As a real estate investor, you probably are aware of the advantages of a 1031 exchange over outright sale of a property. An exchange defers your capital gains taxes, keeps your money working for you, and helps to build equity and maximize your returns. But 1031 exchanges are allowed not only for the good of the investor; by allowing investors to move their capital to the most advantageous investments, section 1031 stimulates the U.S. economy.
By this logic, it wouldn't make sense to allow 1031 exchanges to be made on properties overseas, and this is indeed prohibited. Section 1031 is at least partially intended to encourage investors to invest in property located in the U.S., both for the sake of the economy and because it can be difficult or impossible for taxes to be collected on foreign property (remember that a tax deferral is more of a loan than a gift, and the IRS expects to collect on this loan in the event that you sell a replacement property outright).
In private letter rulings relating to the U.S. Virgin Islands, the IRS has ruled that a property must be income-producing in order to meet like-kind requirements. This is a more constricted definition of a like-kind exchange than that which is normally applied to exchanges made on properties in the United States, which merely requires that your property be held for the purpose of business, trade or investment.
The path of least resistance when it comes to making a 1031 exchange is to confine your transactions to the United States, which comprise the fifty states as well as Washington D.C. In the event that you find it necessary to make an exchange on property located in an outside territory, I advise you to carefully analyze your replacement property to make sure it meets like-kind requirements. You may even want to request your own private letter ruling from the IRS.
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U.S. property investors can save a lot of money by utilizing a 1031 exchange to defer all of their capital gains tax on the sale of investment property. A 1031 tax exchange is like an interest free loan from Uncle Sam!
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