The 1031 exchange is a tax deferral strategy that helps commercial real estate investors reduce their tax liability when making a profitable sale. When they file a 1031 exchange, also called a “like-kind” exchange, the commercial real estate investor doesn’t need to pay capital gains taxes so long as the sale proceeds are reinvested into a replacement property of “like-kind.”
But how do 1031 exchanges work when the investment property is overseas? Or what if the investor is not a US citizen but a non-resident alien who is still subject to the US federal income tax? This article will explore what considerations need to be made for investment properties not located in the US and for non-citizen residents of the US.
But first, let’s explore the basic rules detailing 1031 exchanges first.
What Are The Rules Governing 1031 Exchanges?
There are several requirements that the investor and the investment property must meet to be considered eligible for a 1031 exchange.
Time From Date of Sale
There is a strict timeline for identifying the list of potential replacement properties. This identification period lasts for 45 days from the date of sale. In order to defer capital gains on the sale of the property, the potential replacement property must be identified within this window of time. Additionally, the purchase of the replacement property—the exchange—must take place after 180 days from the date of the sale.
Market Value and Equity
The market value of the replacement property needs to be equal to or greater than the value of the sold property. This is also true of any debts on the property. If the market value and equity on the replacement property are less than the value of the property sold, that difference is still income and liable to be taxed as capital gains.
The replacement property needs to be of the same character or nature as the relinquished property. This doesn’t mean that the properties need to be the same type. For example, a multifamily apartment complex is considered like-kind to a commercial office building. However, the property must be held for use in business, trade, or investment.
Presence of “Boot” Might Be Cause For Taxation
“Boot” refers to any non-like-kind property or assets received in a 1031 exchange to make the exchange equal in value. The boot can be personal property, cash, debt relief, or another type of asset. If the boot is involved in the transaction, it could render the exchange taxable.
No “Held For Sale”
Investors cannot immediately sell the replacement property after a 1031 exchange is approved. Generally, investors must hold for 12 – 24 months.
The taxable entity needs the same for both the relinquished and replacement property.
International Implications of 1031 Exchanges
Though the procedures are more complex, international property is eligible for a 1031 exchange, so long as it is with other international property. The rules governing the exchange are the same for international property exchanges.
However, international property is not considered like-kind to property in the US. Therefore, an investor can’t use a 1031 exchange to reinvest in property overseas if the property they sold was in the US and vice versa.
As for the process of the exchange itself, the sale and purchase of the properties depend on the cultural and institutional norms surrounding real estate in the countries where the exchange occurs.
There are some instances where different real estate procedures and norms might impact a successful 1031 exchange, making it more complicated.
A Case Study: 1031 Exchanges in India
In the US, the usual practice for completing a 1031 exchange is to have the seller of the relinquished property go through an intermediary—generally an escrow company—to receive payment from the buyer.
The practice of using an intermediary in such transactions is so normalized in the US that it is legally required that the buyer not pay the seller directly during 1031 exchanges. In fact, using an intermediary is normalized for most real estate transactions in the US.
However, there are international real estate markets that operate differently. Using escrow or closing companies to mediate transactions in India is frowned upon. Buyers and sellers prefer to interact directly.
This complicates conducting a successful 1031 exchange in India—using an intermediary is legally required for a successful 1031 exchange to occur. To work around this, India allows an Indian bank to act as the mediator, holding the payment in rupees. A bank advocate and the taxpayer must sign and approve the transaction for the funds to disburse to the seller.
What About 1031 Exchanges in Other Countries?
Each country that hosts US investors has its own unique way of working around the rules and regulations that restrict 1031 exchanges. If you are looking to invest in property overseas, you must understand how 1031 exchanges work in the foreign markets you plan to invest in.
About the Author
Roni Davis is a writer, real estate investor, and legal assistant operating out of the greater Philadelphia area. She writes for First National Real Partners, a commercial real estate investing private equity firm.