Section 1031 of U.S. tax code is based on the idea of a mutually beneficial relationship between the real estate investor and the U.S. economy as a whole.  1031 exchanges allow investors to put their capital to work in the most advantageous ways possible, which in turn stimulates the economy by creating more jobs and greater opportunity in the U.S.  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.

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).

If 1031 exchanges are limited to the U.S. so that the economy will benefit and the IRS will be able to collect capital gains taxes in the future, then you may be wondering what rules apply to U.S. territories such as Guam, the U.S. Virgin Islands, and Puerto Rico.  In private letter rulings, the IRS has stated that a Virgin Islands property can only qualify as like-kind in an exchange with a U.S. property if it is income-producing, which is more restrictive than the normal requirements for a like-kind exchange, which merely state that the property must be held for your trade or business or as an 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.