What is a 1031 exchange? I will try to make this simple. It is a provision made by the United States Internal Revenue Service that allows an American citizen or permanent resident investor to sell a property that is used for business or held as an investment and then reinvest the proceeds in a new property without immediately paying capital gain taxes.
The taxes are deferred or avoided altogether. The rules are outlined in section 1031 of the IRS code, hence the name “1031 exchange”. For those interested in buying property in Costa Rica, it’s noteworthy that 1031 exchanges are not limited to U.S. property. However, according to subsection H of the IRS 1031 code, very strict rules and regulations must be followed in order to obtain the benefits of the 1031 exchange in a foreign country. What are the rules, and how can you make them work for you in Costa Rica?
First of all, the arrangement applies only to exchanges of real property and not to exchanges of personal or intangible property. The exclusion of the latter went into effect on January 1, 2018. Thus, exchanges of vehicles, equipment, collectibles, intellectual property, and intangible business assets generally do not qualify under section 1031. Any gains on the sale of such personal or intangible property must be reported and taxes may apply.
Another requirement of the IRS rules is that the properties that are exchanged—that is, one is sold and another purchased—must be of “like-kind”. What does that mean? The IRS explains, “Properties are of like-kind if they’re of the same nature or character, even if they differ in grade or quality”. For example, the “like-kind” of an apartment building would be another apartment building. A rental property for another rental property and so on.
“So how does this all apply to buying property in Costa Rica”? You may ask and “why are you writing about this”? You must be thinking this about now, but hold on continue reading.
According to the IRS definition, real property in the United States is not like-kind to real property outside the United States. So, the 1031 exchange provision could not be applied to selling a U.S. property and using the proceeds to invest in a property in Costa Rica.
However, you can exchange one foreign property for another foreign property and still obtain the 1031 tax benefits. That’s how it can work for you in Costa Rica. You can sell one Costa Rica business or investment property and reinvest in another Costa Rican property. When handled properly, a 1031 exchange can allow your investments to grow while deferring the tax burden into the future when you’ll likely be in a lower tax bracket. I.E. Retirement.
Let’s try to explain this a little more simply. Let’s say for this example that you purchased a small 2 bedroom 2 bath condo 5 years ago and have been renting it out and also visiting it one or twice a year. But now that you love Costa Rica so much you want a bigger property to invest in like a home. You will still rent it out as an investment, but also use it as well. You can defer the capital gains tax on the sale of the condo and buy the larger home.
Keep in mind that if the value of the property you sell is greater than the value of the property you exchange it for, the difference is taxable. That holds true whether you buy and sell for cash or you hold a mortgage on the exchanged properties. For example, if you had a $200,000 mortgage on the property you sold, and the property you buy has a $150,000 mortgage, the difference of $50,000 is considered income.
This matter is related to the tax treaties that the United States has with many foreign countries. Unfortunately according to the U.S. Embassy in Costa Rica there is no tax treaty between the two countries https://cr.usembassy.gov/u-s-citizen-services/internal-revenue-service-u-s-taxes/faqs-paying-taxes-abroad/
Unfortunately, U.S. citizens are taxed on their income regardless of what country it is earned in. In most cases, even if you live in a foreign country, and even if you are a legal permanent resident of that country, you are still responsible to pay taxes to the IRS on all your income. Just like I have been doing for eleven years now.
I know that sounds really bad, especially since I also pay taxes in Costa Rica! I do get a bit of a break from the IRS. It is called the Foreign Earned Income Exclusion. It means exactly what it says. For 2018 under section 911 of the U.S. tax code, the Foreign Earned Income Exclusion is $104,100. Basically, the first $104,100 I earn in Costa Rica, I pay no U.S. income tax.
Making this kind of income in Costa Rica, you can certainly live very nicely, that’s for sure.
It is always important to consult a tax adviser on such complicated issues as this, but the 1031 exchange does work if you know how to do it right.
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