9 Key U.S. Tax Issues

Purchasing or owning real estate property overseas can be an exciting investment opportunity, but for U.S. persons, it comes with significant tax and reporting obligations. Foreign persons becoming U.S. tax residents (e.g., obtaining a green card) may already own overseas properties and should be aware of the U.S. tax issues they will face at the all-important residency starting date.

Here are 9 key points U.S. taxpayers should consider when buying or owning foreign real estate.

1. Understanding The Foreign Earned Income Exclusion vs. Income From Property Ownership

The FEIE does not apply to income generated from foreign real property, such as rental income. While the FEIE may help U.S. taxpayers exclude foreign-earned wages or self-employment income from taxation, any income from renting out foreign real property is fully taxable and must be reported to the IRS.

2. Depreciation Rules For Foreign Real Estate Property

Foreign real estate property used for rental purposes must generally be depreciated over a 30-year period, unlike domestic rental property, which typically uses a 27.5-year schedule. This difference can affect the property’s taxable income and eventual capital gains calculation.

3. Foreign Tax Credits

If the foreign country where the property is located imposes income taxes on rental income, U.S. persons can generally claim a foreign tax credit to offset their U.S. tax liability. However, detailed recordkeeping is required, and differences in tax treatment between the two countries (e.g., deductions and depreciation) can lead to additional complexities. Getting the correct cross-border tax assistance is critical.

4. Foreign Bank Account And Foreign Account Tax Compliance Act Reporting

Ownership of foreign real property itself is not reportable on either the FBAR or FATCA Form 8938. However, when the aggregate of all of the taxpayer’s foreign financial accounts (including accounts used to pay for the property or receive rental income) exceeds US$10,000 at any point during the calendar year, all of the accounts must annually be reported on the FBAR. While foreign real property held directly by the individual (as opposed to ownership through an entity) is not required to be reported on FATCA Form 8938, the form must be filed if the total value of foreign financial assets, including foreign accounts or ownership interests in foreign entities that may be associated with the real estate, exceeds certain thresholds.

5. Capital Gains Tax On Sale Of Foreign Property

When a U.S. person sells foreign real property, the capital gain is subject to U.S. tax. Foreign currency fluctuations can significantly impact the gain or loss. For instance, if the property’s value in the local currency remains constant, but the U.S. dollar weakens, the taxpayer could face a larger taxable gain.

6. U.S. Tax Issues When Foreign Real Estate Property Is Owned Through A Foreign Entity

Purchasing foreign real property through a foreign entity, trust, or partnership may have advantages in the foreign jurisdiction but can trigger complex U.S. tax consequences. For example, when an American holds a foreign principal residence through a foreign entity, he may lose the tax exclusion on certain gain when selling the residence.

Significant U.S. tax issues arise if the entity owning the property is treated as a “Controlled Foreign Corporation” or “Passive Foreign Investment Company,” including loss of favorable capital gains rates on sale of the property. Highly complex information returns must be filed with the U.S. person’s tax return reporting ownership interests in foreign entities (for example, Forms 5471, 8938, 8621). Material information may be required on these returns, including profit and loss statements, and harsh penalties apply for failures to file.

Consulting with a cross-border tax advisor is essential to determine the best ownership structure. Proper tax planning can usually prevent imposition of the CFC / PFIC tax regimes, but to be effective, the planning must be done in advance.

7. Estate And Gift Tax Implications

U.S. citizens and foreign individuals treated as “domiciled” in the U.S. are subject to U.S. estate and gift tax on their worldwide assets, including foreign real property. Planning is essential to ensure proper valuation and to mitigate potential double taxation if the foreign country also imposes gift, estate or inheritance taxes.

8. Exit Tax Considerations For Expatriates

If a U.S. person who owns foreign real property chooses to relinquish their U.S. citizenship or green card, the property’s value may be included in the exit tax calculation, if the individual qualifies as a “covered expatriate”. Determining the fair market value of the property and any built-in gains is crucial for mitigating exit tax, if applicable, and for U.S. tax compliance.

9. Foreign Mortgage Interest Deduction

Mortgage interest on a foreign property is deductible for U.S. tax purposes only if the property qualifies as a primary or secondary residence. Taxpayers must ensure they meet the same rules that apply to U.S. properties for claiming this deduction.

U.S. taxpayers may deduct mortgage interest on their federal tax returns if certain conditions are met, even for a foreign property. There are key points to note:

1. Qualified Residence: The property must be classified as a primary or secondary residence for the taxpayer.

2. Loan Limits: For mortgage interest to be deductible, the loan must not exceed certain limits, which are currently based on up to $750,000 of acquisition debt (or $1 million if the debt qualifies under grandfather rules). The loan proceeds must be used to buy, build, or substantially improve the home.

3. Secured Loan: The loan must be secured by the property itself.

4. Reporting Challenges: Foreign financial institutions issuing mortgages may not issue IRS-compliant Form 1098s, which detail the interest paid. Taxpayers must retain detailed records and supporting documentation to substantiate the deduction.

Conclusion

Owning real estate property overseas offers diversification and potential financial rewards, but it requires careful planning and awareness of U.S. tax obligations. U.S. persons should consult with tax professionals experienced in cross-border transactions to navigate the complexities of U.S. tax and relevant foreign laws.

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This communication is for general informational purposes only. It is not intended to constitute tax advice or a recommended course of action. Professional tax advice should be sought as the information here is not intended to be, and should not be, relied upon by the reader in making a decision.