U.S. Tax and Your Foreign Real Estate: Investment Properties Can Yield Important Tax Deductions
If you are a U.S. citizen or resident alien, the general rule is your worldwide income is reported on your United States Form 1040. Plan to report foreign investment property rentals on your U.S. return.
Foreign investment in real property offering depreciation deductions yields greater tax savings than land-only investments. We will discuss when investment property expenses are tax-deductible on your United States tax return.
Foreign countries may tax rentals. Particular countries have income thresholds before rentals are reported. But you are likely reporting and paying tax in both countries. Gain on sale may be taxed in both countries. Withholding tax on foreign sales is common.
Today, understanding foreign investment property tax is more vital than ever -- especially in our ever-changing global business environment.
Reducing Any Double Taxation
Paying tax in the United States and the foreign country may yield a foreign tax credit in your U.S. return. A credit is subtracted from the tax. A deduction reduces the income that is subject to a tax rate.
A credit may be more valuable than a deduction. But there are limits and possibly carryovers. The credit on your U.S. tax return, claimed on Form 1116, may be less than the foreign tax.
Partial Rental Use
If your current plans are purely rental, the property can generally qualify for rental deductions, even if you’re considering eventually living in the property.
Tax rules quickly get complicated if you also reside in the rental property part of the year. One rule says if you reside there fifteen or more days in the year and you rented it less than fifteen days, just ignore the minor rental portion on your U.S. return.
You vacationed in a foreign country. Arriving home, you got the idea of owning a foreign rental property. Does that make your vacation a deductible rental expense? No.
If your plans are limited entirely to personal use, you might claim an itemized deduction for mortgage interest on the property. It may also be possible to assert a home office deduction for a portion of a foreign residence, within limits and if properly supported.
Tax Planning Your Ownership
Ownership, direct or through a single-member limited liability company (LLC), puts rental income on Schedule E of your tax return. If services turn rentals into hotel operations, income and deductions are reported as business income on Schedule C.
An LLC can add an element of limited liability. A single-member LLC is a disregarded entity for tax purposes barring further action by the individual. An LLC with multiple members normally reports as a partnership on Form 1065. Disregarded-entity status may also prevail for married couples whose community property includes a rental LLC.
Ownership possibilities are U.S. corporations, including S corporations, partnerships or foreign entities, such as holding corporations. Laws of the foreign country need to be consulted. Taxation of realty via U.S. corporations may be discouraged due to double taxation from dividends. A C corporation pays tax at a rate of 21%. An S corporation flows through income to the owners. Our individual tax rates are 10% to 37%.
Projections of income, including taxable income or loss, and long-term plans for the property may be important factors in choosing the best ownership structure.
Projecting the Tax Numbers
Consider the importance of allocating purchase price between depreciable realty and land. Land costs and building costs (as adjusted for depreciation) are subtracted from proceeds in measuring gain on sale. Only building costs are depreciable.
The tax depreciation on foreign rental realty is less than for U.S. real estate. Foreign realty is subject to the Alternative Depreciation System of the tax rules. The different depreciable lives apply to commercial properties and residential rentals.
In general, rental realty expenses on foreign property will qualify as deductions. This includes such deductions as repairs, property and liability insurance. Consider currency gains and losses in the tax analysis.
Planning ownership structure and doing the math can quickly get complicated and require the help of your tax professional.
Dispositions of Foreign Realty
In general, most tax rules on disposing of United States property apply.
The like-kind exchange rules for foreign rental real estate might be available but with special provisions. It isn’t possible to like-kind exchange U.S. investment realty for foreign realty, or vice versa. See Section 1031(h). It may be possible to access like-kind exchange rules when foreign realty is exchanged for other foreign realty.
If your use is exclusively personal and you lived in a foreign home for at least two of the last five years, you may qualify for the generous (but limited) exclusion on home sales. See Section 121.
Your Foreign Investment to Do List
Real estate transaction costs may be significantly higher in some countries. Cost research can be important to your investment decisions. Keep in mind foreign investor tax costs and mitigations.
If you have a foreign bank account to collect the rentals, you may need to file a Report of Foreign Bank and Financial Accounts (FBAR). Foreign entities as owners can require other reporting. See Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations, and Form 8858 if the property is held in a foreign LLC.
Foreign investment property tax deductions are important tax incentives. Your tax adviser can help you manage the complexities of investing in foreign realty — and help you save federal and state taxes.