A 1031 exchange with foreign property allows you to buy one property with the proceeds of the sale of another while avoiding common taxes imposed by the Internal Revenue Service (IRS).
While a 1031 exchange with foreign property is complex, it’s not impossible. In fact, with a little planning and some help from experts, you can handle these transactions like a professional. Here’s what you need to know.
What Is a 1031 Exchange?
A 1031 exchange is a deferred transaction involving two investment properties. Typically, investors sell one property and place the proceeds in a trust. Those funds are then released to purchase another property that’s similar enough to be considered like-kind. Investors that follow the complex rules of 1031 exchanges are rewarded with tax benefits.
The taxes you’d typically pay on the gains of your transaction are deferred. You don’t pay them until you sell the property you purchase in the exchange. If you never sell that property, the tax is never due.
Can You Conduct a 1031 Exchange with Foreign Property?
Yes, you can conduct a 1031 exchange with foreign property. However, both of the items in your transaction must be in the same country. For example, you can sell a property in Italy and purchase another Italian property. However, you can’t sell a property in America and use the proceeds to buy an Italian property.
American investors can use 1031 exchanges to buy or sell foreign properties and get tax benefits. Per tax law, investors with holdings in other countries can earn income through those investments. In other words, foreign properties that are owned by an American citizen are subject to the same taxes as local holdings. By using a 1031 exchange, you can reduce those tax liabilities.
6 Rules Involving 1031 Exchanges With Foreign Property
A 1031 exchange is a complex transaction that comes with plenty of rules. If you’re using foreign properties, the requirements are even more complicated. Here’s what you must do to make these exchanges work (without paying too much in taxes).
1. Both Properties Must Be Foreign
As we’ve mentioned, a transaction like this requires the two linked properties to exist within the same country. IRS rules require the two items to be considered “like kind.” Only two properties existing within the same country can meet this requirement. You can’t sell a property in one country and buy one in another for this type of exchange.
2. Both Properties Must Be Investments
A 1031 exchange is an investment tool, so the properties you sell and buy must be used for a business purpose. For example, you could include things like apartment buildings, rental homes, office parks, and warehouses in an exchange. You can’t use something like the property you live in right now.
3. Both Transactions Must Involve the Same Taxpayer
A transaction like this is designed for one taxpayer, so you can’t do something like sell a property and allow someone else to buy within the transaction. You can set up something like a business or a trust for these types of deals, but in general, they’re made for a single investor who can report them on just one IRS form.
4. The New Property Must Be Worth More
A 1031 exchange works best when the property you purchase is worth more than the one you’re selling. If you accept funds from the sale, that money will be subject to tax. Make the most of the opportunity by ensuring that the property purchased with the exchange is worth more than the one you sell.
5. You Must Meet Specific Time Frames
The IRS requires investors to meet very strict deadlines. You have 45 days from the date of the sale to identify a replacement property, and you have 180 days to complete the purchase. There is no wiggle room on these time frames. These deadlines can be difficult to meet if you’re far from the properties you’re buying and selling.
6. You Can’t Accept the Funds
A 1031 exchange is a dependent transaction involving selling one property and buying another. Accepting the funds from the sale at any point negates the entire transaction and makes the sale taxable. It’s critical that a third party accepts the money for you and holds it for the purchase.
Who Should Help With a 1031 Exchange with Foreign Property?
A qualified intermediary (QI) is a third party that accepts funds and ensures that the transaction doesn’t become taxable. As the IRS explains, a QI is an intermediary that performs critical functions like holding funds, reporting the sale, and withholding taxes (if applicable).
If your exchange involves foreign property, you must choose a QI with experience with this type of transaction. Not all companies either accept these types of deals, and others have never performed one before. It’s very important to choose someone who can guide you properly, as you can’t afford to make mistakes in the process.
Common Pitfalls With Foreign Exchanges
A 1031 exchange comes with plenty of advantages. However, foreign exchanges can be much more complicated than a standard transaction involving investments within the United States. These are a few of the problems others have encountered:
Unexpected Taxes
IRS rules are designed to ensure that people don’t pay taxes twice. For example, those rules can certify that you don’t pay capital gains in the United States and those same taxes within another country on the same sale.
However, some local municipalities can assess taxes on the sale of a property. Those rules can be hard to parse, especially if you’ve never sold property in that country before. It’s important to work with experts who understand these regulations.
Unusual Sales Processes
Buying and selling property within the United States isn’t always the same as completing these transactions in another country. Sometimes, there are special rules and regulations that can hang up a deal. Knowing about these problems in advance is important, as the 1031 exchange deadlines are strict and can’t be shifted.
Exchange Rates
Some countries have strict rules about their currency. For example, they may require money within a 1031 exchange to be within the country’s currency. An unfavorable exchange rate could eat into your profits and make the transaction a little less profitable.
A knowledgeable partner should help you to understand this issue. In some cases, a partner might even encourage you to avoid these transactions altogether.
Work With an Expert
At 1031 Pros, we work exclusively on exchanges. Our services are fast, reliable, transparent, and secure. We can help you to complete a transaction with foreign property in a manner that’s safe, accessible, and easy to understand.
Don’t put your money (or investments) at risk. Get the expert help you need to ensure your investment transaction is done right. Talk to us today to get started.
References
Like-Kind Exchanges Under IRC Section 1031. (February 2008). Internal Revenue Service.
Overview of U.S. Taxes on Foreign Income for Individuals. (October 2023). Thomson Reuters.
Miscellaneous Qualified Intermediary Information. (August 2024). Internal Revenue Service.
Topic No. 865, Foreign Tax Credit. (June 2024). Internal Revenue Service.
Like-Kind Exchanges of Real Property. (January 2022). Journal of Accountancy.
The Basics of a 1031 Like-Kind Exchange. Oklahoma Bar Journal.
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