Many Americans are now choosing to invest in foreign real estate. Owning a foreign rental property can be a very profitable investment if appropriately conducted. Indeed, international and domestic rental properties are treated very similarly by the IRS. The tax principles and benefits of owning property abroad are very similar to the tax principles and benefits of American property. However, there are some key differences to be aware of should you decide to purchase property in a foreign country.
Foreign Rental Property Fundamentals
United States tax benefits significantly depend on how you use the property. If a property is utilized for personal use, you can only deduct mortgage interest. If the home is being used as a rental property, then you can deduct property taxes.
The IRS has specific stipulations for what is and what is not considered a rental property. If you use your rental property as a personal residence, there are limitations on what rental expenses you can deduct. If you use your rental property for personal use for more than 14 days or more than 10% of the total days you rent it to others at a fair rental price, the property is no longer considered a rental property. For example, if you stay in your rental home for 30 days, you must then earn fair rental value for 300 or more days for the property to be viewed as a rental property and eligible for tax deductions.
It most scenarios, a property owner will collect rent from tenants. This payment is then treated as taxable rental income. As a property owner, you can then deduct any expenses associated with operating your rental property from your taxable rental income.
Taxable Rental Income Example:
- Rental income on a property is $18,000 for a given year.
- Your expenses to maintain and operate the property was $8,000 for the year.
- The taxable rental income is then $10,000.
Typical Expenses That Can Be Deducted From Your Taxable Rental Income:
- Mortgage Interest
- Property Insurance
- Liability Insurance
- Repair/Maintenance Costs
- Travel Expense Related to Maintaining the Property
- Foreign Property Taxes
- Advertising Expenses
- Fees Paid to Property Managers
A full list of qualified income expenses can be found on Schedule E. These expenses are then reported under the income section of Form 1040.
What Is Depreciation?
The United States tax system is one of the few countries that utilize the idea of depreciation. Indeed, depreciation is a tax benefit that Americans can use on both domestic and foreign rental property.
The idea behind depreciation is that a property owner can depreciate the value of their property while it is being used for rental purposes. This benefit temporarily reduces gross income.
When the rental property is then sold, the accumulated depreciation is subtracted from the basis. This means that the additional tax is paid back. Ultimately, depreciation on a rental property allows the owner of the property to distribute the deduction across the useful life of the property, rather than taking one significant deduction during the purchase year. Overall, this lowers the rental property’s taxable income.
It is important to note that depreciation can only be utilized on the value of a structure, not the value of the land that the structure is on. Land is never depreciable.
Depreciation of Foreign Rental Property
There are some key differences when it comes to domestic and foreign rental property depreciation. The current domestic residential property is depreciated over 27.5 years. In comparison, foreign residential property is depreciated over 30 years. The depreciation system of international real estate is stipulated under IRC Section 168(g)(1)(A).
Foreign Real Estate Depreciation Example:
- Your foreign rental property cost was $300,000.
- You divide $300,000 by the IRS allowed 30 years.
- The depreciation expense deduction each year would then be $10,000.
What About Double Taxation?
If you own a home abroad, you will likely owe taxes in the country where the property is located. To avoid double taxation, you take a tax credit on your United States tax return. A tax credit is simply an amount of money that taxpayers can subtract from taxes owed to the government. As a property owner, you are allowed to take a tax credit for any taxes you paid to foreign countries relating to the total net rental income of your property.
Keep in mind that there are limitations with a tax credit, as there is a maximum allowable tax credit. You can never take a tax credit for more than the amount of the United States tax on the rental income after expenses have been deducted.
Selling Your Foreign Rental Property
Should you decide to sell your foreign rental property, there are some legalities you need to be aware of. When you sell a property in the United States, you can utilize a 1031 exchange. In a 1031 exchange, you can swap one investment property for another like-kind property. This exchange is then tax-deferred.
You can utilize the 1031 exchange on foreign property sales as well. However, the United States Government does not consider any property in another country to be like-kind to any property within the United States. This means to utilize the 1031 exchange when selling your foreign rental property, you must replace it with another foreign property for the transaction to be tax-deferred.
For example, you could sell your Panama rental home for a different like-kind rental house in Panama, or you could buy a new like-kind rental home in Costa Rica. The only stipulation is that the new rental property you acquire cannot be within the United States to be eligible for the 1031 exchange.
Contact the Experts
While rental property ownership abroad can be a profitable investment, foreign rental property depreciation and IRS income guidelines can also be tricky to decipher on your own. Following IRS guidelines is an important matter, and you need to get it right the first time. Don’t leave this up to chance, contact a tax professional today.
At Silver Tax Group, we are experienced tax attorneys who are ready to help you resolve all of your IRS headaches and tax issues. Our goal is to help every client achieve the best possible outcome in their tax case. You deserve to be represented by a qualified and experienced tax attorney. Contact us today to speak with one of our qualified tax professionals about your specific situation. We look forward to hearing from you.