Foreign investment in U.S. real estate (while significant in 2020) has dropped for two consecutive years. Conversely, new U.S. investment in foreign real estate hit record highs in 2020.
During the first half of 2020, outbound investment in the multifamily sector was higher than any other total year on record, and Q1 2020 investment was already higher than all of 2019 investment. As with all investing, there are potential tax pitfalls to navigate; investment in foreign real estate by U.S. investors is no different. The following is a brief checklist for U.S. investors of foreign real estate.
If the property is acquired for personal use (e.g., a first or second home) then the interest on the first $750,000 ($375,000 if married filing separately or single) of the qualified mortgage may be deducted. The limitation on the mortgage amount is due to changes from the 2017 Tax Cuts and Jobs Act (“TCJA”) and is only for indebtedness entered into after December 15, 2017. Prior to that date, the limit was $1 million.
The TCJA also made a significant change to the deductibility of property taxes. While the most attention has surrounded the reduction in the state and local tax deductible cap of $10,000, the TCJA fully eliminated the ability to deduct foreign property taxes as an itemized deduction. 1
Mirroring the rules for domestic real estate used as a home office, utilities, insurance, and maintenance are not deductible for foreign property unless it is used as a home office. However, the home office deduction is only available to taxpayers who are not considered employees. To qualify as a home office expense, the expense is limited to a percentage of the property used as a home office or a safe harbor amount, as proscribed by IRS rules.
Taxpayers selling their principal residence can take advantage of IRC Section 121 to exclude up to $250,000 ($500,000 for a married couple filing jointly) on gains arising from the home’s disposition regardless of whether the residence is in the U.S. or a foreign country.
Even though the U.S. tax implications for foreign rental properties are very similar to those of U.S. rental properties, there are important differences.
Income taxes paid on the rental income in the foreign jurisdiction are a direct credit against U.S. taxes owed on that activity. Therefore, if the foreign tax rate is higher than the U.S. tax rate, no U.S. tax may be owed on that activity. But if the U.S. tax rate is greater than the foreign tax rate, then the taxpayer will have to pay U.S. taxes on the difference between the foreign rate and the applicable U.S. tax rate.
Other reporting requirements may arise depending on the structure of the foreign property ownership. There are reporting requirements for certain foreign corporations, such as Form 5471 or Form 8858 to report foreign disregarded entities. Furthermore, if the taxpayer must open a bank account to collect rent, then that taxpayer may have to file a Report of Foreign Bank and Financial Accounts (“FBAR”)if the aggregate value of all accounts is $10,000 or more "on any given day of the calendar year." While these additional reporting requirements are merely reporting, and do not assess tax, the failure to comply with these requirements can carry significant civil penalties. It is critical to know and understand these reporting requirements and a specific jurisdiction’s property holding requirements.
Currently, all foreign property must be depreciated using the Alternative Depreciation System (“ADS”). Therefore, the properties depreciable life will be 40 years for commercial properties and 30 years for residential rental properties that were placed into service after January 1, 2018. The requirement to use ADS also precludes the use of bonus depreciation on any of the foreign property. Similarly, equipment purchased for the rental property cannot use IRC Section 179 to accelerate the deduction on the purchase of the equipment; it must be depreciated over its applicable life.
There is no difference between the gain and depreciation recapture from the sale of property that is either U.S. or foreign. However, if the individual paid foreign taxes on the sale, the foreign taxes may be creditable to reduce the U.S. tax from the sale.
Like-kind property transactions under IRC Section 1031 can be used to defer gain on exchanges of two foreign properties, not a foreign and a U.S. property. So, for example, the U.S. taxes on the sale of real property in Germany can be deferred using a 1031 exchange for the purchase of real property in Israel, England or the United Arab Emirates; but not for a property located in Florida or any other U.S. jurisdiction. For 1031 purposes, foreign real property is considered like-kind only to other foreign real property.
Finally, if you obtain a foreign currency denominated loan on the property that you purchase, there may be foreign currency gain or loss on each mortgage payment paid or when the mortgage is paid off, which is not the case when a U.S. dollar denominated loan is obtained.
There are many tax and non-tax considerations in owning foreign real estate. It is vital to be aware of these differences when living or investing in a foreign country, as it may mean the difference between paying tax, taking a foreign tax credit, and reporting the activity on an annual basis. Foreign laws constantly change, and these changes may impact your global returns on the property acquisition, as well as your U.S. tax liability. Due to the tax and acquisition complexities involved, this is an area where consultation with your business advisor is paramount.
1 While the ability to deduct foreign property taxes has been eliminated as an itemized deduction, it may have provided the ability to exclude such taxes under the Foreign Housing Exclusion, if the taxpayer qualifies. Please consult your tax advisor.
