Considerations for U.S. Persons Purchasing Foreign Real Estate
There are many reasons why a U.S. person may want to own residential real estate in a foreign country – this article provides an overview of some of the U.S. tax rules that determine what types of disclosures are typically required.
In today’s global economy, many U.S. persons find themselves working abroad, involved in “cross-border” marriages (e.g., a U.S. person married to a non-U.S. person), or may wish to have family vacations or spend a portion of their retirement overseas. As such, more U.S. persons are contemplating purchasing real estate overseas. Whatever the reason, once a U.S. person decides to acquire foreign real estate, there are many U.S. tax reporting considerations at stake.
Many foreign countries do not allow non-citizens to directly own real estate within their borders. In such jurisdictions, it is not uncommon for a U.S. person to hold the foreign real estate in a trust or through a locally organized corporation. One of the first decisions a prospective buyer will have to make is how to hold the property, whether outright, or through an intermediary holding entity. Foreign entities used to acquire real estate will be reportable annually on Form 8938 to the extent that the holding entities meet the definition of a specified foreign financial asset.
Additionally, transactions with foreign trusts, and beneficial interests in the property or income of a foreign trust, typically must be disclosed annually to IRS on Form 3520 and/or Form 3520-A. Alternatively, if a corporate-type entity is used to acquire and hold the foreign real estate, absent a check-the-box election (which should be timely filed at the outset), the U.S. owner of the foreign corporation could be subject to the Controlled Foreign Corporation (CFC) tax rules. Holding a CFC might result in higher U.S. income taxes due upon the disposition of the foreign real estate. This is because income or gain from a CFC, generally does not qualify for long-term capital gains rates, and is typically taxed at the highest ordinary income tax rates at the time it is earned.
Foreign Currency Issues and Tax Basis
In general, a U.S. person’s taxable income and resulting tax liability must be calculated and paid in U.S. dollars. This means that when a U.S. taxpayer executes a transaction in foreign currency, these foreign currency amounts must be translated into dollars. If the foreign real estate is purchased with foreign currency, then the tax basis in the property equals the dollar value of the foreign currency on the date of acquisition.
For instance, if a U.S. taxpayer acquires a personal residence in London for £2 million, and on the date of the acquisition the average spot rate was 1.5 to 1, then the U.S. dollar tax basis in the home would be $3 million. This is true, even if the U.S. dollars exchanged for British Pounds a few days prior to the transaction were more than $3 million.
Sale of Property Subject to Mortgage Debt
The tax rules governing mortgage debt denominated in foreign currencies can trigger gain recognition with a simultaneous loss disallowance upon the payoff of the debt by U.S. taxpayers. This is because the financing transaction for personal property is considered to be a separate and discrete event from the purchase of the underlying real estate.
In our previous example, the U.S. taxpayer acquired a personal resident in London for £2 million. Assume instead that only half of the purchase price was executed in the form of a down payment, with the other half financed through a foreign currency denominated mortgage loan (for £1 million, equivalent to $1.5 million on the mortgage origination date).
At the time of the purchase, 1.00 GBP was worth 1.50 USD, but sometime later, when 1.00 GBP has appreciated and is worth 1.60 USD, the residence is sold for £3 million, of which £1 million is used to repay the mortgage debt. According to the relevant tax rules, the borrowing and repayment of the mortgage loan could generate a non-deductible personal loss.
The gain on selling the residence is calculated as the amount realized at time of sale less the adjusted basis at the time of purchase, or $4.8 million in proceeds less the $3 million in tax basis for a taxable gain of $1.8 million (if the residence otherwise qualified under Sec. 121, then up to $500,000 of the gain could be excludable). The mortgage debt, however, would result in a loss calculated as follows:
|$1,500,000||USD equivalent of £1 million mortgage debt on the purchase date|
|$1,600,000||USD equivalent of £1 million on the payoff date|
|$100,000||USD loss due to the fluctuation in currency rates|
Per the relevant rules under Sec. 165, since the mortgage transaction was not entered into in the normal course of a trade or business, nor for a profit motive, then the currency/translation loss is non-deductible and cannot be used to offset the gain realized on the sale of the property at the higher local currency value.
As this article touches upon, there are numerous reporting requirements that come into play when a U.S. taxpayer decides to acquire, hold, or sell, foreign real estate. Although beyond the scope of this article, it is worth noting that some countries may also impose transfer taxes fees (i.e., Stamp Duties in the U.K.) on the sale or exchange of residential real estate. There may also be estate or inheritance tax exposures in the foreign country; these are issues that should be vetted by local tax counsel prior to the execution of any transaction.
Source: Reproduced with permission from Andersen Tax, February 2015