The U.S. tax code’s section 1031 is founded on the premise that establishing a mutual relationship would be advantageous to both the real estate investors and the U.S. economy in general. This means that by virtue of 1031 exchanges, all investors are allowed to maximize the use of their capital that may translate to more jobs and opportunities, thus boosting the economy of the United States.
This is one major reason why 1031 exchanges cannot occur outside of U.S. territory. In addition, a tax deferment means that the IRS will want to collect your capital gains taxes in the event that you someday sell your replacement property, and it can be very difficult for them to collect taxes on the sale of foreign property.
The law forbidding 1031 exchanges that has to do with property in a foreign territory is understandable, however, it can be a little vague to consider the case of U.S. territories like Puerto Rico, Guam, and U.S. Virgin Islands. In these territories, you are allowed to make an exchange on a property however, one has to be very careful in the transaction.
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.
When making a 1031 exchange, it is best to limit your transactions within the United States that includes all the fifty states and the Washington, DC. This ensures that you will meet fewer constrictions along the way. Moreover, you must carefully study your replacement property and ensure that like-kind requirements are fulfilled. If the need arises, secure from the IRS your own private letter ruling.