How to Get the Most from Overseas Real Estate
Priced from $6 to $11 million,
Beach Enclave Grace Bay villas, in Turks & Caicos
feature four-to eight-bedroom
beachfront and oceanview residences
showcasing stunning examples of contemporary beach architecture.
More and more, U.S. citizens are taking advantage of opportunities to purchase overseas vacation homes, investment properties, and places to settle in retirement. And while the thrill of finding that coastal hacienda where you can bury your feet in the sand is intoxicating, it’s vital to understand the practical implications of your purchase.
For me, as a former attorney for the Internal revenue Service (IRS), the tax implications of any transaction are never far from my mind. Don’t be discouraged; there are ways to make owning real estate abroad work for you. This is a “good news” article!
For the most part, if you own the foreign property in an individual capacity (that is, not through a corporation or trust), the same tax rules apply to property located in the U.S. However, you need to be aware of some crucial differences. As an initial matter, you’ll be happy to know that real estate owned by an individual is not considered an account for the Report of Foreign Bank and Financial Accounts (commonly referred to as FBAR) and therefore is excluded from FBAR reporting. This is true regardless of whether you use the foreign residence as a home or a rental property. That’s good news.
But there are other U.S. tax benefits of foreign property ownership, including the implications of selling property, that do depend on how you use the property. The basic principles of your foreign property tax reporting requirements are described below.
Personal Use of Your Home Abroad
If you use your foreign home as your primary residence (in other words, if you spend the majority of your time there) or as a second home (i.e., as a vacation home), you can deduct mortgage interest.
The amount of interest you can deduct depends on whether the loan was made before or after December 16, 2017. (see IRS Publication 926, Home Mortgage Interest Deduction, for more information.) Just like for a domestic home, the mortgage interest deduction for a foreign residence is taken on Schedule A, itemized Deductions.
If the lender is a foreign person (including a foreign bank), it will most likely not provide you (or the IRS) with a Form 1098, Mortgage Interest Statement, totaling the interest you paid during the year. If that’s the case, you can still deduct the mortgage interest on Schedule A, but you should attach a statement to your tax return explaining to whom you paid interest. Keep detailed records of your payments for at least three years if the IRS requests evidence.
Currently, the significant difference with foreign property used as your home, as opposed to a home located in the U.S, is that you cannot deduct foreign property taxes in the years 2018 through 2025. The itemized deduction for foreign real estate taxes is scheduled to return in 2026.
Even if you use your foreign home as your primary residence, utilities, maintenance, and similar expenses can’t be deducted on Schedule A. This is the same rule that applies to U.S. residences. However, if you operate a business from the home and are able to claim the home office deduction, these expenses may offset self-employment income on Schedule C, Profit or Loss from Business. (For a full explanation of tax deductions for your home office, see Publication 587, Business Use of Your Home.)
Foreign Home as Rental Property
If you do rent out your overseas property, different rules about what expenses can be deducted apply, depending on whether you also use the home for your personal use.
If you rent the home for 14 days or less, and use the property as a home (as described below), you do not have to report the rental income to the IRS. That’s the case regardless of whether you earned $100 pr $100,000 in rental income. In this case, however, your deductions would continue to fall into the category of personal use of your foreign home, as described in the paragraphs above.
If, on the other hand, you rented the home for 15 days or more and did not use the property as a home, you do have to report the rental income to the IRS. The good news, however, is that when the IRS considers a property a rental, it generally allows you to deduct all expenses related to the rental of the property using schedule E, Supplemental Income and Loss.
So, which one do you qualify for? Let’s break it down.
The IRS considers a property a home (as opposed to a rental) if your personal use was the greater of:
• 14 or more days during the year, or
• 10% total of the days it was rented to others at a fair rental price.
As an example, let’s assume that Mary owns a condo in Costa Rica. In 2021, she rented the unit at a fair rental price for 280 days. She also used it for a 10-day vacation with her family, and allowed her brother to use it for 10 days, rent-free, on a separate occasion. Allowing a family member to use the unit without paying rent counts as Mary’s own personal use.
Although Mary used the condo in a personal capacity for more than 14 days, she is not considered to have used it as a home. Why not? Because 10% of the days it was rented is greater that 14 days (10% of 280 days equals to 28 days). Thus, Mary falls under the 10% rule rather than the 14-day rule. Since she used the house in a personal capacity for only 20 days, she is not considered to have used it as a home.
Because Mary rented the property for more than 15 days, she must include the rental income on her return and can deduct all related expenses related to the rental of the property. These expenses can include property taxes, mortgage interest, insurance premiums, utilities (if paid by Mary), advertising costs, management fees, commissions, and depreciation.
And there’s more. Travel expenses incurred to manage or maintain the renal property (including the cost of airfare, local transportation, lodging, and meals) may also be deductible. Whether you can deduct some or all of these costs depends upon how much of your trip is related to the business of your rental and how much of it is for personal reasons. If the purpose of your trip is part business and part persona, the allocation of expenses is required. ( See IRS Publication 463, Travel, Gift, and Car Expenses, to explain the rules and examples. )
Repair and maintenance costs that keep the property in an efficient operating condition, such as painting a room, house cleaning between tenants, or replacing door locks, can also be deducted.
An important detail to note is that expenses for improvements to the property, such as new construction, replacement of windows, or landscaping, must be added to your basis in the property, rather than deducted. Publication 527, Residential Rental Property, has tables listing deductible expenses as compared to improvements. It also explains how to report income and expenses if you use the property as a home and rent it for more than 15 days.
Sale of Your Foreign Home
The rules for sale of a foreign property are similar to those for selling a home in the U.S. if you lived in the home as your primary residence for two out of the precious five years, you can exclude a portion for he gain for U.S. tax. In 2021, the amount of gain a married couple can exclude from the sale of their principal residence is $500,000; the exclusion is $250,000 for a single person. If you don’t meet the two-in-five-year rule, however, you will owe capital gains tax on your profit.
Whether you meet the rule to exclude gain or not, it is important to keep track of improvements that you make to your foreign property. These costs raise your investment in the property (called the basis). The higher your basis, the less gain you have when the property is sold. For example, if you purchase a beachside villa in El Salvador for $120,000 and invest $300 in building a rooftop terraza and another $700 in installing a pool, these costs would increase your basis $1,000 to $121,000. While adding such a small amount to your capital investment in the property doesn’t seem like much, if you assume a 15% capital gains tax rate, increasing your basis to $1,000 would save you $150.