What’s the point of understanding the rules if you have zero grasp of the game you’re about to play? What’s a 1031 Exchange in the first place? In layman’s terms, the exchange lets you defer payment of capital gains taxes upon selling a commercial or investment property. However, you need to reinvest your funds within a defined time limit in ‘like-kind’ (more on this in a bit) property or properties. Such properties also need to be of equal or higher value.
If you’re browsing for “1031 Exchange foreign property”, this post has you in mind. But first, let’s examine some directives from the 1031 exchange ‘rulebook.’
This rule stipulates that if you intend to acquire a replacement asset to reap the perks of a 1031 exchange, you need to identify a potential replacement within a 45-day window. The time starts when you sell your real property and lapses at midnight 45 days later.
You are only at liberty to buy an investment property you’ve identified. Failure to adhere to this rule can easily void the exchange. On a positive note, you can acquire all of the properties you identify or opt to leave out some of them.
Under this rule, you can only identify three properties you may acquire. Upon identification, you can then go ahead and buy one or all of the properties as a replacement for the property you’ve sold.
If you intend to identify more than three properties, this rule allows you to do so. In this case, you have the green light to identify unlimited properties, provided their aggregate market value doesn’t exceed 200% of the value of the real property you’ve relinquished.
You Can Only Exchange Like-Kind Properties
“Like-kind” implies that the replacement property needs to be similar to your original asset. In short, the relinquished property and the new property you are eyeing have to be identical in a sense. What similarities are we referring to in this case?
Generally, if you let go of real estate, any other similar asset you plan to buy fits the bill. But, both properties must only be used as investment avenues for business or other productive(trade-related) purposes. Thus, private properties do not qualify.
Besides, the quality of the properties isn’t a determining factor. Quality could imply an asset’s value. As a result, even if the relinquished and identified assets differ in their market value, we can still consider them kind.
Let’s take the example of rental properties such as apartments. If you sold an apartment and opted to purchase a condo building as a replacement, the two properties are like-kind. Why? Both are income streams, and they’re owned primarily for business and not personal use. I hope I haven’t been laboring at this point.
You are not mandated to acquire like-kind replacement assets in your home state or the same place. You can exchange property with a similar holding located anywhere within the U.S.
Unfortunately, the Internal Revenue Code(IRC) generally prohibits exchanging U.S. property with replacement properties in a foreign nation. According to the IRC, the two assets are not of the like-kind. Simply put, you can’t relinquish your holding in New York and acquire a similar asset in Mexico.
What option would you have if you wanted to replace an investment property in a foreign country? You can sell the foreign asset and replace it with a similar one overseas. Alternatively, upon letting go of the property, you may reinvest your earnings back in the U.S.
Remember to fulfill your tax obligations upon selling a foreign-owned investment by reporting your capital gain or loss in your tax return to the Internal Revenue Service(IRS). Otherwise, you might be on the hook for tax evasion. Frequently, such fights with the government could leave you with a ‘black eye’!
Incidental Property Rule
Incidental property, in this case, refers to personal belongings that are part of the acquired real estate in a valid 1031 exchange. If you receive incidental property as part of replacement real estate, then the gains from such personal property are taxable. How can you determine that personal property is incidental? Generally, the valuables should fulfill two conditions:
- You should acquire personal property alongside the like-kind property.
- The total market value of the personal effects should not exceed 15% of the value of the replacement property or enormous commercial asset.
Let’s use an illustration to clarify these points further. Let’s suppose you plan to buy a commercial home for $500,000, which includes personal property valued at $40,000, representing 8% of the value of the more significant asset. As a result, you don’t have to identify the personal property separately. In addition, the incidental property isn’t included as part of the 3-property rule.
In summary, by sticking to 1031 exchange rules, you can defer your tax liability. In doing so, you get to free up more capital for reinvesting in replacement properties that could bring in better rewards. I hope these rules provide a guideline you can adhere to in your investment journey.