As tax season dawns upon us, many investors are searching for tax-saving strategies. One that is often misunderstood is the 1031 like-kind exchange that an American can use to defer capital gains taxes on investment real estate profits.
Many real estate and tax experts still think that you can't do a like-kind exchange with foreign real estate. You can. The question is whether or not you should.
First, some background. A 1031 like-kind exchange is a section of the U.S. tax code that allows for investment property, real estate or otherwise, to be exchanged for similar investment property. You can exchange a piece of factory equipment for another piece of factory equipment…or you can exchange a commercial building for a residential apartment building (that is, investment real estate for investment real estate).
Of course, generally speaking, things like factory equipment don't appreciate over time, whereas real estate can. Therefore, the ability to exchange an appreciated property for another property and thereby defer the capital gains taxes (both on the absolute appreciation and any recaptured depreciation that would have occurred with a sale) can be an excellent tax-planning tool.
U.S. real estate investors are generally well aware of the benefits of 1031 like-kind exchanges. A whole real estate industry has evolved around the concept. However, many don't realize they can do an exchange with foreign property.
The catch is that you can't exchange a U.S. property for a foreign one under the 1031 rules. It has to be U.S. for U.S. or foreign for foreign. In other words, you must make your first foreign real estate investment…and then think about like-kind exchanging it for another when you're ready to execute your exit strategy.
You could exchange a rental apartment in Buenos Aires for a farm in New Zealand…or a ranch in Uruguay for a beach house in Puerto Vallarta.
Of course, it isn't a literal exchange. You don't have to find a farmer in New Zealand who wants an apartment in Buenos Aires. However, you do have to follow the 1031 rules carefully. These include certain timelines for identifying properties you want to buy as part of the exchange and for closing on the selected new property.
In addition, it's very important to understand that you can't actually touch (that is, take possession of) any proceeds from the sale of the original property. You have to use a qualified intermediary to hold the proceeds from the sale of the first property for you and then pass them along to the seller of the property for which you are exchanging.
You can find the specifics for the rules online at any number of sites specializing in 1031 exchanges.
Many investors get excited when they learn they can do an exchange with a foreign investment property. However, as I mentioned, it's a great opportunity in theory, but not always in practice.
While deferring your U.S. capital gains taxes is obviously beneficial, you don't want to end up deferring U.S. taxes (meaning you have to pay them later) when you could get a credit against them today and avoid them altogether.
If you sell an investment property in Spain for a profit, you'll owe capital gains taxes to the Spanish government (a tiered rate starting at 21%).
U.S. capital gains taxes can be 0% if you have low enough income, but most likely you'll be at the 15% tax rate on your capital gains (note it could be as high as 20%).
Therefore, because you must pay the Spanish government at least 21%, you can be better off in the long run taking that as a credit against the 15% tax due to Uncle Sam, rather than doing a 1031 like-kind exchange and deferring the U.S. capital gains tax.
Obviously, if you're selling a property in a country that doesn't charge capital gains taxes (New Zealand, for example), then doing the exchange makes sense for your U.S. tax purposes.
You also have to weigh the expense of doing the exchange against the potential U.S. capital gains tax. The cost of exchanging a U.S. property for a U.S. property exchange can be minimal…as little as US$495 through do-it-yourself websites.
However, a foreign-for-foreign exchange will likely cost you more, maybe as much as US$1,500, meaning that, at the current capital gains tax rate of 15%, you break even only if your gain is US$10,000 or more. For smaller properties and smaller profit gains, an exchange may not make sense.