How is the Sale of a Foreign Personal Residence Taxed in the US?
One of the most common issues I see (and probably the one with the most impact) is the taxation on the sale of a foreign personal residence.
US citizens (and green card holders) are required to use the US Dollar as their “functional currency” for all “personal” transactions, including the purchase and sale of a foreign residence. For most American expats, there are actually two separate taxable transactions that occur when you sell a foreign residence – “Capital Gain” from selling the residence, and “Exchange Rate Gain” from paying off a mortgage denominated in a foreign currency.
Taxation of Capital Gain
The current tax rate on the gain from selling a personal residence is 15% for 2010 (as long as you have held the property for at least a year). The gain is calculated by translating the purchase price using the exchange rate at the time of the purchase, the cost of capital improvements using the exchange rate at the time the improvements were made and the exchange rate at the time of the sale, rather than by using the exchange rates at the time of sale in all three cases (C.J. Quijano v. US; 96-2 USTC P 50,441). If you meet the requirements of IRC Sec. 121 (you owned and used the property for 2 of the 5 years prior to the sale or meet one of the exceptions), you are allowed to use the $250,000 ($500,000 if MFJ) exclusion available to properties located in the US. If the result is a capital loss, this is considered a personal, non-deductible loss.
Taxation of Exchange Rate Gain
The Exchange Rate Gain from paying off a mortgage denominated in a foreign currency is treated as a separate transaction and is calculated by translating the amount of the loan using the exchange rate at the time the loan was originated and the exchange rate at the time the loan was paid off. The resulting “gain” is taxable as “ordinary income” using your marginal tax rate (maximum 35% for 2010). Again, if the result is a capital loss, this is considered a personal, non-deductible loss.
Note that you cannot use the loss from the mortgage payoff (which we see a lot these days) to offset the capital gain from the sale of the home (Revenue Ruling 90-79, 1990-2 CB 187).
These rules may look harmless enough, but the results can be devastating and should be taken into account if you are considering selling (or before buying) a foreign residence.
Source: Worldview Wealth Advisors, By David Colvin, CPA, CFP – 2011