Much is written about tax compliance and withholding imposed upon a foreign entity or person owning real estate in the United States. The fact that many U.S. taxpayers own real estate outside of the country is often disregarded.
The intent of this post is to touch upon some of the differences of which an investor or potential investor in foreign real estate should be aware.
Depreciation and foreign property holdings
One of the main differences in holding a U.S. rental property compared to a foreign rental property is depreciation. The Internal Revenue Code requires any tangible property used predominantly outside the U.S. during the year to use the Alternative Depreciation System (“ADS”). Residential rental property located in a foreign country must use ADS, resulting in depreciation over a 40 year recovery period compared to the 27.5 year recovery of U.S. residential property.
1031 exchanges aren’t allowed
I have discussed the tax deferral afforded by entering into a 1031 like-kind exchange in previous posts. However, the Internal Revenue Code does not allow taxpayers to exchange U.S. investment property for foreign investment property. U.S. property is limited to the 50 states and the District of Columbia only. Property located in U.S. territories, such as Puerto Rico, is not like-kind to property located within the United States. There are limited exceptions, under certain circumstances for property located within the U.S Virgin Islands, Guam and the Northern Mariana Islands.
Taxpayers can obtain deferral afforded by a 1031 exchange when trading U.S. property for U.S. property, but not U.S. property for foreign property. However, foreign property is deemed liked-kind when exchanged for other foreign property, thus qualifying for 1031 exchange treatment.
Preventing double taxation
If a taxpayer operates a property abroad as a rental property, taxes will be owed in the country where the property is located. To prevent double taxation, a U.S. taxpayer can claim a credit on the U.S. tax return for taxes paid to the foreign country relating to the net rental income. It is important to note that a taxpayer cannot claim a credit for more than the amount of U.S. tax on the rental income.
The foreign tax credit is also available if the property is sold and there is any capital gains tax in the foreign county.
Additional reporting obligations
A U.S. taxpayer may have additional filing obligations with their tax return as a result of the foreign rental activity.
For example, if a U.S. taxpayer establishes a foreign bank account to collect rent and the aggregate value of the account is $10,000 or more on any given day, an FBAR (Report of Foreign Bank and Financial Accounts) is required to be filed.
If the property is held in a foreign corporation, Form 5471 (Information Return of U.S. Persons with Respect to Certain Foreign Corporations) is required to be filed. If the property is held in a Foreign LLC, then Form 8858 (Information Return of U.S Persons with Respect to Foreign Disregarded Entities) may be required.
We’ve got your back
Don’t go it alone if you’re an investor in foreign real estate. Contact me at sfilip@krscpas.com or 201.655.7411 for assistance with tax planning for your international holdings.