The 1031 exchange is a way for real estate investors to postpone paying capital gains taxes when they sell an investment property. This tax benefit is available to U.S. tax payers on property residing inside and outside the U.S.
If you sell an investment property and put all the money from that sale into another property of “like kind,” then you can avoid all taxes on the sale.
Defining “Like Kind”
The most important rule in the 1031 exchange is the “like kind” rule. When you sell a property, the new one you purchase must be of like kind to the property you sold.
As long as you follow the proper protocol, and the sold and the purchased properties are like kind, then you can avoid the capital gains taxes of selling your investment property.
Generally, these kinds of properties can all be considered like-kind:
- Long term rental property
- Short term rental property
- Land (even unimproved land)
- Single family home
- Multi family home
- Commercial property
- Any other type of real property used as an investment (this can include mineral and water rights)
You can see that there is a lot of flexibility when it comes to what type of property can be used in an exchange.
You can exchange single family homes for multi family homes (and vice versa). Commercial property can be exchanged for residential property. Heck, you can even exchange a hotel for a plot of raw land. As long as both sides of the exchange are used for business or investment, you’re good.
But there is another rule in the IRC Section 1031 that can make one piece of real property not be like kind with another.
U.S. real property vs non-U.S. real property
While just about every type of real property from within the U.S. is like kind with any other type of real property, the rules change when the property is outside the U.S.
The IRS 1031 fact sheet states that:
“One exception for real estate is that property within the United States is not like-kind to property outside of the United States.”The Internal Revenue Service IRC Section 1031 Fact Sheet
That means that a single family home in the U.S. can not be sold and exchanged tax-free for a single family home outside the U.S.
Real estate inside the U.S. is like kind with other U.S. real property. And real estate outside the U.S. is like kind with other real property outside the U.S.
1031 Exchange Process Outside the U.S.
The rules for a 1031 exchange don’t change when you are dealing with property outside the U.S. The process is identical.
Here’s a recap of my article on the 1031 exchange process.
1031 exchange process recap
First, you should set up your 1031 exchange with professionals (a law firm) before selling. There is a decent amount of paperwork involved in doing a proper exchange, so start early.
Next you’ll need to find an intermediary. The cash received when you sell your property cannot be mixed with any other money, so a qualified intermediary is needed to hold that money and ensure it is kept for the sole purpose of purchasing the new property.
Then you can sell you property. When you do this all proceeds from the sale should go into an account held by your intermediary.
You’re on the clock after selling your property. You will have 45 days from closing to identify one to three properties to purchase. This is a required part of the process.
You also have 180 days from the closing of your sold property to close on the purchase of your new property. The seller of this property must agree to sign paperwork allowing the 1031 exchange to happen.
At that point the exchange is complete. You simply have to file your taxes properly at the end of the year to get your tax benefit.
Boot in a 1031 exchange
If you follow the two rules below, you’ll never have to worry about boot:
- Buy a property worth more than the one you’re selling
- Put all the money from the sale of your property towards the purchase of the new one.
If you do that, you’ll avoid any taxation on your 1031 exchange. There are two primary types of boot that happen in exchanges.
The first is cash boot. If you leave a 1031 exchange with any cash, then you will be paying taxes on that cash.
Here’s a quick example.
- Sold property – $200,000
- Bought property – $180,000
- Cash boot – $20,000
If you buy a property worth $20,000 less than the property you owned, then you will likely end up with $20,000 in cash. That cash can be taxed as capital gains.
Read my 1031 exchange boot article for more information and in depth examples.
Mortgage boot is slightly more complicated. It’s possible to leave a 1031 exchange with no cash, but with less debt. If you carry less debt after your exchange than you had before, the difference is called mortgage boot and is subject to taxation.
Here’s an example.
- Property sold – $200,000
- Debt held on sold property – $60,000
- Cash from sale – $140,000
- Property bought – $180,000
- Down payment – $140,000 (all the cash from sale)
- Debt held on new property – $40,000
You can see that we applied all the cash from the sale of our property to the purchase of the new property. However, because the new property had a lower value, we now hold less debt on the new property.
We had $60,000 principle balance on the old mortgage and the new mortgage only has a $40,000 balance. We reduced our debt obligation by $20,000.
So that $20,000 is now subject to capital gains taxation.
Again, my article on boot has more information and more in depth examples.
It’s completely possible to use the tax advantages of a 1031 exchange with real estate outside the U.S.
In fact, the rules around doing this are the same outside the U.S. as they are inside. However, foreign real estate can only be exchanged for other foreign real estate.
Real estate in the U.K. can be exchanged for property in Canada or Japan, but it can’t be exchanged for U.S. real estate.
If you remember that and follow the two rules for avoiding tax in a 1031 exchange (buy a more expensive property and don’t keep any cash), then you’ll get your tax free exchange on foreign real estate.