Interesting question, Raymond! Over the last several years, section 1031 like-kind exchanges have become a very popular tax-deferral tool. Under section 1031 of the IRS code, investors do not recognize any gain or loss "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."
With a provision as powerful as section 1031, it's no wonder it has become such a popular tool among investors. Given its growing popularity, savvy investors like you are seeking additional guidance on exactly what types of property can be exchanged under section 1031.
One common question among investors, like yours above, is whether or not a section 1031 exchange can be completed with foreign property. Before I answer your question, I'll give a quick review of the type of property that can be exchanged.
The first step to ensure that a property can be subject to a section 1031 exchange is that it must be a qualifying property. A qualifying property is any real property that is held for productive use in a trade, business, or any other investment purpose. Property held for personal use (e.g., primary residence or vacation home) cannot be used to complete a like-kind exchange.
For the purpose of section 1031, "property is real property if on the date it is transferred in an exchange, that property is classified as real property under the law of the state or local jurisdiction in which that property is located." In short, the definition of real property is governed by the jurisdiction in which the property is located.
Secondly, the property must be exchanged for another property of similar nature, character, or class to qualify as "like-kind."
Now that we refreshed ourselves on the definition of qualifying real property for the purpose of section 1031, let’s look to see whether foreign property qualifies for a section 1031 exchange.
Note: In addition to ensuring that the property subject to the exchange is qualifying real property, there are some additional technical requirements to complete the exchange. These requirements can be found here.
Allowable foreign exchanges
In general section 1031, the Internal Revenue Code (IRC) does not allow exchanges between a U.S. property and a foreign-based property. The IRC specifically states that property held in the U.S. is not of a like-kind with foreign-held property.
So, if you own an investment property in California and want to complete a section 1031 exchange with an investment property in Portugal, unfortunately this type of exchange is prohibited by the IRC because it is not of a like-kind.
While you cannot exchange your U.S. property with a foreign investment property, you are absolutely free to sell either property.
Sale of foreign property
If you sell your foreign-held real estate, you will recognize capital gains or loss on the sale. This transaction is reportable to the IRS because U.S. citizens and permanent residents have to report their worldwide income on their tax return.
The bottom line
So the short answer is no, you can't use a 1031 exchange for foreign property. But I'm glad you asked, because other investors can learn from it. Now that the world is opening back up, investors are seeking new locations for the latest investment. While a 1031 exchange doesn't apply for foreign property, there are other routes to take. To be certain of the tax implications and benefits, seek out the guidance of a competent advisor.
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