1031 Exchange Outside the United States: Can You Perform a Foreign Property Exchange?

Expats and those who own property overseas have to worry about double taxation, but in some cases, U.S. taxes can be deferred on foreign property exchanges through a 1031 exchange outside the United States.

In a previous post, we discussed state-to-state exchanges and how it’s possible to perform a 1031 exchange between U.S. states and select U.S. domestic territories. But what if you live abroad, or own property outside the U.S.? Is there no choice but to pay capital gains taxes on your property sale?

It is possible to utilize IRC Section 1031 for foreign assets, but only in certain situations. Understanding when a 1031 exchange outside the United States is allowed (and why it may or may not be advantageous) can be a crucial part of wealth and retirement planning for those who live overseas, own international businesses, or hold property in their countries of origin.

Foreign Property and Like-Kind Rules in a 1031 Exchange Outside the United States

One of the most useful aspects of IRC Section 1031 is the rather broad definition of like-kind property. While Section 1031 only applies to real property, any real property used in a productive trade or business or held for investment will likely qualify. As an IRS fact sheet states, “Most real estate will be like-kind to other real estate.” However, there is an important exception in a 1031 exchange outside the United States involving foreign property.

The portion of the tax code under heading §1031 Exchange of real property held for productive use or investment (also found here) contains an important section titled, “Special rules for foreign real property,” which states: “Real property located in the United States and real property located outside the United States are not property of a like kind.”

This means you cannot perform a 1031 exchange between a U.S. property and foreign property outside the United States. If your relinquished property is located within the United States, then your replacement property must also be located within the United States.

Rare exceptions include the territories of Guam, the Northern Mariana Islands, and the Virgin Islands, where property may be considered like-kind to property located within the United States (see Temp. Reg. Section 1.935-IT (c) (ii)(E); TD 9194).

Can You Exchange One Foreign Property for Another?

That doesn’t mean an exchange with foreign property isn’t possible. While foreign property is not considered like-kind to domestic property, foreign real estate used for investment is considered like-kind with one another.

You can perform a 1031 exchange outside the United States with foreign properties so long as your relinquished and replacement properties are both located outside the United States.

You can exchange a foreign property for another type of property within the same country or for a property located in another foreign country. For example, a rental property in the Cayman Islands can be exchanged for farmland in the Cayman Islands, a retail storefront in New Zealand, or a vacation property in Switzerland that is rented out most of the year.

What makes foreign exchanges complicated is that they require the exchanger to factor in the tax system of the country (or countries) where the foreign investment property is located , as well as that country’s banking laws and regulations. Exchanges with foreign property have the same IRS rules as standard U.S.-based exchanges, but compliance can be difficult depending on how different the banking system in question is from the U.S. system.

Challenges of a Foreign Property 1031 Exchange: Cross-Border Complexities to Know Before you Exchange

One thing we pride ourselves on at JTC is our commitment to 1031 best practices. As a Qualified Intermediary (QI), we employ strict security measures regarding how exchange funds are handled. This gives our clients peace of mind that everything is being done by the book so they can successfully qualify for tax deferral.

A major component of 1031 best practices is the use of Qualified Escrow accounts to hold exchange funds. Client funds are never commingled with operating funds, and any fund movement requires dual authorization from the exchanger and JTC. Unfortunately, some countries’ banking systems don’t utilize an escrow structure, making a 1031 exchange outside the United States involving foreign property more complex.

There may also be some limitations on the amount of money that non-citizens can transfer into and out of certain countries. For instance, several nations now have their own versions of the U.S. Patriot Act that restrict or prohibit the transfer of money into or out of the country and/or set onerous requirements on international real estate transaction.

Similarly, financing an acquisition through a foreign lender may present difficulties and could take considerable time in foreign property investment markets.

Different QIs have different procedures when it comes to holding funds during a foreign exchange. It’s possible to transfer the sales proceeds to the United States, where they can be held in U.S. banks in American dollars, and then transferred to the country where the replacement property is being acquired.

The problem with this is that some countries impose exit taxes or limit currency remittance, and conversion rates can affect the value of funds during a 1031 exchange outside the United States involving foreign real estate.

If the exchange is taking place entirely in one country (meaning the relinquished and replacement properties are located in the same country), it’s possible for exchange funds to be held in that country during the exchange. 1031 rules state the exchanger cannot take constructive receipt of funds, which is why a QI is necessary. In countries without the types of accounts typically used for 1031, it’s still possible to hold funds in an account that abides by local rules and U.S. 1031 rules, but it needs to be done right.

If your exchange involves properties in two different non-U.S. countries, you may face additional complications regarding fund transfers, currency conversion, and compliance requirements for international property exchanges.

To successfully execute a 1031 exchange outside the United States involving multiple countries, you need to work with specialists who understand the laws in all jurisdictions involved. Depending on where you and your properties are located, you could also be at risk for double taxation.

How 1031 Exchanges Work for Expats and Non-Residents

Properties owned in other countries are subject to taxes in those countries, and U.S. citizens living abroad are subject to taxes in the countries where they live. If you’re paying U.S. taxes and taxes in your country of residence, how do you avoid being taxed twice on the same income?

U.S. citizens living abroad can take advantage of tax treaties that help them avoid double taxation. There are 66 such countries, and if you live in one of them, you won’t be taxed by the IRS on income for which you’ve already paid taxes in your country of residence. But if you live in a country without a U.S. income tax treaty, you may be subject to double taxation. Depending on the tax rate of the country in which you live, this could be a substantial burden.

The same is true of capital gains taxes on a property sale: if you paid taxes on the sale in the country where the property is located, you can receive a tax credit in the U.S. to avoid double taxation, so long as the country has a U.S. tax treaty. But because you have to pay those foreign taxes, you won’t be able to reinvest your full sales proceeds like you could with a properly-structured 1031 exchange. Losing out on this benefit may make your exchange no longer financially advantageous, depending on the taxes paid and the property you hoped to acquire.

What about if you live abroad and want to perform an exchange with property located in the U.S.? The key thing to consider is where the entity that owns the property is established. If you are the legal owner of the property, then the sale will be taxed based on where you live and where the property is located. If the property is located in the U.S., you can perform an exchange with another U.S. property, but you will also owe taxes in your country of residence, reducing the amount you have to reinvest.

FIRPTA Rules: What Foreign Sellers of U.S. Property Need to Know

Foreign investors also have to worry about the Foreign Investment in Real Property Tax Act (FIRPTA), which affects foreign property sales when the seller is an international investor.

The buyer/transferee or certain agents of the buyer may be required to withhold up to 15% of the gross sales price as withholding tax. If the buyer is purchasing the property as a personal residence and the sale price is between $300,001 and $1 million, just 10% of the gross sales price must be withheld. Otherwise, 15% of the gross sales price must be withheld.

Within 20 days following the date of transfer, this sum needs to be sent to the IRS. Consequently, you will not be able to utilize that capital when acquiring your replacement property.

It is possible to obtain an exception so you can use the sales proceeds in a 1031 exchange, but this requires careful planning well in advance of the relinquished property sale.

Furthermore, Treasury Decision 9082 mandates that all foreign sellers of U.S. real estate must possess a Taxpayer Identification Number (TIN) in order to fulfill the necessary withholding obligations or to apply for a reduced tax withholding rate. Individuals who are ineligible for Social Security Numbers (SSN) can obtain Individual Taxpayer Identification Numbers (ITINs) by submitting Form W-7, thereby satisfying the requirement to provide a TIN.

Whether you live in the U.S. and want to exchange properties abroad, live abroad and want to exchange properties in the U.S., or you’re a U.S. citizen living abroad and want to exchange properties in other foreign countries, you have to worry about the tax systems in the countries where your properties are located, the country of your citizenship, and the country where you live.

Global 1031 Strategy: How Foreign Domiciliation Can Work in Your Favour

Imagine you’re a U.S. citizen, live in the UK, own property in India, and want to exchange it for property in Egypt. That’s four different countries whose tax systems you need to worry about in order to successfully execute your 1031 exchange involving foreign property.

An average QI that only has experience working in the U.S. won’t be able to get the job done right. You need more than just 1031 expertise – you need global business and tax expertise as well.

One thing that sets JTC apart from other Qualified Intermediaries is that we’re a global company that does so much more than just 1031. We have offices in jurisdictions around the world, with local staff that understand the laws and business culture in those areas. We also have a Private Capital Services division that works with individuals and families with complex monetary and investment interests around the globe.

JTC specializes in foreign domiciliation, especially in tax-free jurisdictions. If you or your properties are located in a jurisdiction with no income tax, you could potentially execute a 1031 exchange without having to pay local taxes. By deferring U.S. taxes as you would with a U.S.-based like-kind exchange, you could reinvest your full sales proceeds in your replacement property. JTC has offices in several of these jurisdictions and can work with our 1031 clients to take advantage of what they have to offer.

The biggest thing you should take away from this blog is that 1031 presents opportunities all over the world, and you have a lot of options when it comes to deferring taxes on property sales. JTC is unique in that we combine the power of our global reach, PCS division, and 1031 experts to develop tax deferral, domiciliation, and investing strategies for our clients that allow them to protect their assets and build wealth for the future.

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