FOREIGN REAL ESTATE – A TAX OVERVIEW
U.S. expats are generally involved with foreign real estate in one of two capacities – either as a personal residence or as investment property. The tax consequences can differ greatly between these two scenarios, as follows:
1. Foreign Real Estate as Primary Residence
With respect to purchasing real estate, an individual that buys a primary residence overseas is generally entitled to the same U.S. tax benefits as a homeowner in the U.S. As such, you can deduct mortgage interest, property taxes, and certain other items on your personal income tax return.
Primary Residence Exclusion
With respect selling real estate, the primary residence exclusion rule may apply. Under this rule, an individual can exclude a gain of up to $250,000 realized from the sale of his or her home ($500,000 if married and filing jointly), provided they meet the “ownership test” and “use test.” This exclusion is not limited to homes in the U.S.
The Ownership Test – If you owned the home for at least 24 months (2 years) during the last 5 years leading up to the date of sale (date of the closing), you meet the ownership test.
The Use Test – If your home was your residence for at least 24 of the months you owned the home during the 5 years leading up to the date of sale, you meet the residence requirement. The 24 months of residence can fall anywhere within the 5-year period. It doesn’t even have to be a single block of time. All you need is a total of 24 months (730 days) of residence during the 5-year period.
If you do not fulfill the ownership and use tests, you still may be eligible for a partial exclusion if you can show the main reason you sold your home was because of a change in workplace location (even within the U.S.), for health reasons, or because of an unforeseeable event.
It is important to note that any exclusion afforded under U.S. tax law does not release you from your obligation file or pay tax in your foreign country of residence. You could still end up paying tax on the gains in your country of residence while excluding all the gains from U.S. tax under the primary residence exclusion rule.
In many cases, however, the opposite tax scenario unfolds. Meaning, a U.S. expat’s country of residence will exempt the entire consideration from the sale of a primary residence, whereas the U.S. will tax the sale amount above the primary residence exclusion.
Gain realized from the sale of a personal residence in excess of the exclusion amount is subject to U.S. tax and cannot be excluded under the foreign earned income exclusion (“FEIE”). However, the gain can be reduced by using foreign tax credits.
An important point worth noting is that under the new Net Investment Income Tax regime, gain realized from the sale of a home and which is excluded under the primary residence rule, will not be subject to the NIIT.
Deducting Mortgage Interest
The tax code does not distinguish between a home in the U.S. and a home abroad, provided the basic requirements are met. These requirements are: (i) the mortgage must be a loan secured by a qualified home in which you have an ownership interest; and (ii) a qualified home is either your primary residence or a second home. You can choose which home you want to treat as your second home for purposes of the deduction. In addition, in order to claim the deduction on your return, you will need to itemize your deductions.
Other important issues that may be relevant include:
Real estate tax – Taxes paid for your first and second home are also deductible with the only caveat being that you cannot deduct taxes paid for local benefits and improvements that increase the value of the property.
Rental properties – Interest paid on a mortgage taken on a property that you rent out can also be deductible if you either live in the home for 14 days during the year or more than 10% of the days it is rented out – whichever is longer.
Home office in a second home – Expenses related to a home office in a second home can also be deducted provided you meet the requirements of a qualified home (i.e., in the previous bullet).
Foreign Currency Considerations
Consideration should also be given to the tax consequences associated with currency exchange differences if the real estate was bought and/or sold using foreign currency.
In general, the gain or loss (after the currency exchange) that results from paying off a foreign mortgage qualifies as a personal gain. Resulting losses are not deductible, and resulting gains are taxable at the standard income rate. Any losses incurred during the sale of a home cannot be offset by a currency exchange gain.
2. Foreign Real Estate as Investment Property
If you own business or investment property, which does not qualify for the primary residence exclusion, there are several methods for gain deferral, the most common of which is the like-kind exchange. To defer gain from a like-kind exchange, you must have exchanged business or investment property for business or investment property of a like kind. Gain from a like-kind exchange is not taxable at the time of the exchange, but rather is taxable when you sell or otherwise dispose of the property that you receive. There is a specific set of criteria that needs to be satisfied in order for a property sale to qualify as a like-kind exchange – it is best to consult with a tax advisor regarding this matter.
It should be noted that the Tax Cuts and Jobs Act, signed into law at the end of 2017, makes two significant changes to the rule allowing for the deferral of realized gain on like-kind exchanges. First, the rule is modified to allow for like-kind exchanges only with respect to real property that is not held primarily for sale. Second, real property located in the United States and real property located outside the United States are no longer considered property of a like kind. These changes become effective starting with the 2018 tax year.
For situations where the tax burden associated with a real estate taxation is significant enough, many U.S. expats have considered renouncing their U.S. citizenship as a potential solution. Although renouncing one’s U.S. citizenship may sound appealing, it does not come without its own set of tax considerations.
For a further analysis of the hidden tax costs of renouncing U.S. citizenship, please read our popular article featured on CNBC.com on the subject: