Can You Do a 1031 Exchange With Foreign Property?

A 1031 exchange, also known as a like-kind exchange, offers a tax deferral opportunity for real property investors. This provision of the U.S. tax code allows investors to postpone capital gains taxes when they exchange one investment property for another of a similar nature, enabling reinvestment of full sale proceeds into a new property without immediate taxation. The central question for many U.S. taxpayers with international holdings often revolves around whether foreign property can qualify for such an exchange.

Understanding 1031 Exchange Eligibility

A 1031 exchange is available for real property held for investment or productive use in a trade or business. Both the relinquished and acquired properties must meet this standard. Personal residences do not qualify.

Properties are considered “like-kind” if they are of the same nature or character, even if their grade or quality differs. For instance, an apartment building can be exchanged for undeveloped land. To maintain tax-deferred status, a Qualified Intermediary (QI) must hold the sale proceeds, ensuring the taxpayer does not have direct access to the funds.

Strict timelines govern the 1031 exchange process. An investor has 45 calendar days from the sale date to identify replacement properties in writing. The purchase of the replacement property must be completed within 180 calendar days from the original sale date. Missing these deadlines makes the entire gain taxable.

The U.S. Situs Requirement

While a 1031 exchange defers capital gains on like-kind real property, a specific limitation applies to international assets. Under Internal Revenue Code Section 1031, real property located in the United States and real property located outside the United States are not considered like-kind. This means an exchange of U.S. real property for foreign real property, or vice versa, will not qualify for tax deferral. For example, a U.S. taxpayer cannot exchange a property in the U.S. for one in Canada or Mexico and defer the gain.

However, regulations permit an exchange of foreign real property for other foreign real property. For U.S. citizens and permanent residents, who are taxed on their worldwide income, this allows deferral of U.S. capital gains tax when exchanging one investment property located abroad for another investment property also located abroad.

Tax Implications of Selling Foreign Real Property

When a 1031 exchange is not an option for foreign real property, U.S. taxpayers must account for the sale on their U.S. tax return. U.S. citizens and residents are subject to U.S. taxation on their worldwide income, which includes profits from the sale of foreign real estate. The capital gain is calculated by subtracting the property’s adjusted basis (original cost plus improvements, minus depreciation) from the selling price. All figures must be reported in U.S. dollars, using the exchange rates applicable on the dates of purchase, improvement, and sale.

Capital gains realized from the sale are subject to U.S. capital gains tax rates, which vary depending on how long the property was held. If held for more than one year, the gain is a long-term capital gain taxed at preferential rates (0%, 15%, or 20%). Short-term capital gains (held one year or less) are taxed at ordinary income tax rates.

To mitigate double taxation, U.S. taxpayers can claim a foreign tax credit (FTC) on Form 1116. This credit reduces U.S. tax liability dollar-for-dollar by the amount of income taxes paid to a foreign country. The foreign tax credit is limited to the U.S. tax on the foreign source income, and any unused credit can be carried back one year and forward for up to 10 years.

Depreciation recapture is another aspect for foreign rental properties. If depreciation was claimed, a portion of the gain, up to the amount taken, may be taxed at a higher ordinary income tax rate, typically up to 25%. This recapture occurs regardless of whether depreciation was actually claimed, as long as it was allowable.

Reporting Requirements for Foreign Real Property

Beyond the tax on sale, U.S. persons holding foreign real property or receiving proceeds from its sale have specific reporting obligations to the U.S. government. Two prominent forms are the Report of Foreign Bank and Financial Accounts (FBAR) and Form 8938, Statement of Specified Foreign Financial Assets.

The FBAR, filed on FinCEN Form 114, is required if a U.S. person has a financial interest in, or signature authority over, foreign financial accounts with an aggregate value exceeding $10,000 at any time during the calendar year. This includes foreign bank accounts where sale proceeds might be deposited. The FBAR is an informational report and does not directly result in taxes due. The filing deadline for the FBAR is April 15th, with an automatic extension available until October 15th.

Separately, the Foreign Account Tax Compliance Act (FATCA) mandates reporting of specified foreign financial assets on IRS Form 8938. This form must be filed with an individual’s annual federal income tax return if the total value of these assets exceeds certain thresholds. For U.S. residents, these thresholds are generally $50,000 for single filers ($75,000 at any time) and $100,000 for married couples filing jointly ($150,000 at any time). For U.S. citizens living abroad, the thresholds are higher, typically $200,000 for single filers ($300,000 at any time) and $400,000 for married couples filing jointly ($600,000 at any time).

Specified foreign financial assets include foreign bank and brokerage accounts, foreign-issued life insurance policies with cash value, foreign securities, and interests in foreign entities. It is possible to be required to file both an FBAR and Form 8938.