Can I use a §1031 Exchange to Acquire Real Estate Outside of the U.S.?
James T. Walther, Esq., LL.M., General Counsel
Julia Mastrotto, Esq., Counsel
As a national qualified intermediary, we are frequently asked by investors selling U.S. real estate if they can utilize an IRC Section 1031 exchange to acquire property outside of the United States (a.k.a. international or foreign real estate). The following questions commonly arise when investors seek to purchase vacation rentals or when a retirement plan involves properties outside of the United States:
Can real estate in Puerto Rico qualify as relinquished or replacement property in a 1031 exchange?
Is a U.S. property and a property in Puerto Rico “like kind” to one another?
In this article, we will discuss the limitations to exchanging international property, the “like-kind” requirement as it pertains to properties within and outside the United States, and generally when a taxpayer can use a 1031 exchange to acquire property located outside of the continental U.S.
In discussing the above, we consider two main concepts:
1. U.S. real estate is only “like-kind” to U.S. real estate, and international real estate is only “like kind” to international real estate.[i]
a. Therefore, under §1031, international real estate cannot be exchanged for U.S. real estate and vise-versa.
2. “U.S. Real Estate” refers to property within the Continental U.S., including “coordinated” U.S. Territories (Guam and the U.S. Virgin Islands are considered U.S. real estate, but not Puerto Rico)
1) §1031 provides that U.S. real estate is only of “like-kind” to U.S. real estate.
Section 1031(h) of the Tax Code spells it out, sort of.
Section 1031(h): Special rules for foreign real property. Real property located in the United States and real property located outside the United States are not property of a like kind.
This raises the question, what is considered “outside” the United States for purposes of Section 1031?
Section 7701(9) reads: United States. The term “United States” when used in a geographical sense includes only the States and the District of Columbia.
2) How about the islands?
Let’s talk 1031 Exchanges for Puerto Rico and other U.S. Territories.
Special rules allow real estate in U.S. Territories to qualify as “like-kind” real estate. Under §932 and §935[ii] of the Tax Code and corresponding temporary regulations, these special rules apply the Tax Code to “Coordinated Territories” of the U.S. (Guam, the Marianna Islands, and the U.S. Virgin Islands).
Puerto Rico is a Protectorate of the U.S. but not a “coordinated territory,” therefore real estate in Puerto Rico is not considered “U.S. real estate” for purposes of Section 1031. During the 2017-18 Legislative Session, Bill, H.R. 5430 – Puerto Rico Real Estate Exchange Fairness Act of 2018, was introduced in the House of Representatives, but did not become a law.[iii] The Bill sought to apply Section 1031 to real property located in Puerto Rico. In March 2021, the Bill was re-introduced as Bill H.R.1742, the Real Estate Exchange Fairness Act of 2021. Similarly to its 2018 counterpart, this Bill also did not become a law. “This bill requires Puerto Rico to be treated as part of the United States for the purpose of determining if an exchange of real property qualifies as a like-kind exchange for tax purposes. (Under current law, real property located in the United States and real property located outside of the United States are not property of a like kind.)” Considering this, for those investing or planning to invest in real estate in Puerto Rico, it currently will not qualify as “like-kind” to U.S. real estate.
3) International real estate is “like-kind” to international real estate
In order to take advantage of IRC Section 1031, a taxpayer should ensure that the Tax Code and Section 1031 applies to them, as the same only apply to U.S. taxpayers. Otherwise, they should ensure that one of the special rules applies to them if they are a resident of a U.S. Territory/Possession (See #2 above).[iv] If so, they can potentially use a 1031 exchange to (1) exchange U.S. real estate for U.S. real estate, or (2) to exchange international real estate for international real estate. However, they cannot exchange international real estate for U.S. real estate under §1031.
Caveat: Please note that for purposes of §1033 (involuntary conversion exchanges) the rules are notably more flexible such that involuntarily converted U.S. property can be replaced with property outside of the U.S.[v]
Conclusion: Unfortunately for U.S. real estate investors looking to acquire island vacation investment property, real estate in Puerto Rico is currently not an option under Section 1031, unless both the relinquished and replacement properties are foreign real estate. In which case, if a U.S. taxpayer is selling international real estate, then real estate in Puerto Rico may be an option.
[i] Internal Revenue Code Section 1031(h) provides the special rule for foreign real estate: “Real property located in the United States and real property located outside the United States are not property of a like kind.”
[ii] Upon research and review, one may find that IRC §935 was repealed; however, its corresponding regulations are still in effect until each “Pacific Possession” signs an agreement implementing the repeal. To date, only American Samoa has done so, leaving Guam and the Northern Marianna Islands within the scope of §935 and its corresponding regulations.
[iii] The Bill proposed to add the following language to Section 1031(h): “(3) UNITED STATES. —For purposes of this subsection, the term ‘United States’ shall be treated as including Puerto Rico.”
[iv] See IRS Classification of Taxpayers for U.S. Tax Purposes – https://www.irs.gov/individuals/international-taxpayers/classification-of-taxpayers-for-us-tax-purposes
[v] This anomaly is noted in IRS Publication 544 among other IRS guidance. The Committee Report for the Omnibus Budget Reconciliation Act of 1989, P.L. 101-239 (H-Conf. Rept. 101-386) a piece of legislation that created IRC §1031(h), explicitly stated that 1033(g) was considered outside of 1031(h).
Legal 1031 does not provide tax or legal advice, nor can we make any representations or warranties regarding the tax consequences of any transaction. Taxpayers must consult their tax and/or legal advisors for this information. Unless otherwise expressly indicated, any perceived federal tax advice contained in this article/communication, including attachments and enclosures, is not intended or written to be used, and may not be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein.
Copyright © 2022 Legal1031. All rights reserved.