Property investment is a great way to generate passive income for Americans living abroad. But with every property sale comes a potential tax burden, so it’s important to understand the ins and outs of 1031 exchanges, which can provide a way to avoid paying capital gains taxes on your investment properties.
In this article, we’ll look at what a 1031 exchange is, how they work, and considerations for investment properties abroad.
What is a 1031 Exchange?
A 1031 exchange is a swap of one real estate investment property for another that allows capital gains taxes to be deferred.
The 1031 exchange tax benefits date back to 1921. Back then, Congress amended this section of the tax code to encourage investors who had suffered losses during World War I by giving them an opportunity for tax deferral on gain realized through “like-kind” exchanges or trade-ins.
The popularity of these transactions grew exponentially over time as more people looked for ways to reduce their tax burden. Only recently, Congress clarified and limited which types of property qualify for this capital gains tax deferral, and which don’t.
In the past, one could exchange different types of investment properties and take advantage of the 1031 exchange. However, the 2017 Tax Cuts and Jobs Act, limited Section 1031 exchanges to real property.
You cannot apply it to exchanges of personal or intangible property, or crypto. It also generally does not apply to exchanges of machinery, equipment, vehicles, artwork, collectibles, patents and other intellectual property and intangible business assets. 1031 Exchanges are limited to investment real estate.
1031 Exchange for real estate
As a real estate investor, you probably heard that 1031 exchanges are a way to avoid, or actually defer, paying capital gains taxes. In a 1031 exchange, you sell one investment property and use the proceeds to buy another investment property or pay down debt related to your purchase.
The IRS allows investors to defer capital gains taxes on the sale of a property if they buy another property within 180 days. The catch is that the properties and the overall exchange process must meet certain requirements to qualify.
1031 Rules for real property exchanges
The IRS has specific requirements for a 1031 exchange:
- The properties must be like-kind.
- Both properties must be investment properties, not personal residences, and you’ve owned it for at least one year.
- You have to reinvest 100% of the sale price in the new property.
- You can’t take equity out of the new property, but you can take debt out.
- You must use a qualified intermediary to hold your money for you during the 1031 exchange process.
- You must stay within the 1031 exchange timeline, i.e., the 45-day rule and the 180-day rule.
If you don’t follow all these rules, you will pay a whopping capital gains tax of up to 40%!
Let’s go through each rule in more detail.
What is a like-kind property for 1031 Exchange?
Properties are like-kind if they’re of the same nature or character. The two properties don’t need to be identical; in fact, they could be very different from each other. They just have to share a similar nature and class.
Here are the general characteristics of what makes two properties like-kind. They must be the same in
- Nature, e.g., building vs land
- Class, e.g., commercial vs residential
- Character, e.g., vacant land vs apartment building
- Quality, e.g., raw land vs improved property
For example, an apartment building would generally be like-kind to another apartment building.
Important for US expats is that real property in the United States is not like-kind to real property outside the United States.
Investors with foreign real estate can still qualify for the 1031 exchange by exchanging a foreign investment property with another foreign investment property.
As long as the two properties are like-kind, you can use them to do a 1031 exchange.
Exchange is limited to investment properties
You can only do a 1031 exchange with an established investment property, not with your personal residence or any property that you have owned for less than one year.
The IRS requires this time frame because it doesn’t want people to use the 1031 to buy and sell their principal residence every few years without paying taxes on gains each time they do so. It also doesn’t want people buying and selling similar properties just for their tax benefits (i.e., flipping).
Reinvest 100% of the sale Price in the new property
To avoid any capital gains tax on the sale of a property, you must reinvest 100% of the sale price in the new property.
If you do not reinvest 100% of your proceeds from your sale into another like-kind investment, you will owe taxes on any gains that weren’t reinvested into another like-kind real estate asset within the required timeline. – More about the time requirements in a moment.
You can’t take equity out of the new property, but you can take debt out.
You can use the proceeds from the sale of your old property to pay off any debt on your new property. If there are no other debts on the new property, then all proceeds from selling your old property can be used towards buying a new one.
You must use a qualified intermediary, or QI, for the 1031 exchange process. This can be an attorney, real estate agent, or a 1031 exchange company.
Investors cannot receive proceeds from the sale of a property while a replacement property is being identified and purchased. Instead, funds are held in escrow by the 1031 exchange intermediary until the replacement property is purchased.
Be sure that your QI is qualified by checking their credentials and references, as you will have to trust them with your money during the exchange process.
1031 Exchange timeline
1031 Exchanges have a very strict timeline that you need to follow. There are two key timing rules:
45-Day Rule: The IRS only allows 45 days to identify a replacement property for the one that was sold.
180-Day Rule: You must close on the new property within 180 days of the sale of the old property. That means that the purchase and closing of the replacement property must occur no later than 180 days from the time you sold the current property. You must receive the new property within this 180-day period.
You can also buy the replacement property before selling your investment property. You should still comply with the 45-day rule and the 180-day rule.
The best approach is to start 45 days before the closing of the sale of your old property. This gives you time to prepare documents, including agreements with buyers and sellers, as well as apply for permits where necessary.
It also gives you some leeway if there are delays between start and closing—for example, if there’s an issue with one of the buyer’s loans or another delay arises during escrow (the legal process by which real estate purchases are settled).
International 1031 exchange with foreign properties
The tax benefits of Section 1031 are not limited to US investments. Investors with overseas properties can also leverage it when they exchange one foreign property for another. The two investments don’t even need to be in the same country. But both must be outside the United States.
Some challenges for an international 1031 exchange of foreign properties include different closing processes with different paperwork. It’s also not straightforward to hold the funds locally with a qualified intermediary if both properties are in the same country.
Without appropriate local intermediary and escrow, you may need to use an US escrow account. This could result in currency exchange gains/losses when transferring the funds back and forth.
1031 Exchange for foreign investors in the US
When foreign investors sell real estate in the US, they have to comply with FIRPTA rules. These rules include federal withholding requirements, specific times, and exemptions.
So, while non-US people can also benefit from a 1031 exchange, navigating the requirements and timelines of both FIRPTA and 1031 can be quite challenging.
Participating in a 1031 exchange does not automatically avoid FIRPTA withholding. To be exempt, special rules and steps must be followed.
Tax consequences for not following the 1031 rules
If you don’t follow the 1031 Exchange rules, you will have to pay capital gains tax on the sales of your investment property. The tax rate can be up to 40%!
Before you engage in any kind of real estate transaction, it’s imperative that you understand the rules and regulations associated with it.
Ensure that all involved properties meet the requirements and that you stay within the allowed timeline.
Depreciation recapture for rental properties and 1031 exchange
If an investment property is rented out, the owner must report the rental income on their tax return. At the same time, they can also claim a depreciation expense.
Depreciation reduces the cost basis of the property. Therefore, the taxable gain will be higher when selling the property. Depreciation recapture means that you will need to pay taxes at the ordinary income tax rate for the depreciation expense claimed over the rental period.
With the 1031 exchange strategy, this taxable event of depreciation recapture can also be deferred. Talk to an experienced tax accountant.
When and how to file a 1031 like-kind exchange with the IRS
You need to report the 1031 exchange in the tax year that you transferred property to another party in a like-kind exchange. For example, let’s assume that you transferred your rental property to a third party on June 1, 2024. That means you need to report the 1031 exchange in your 2024 tax return that is due by April 15, 2025 (without extensions). If you transferred property to a related party, special rules apply.
This report is done through IRS Form 8824. This form is used to calculate the amount of gain that is being deferred and the amount of gain that will be taxed in the current year (if applicable).
1031 Exchanges are tricky but may be well worth it if you want to avoid paying capital gains tax on your investment properties.
1031 Exchanges are a great way to defer paying capital gains taxes. If you buy one property, sell it, and then use the money to buy another property, you can do this over and over again without having to pay any additional taxes (as long as they’re like-kind and meet the other requirements).
If done correctly, 1031 exchanges could save investors thousands of dollars every year in taxes by allowing them to defer capital gains tax with “like-kind” properties that are similar in nature, but not necessarily value.
Consult with an experienced tax advisor to ensure that you meet the IRS requirements.
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