exchange and you lose that possibility and eventually will pay taxes again to Uncle Sam on that any deferred gain.
What about a case when you’re selling a property in a country that charges capital gains tax but at a lesser rate than you’d pay in the United States? In this case, you probably don’t want to do a 1031 like-kind exchange either. You can take whatever capital gains tax you pay locally as a credit toward the U.S. tax.
The bottom line is you’re not going to be able to move U.S. real estate investment capital offshore without paying capital gains taxes first… and when you do start investing in offshore real estate, the benefits of a 1031 like-kind exchange only really help when selling property in a country that doesn’t impose capital gains taxes on real estate, of which there are only handful. Belize is one. New Zealand is another. Croatia doesn’t charge capital gains taxes on real estate held in your personal name for three years or more. And some other countries have similar waivers or reductions in capital gains on real estate held for extended periods, including France and Italy, for example.
Lief Simon offers offshore advice in his free twice-weekly Offshore Living Letter and the monthly Simon Letter. For more information on overseas real estate, read more about the upcoming 2015 Global Property Summit.