More and more people are looking overseas for vacation homes, rental income properties and places to settle down during retirement – whether that’s five or 30 years away. The tax benefits of owning property abroad are similar to those of owning at home, with a few exceptions.
The benefits property owners get from U.S. tax law depend on how the property is used. If you live in the home, for example, you generally can deduct mortgage interest and property taxes. If the property is used for rental income, you can still deduct mortgage interest and property taxes, plus deducting a number of other expenses, including property and liability insurance, repair and maintenance costs, and local and long-distance travel expenses related to maintaining the property.
Read on to see how U.S. tax laws treat foreign property ownership, as well as the tax implications of selling the property.
Property for Personal Use
If you use the property as a second home – not as a rental – you can deduct mortgage interest just as you would for a second home in the U.S. This includes being able to deduct 100% of the interest you pay on up to $1.1 million of debt that is secured by your first and second homes (that's the total amount – it's not $1.1 million for each property). You can also deduct property taxes on your second and, for that matter, as many properties as you own. As with a primary residence, you can't write off expenses such as utilities, maintenance or insurance unless you are able to claim the home-office deduction.
Tax rules are more complicated if you receive rental income on the property. Different rules apply, depending on how many days each year the home is used for personal rather than rental use. In general, you’ll fall into one of three categories:
- You rent out the home for 14 or fewer days. The home can be rented to someone else for up to two weeks (14 nights) each year without having to report that income to the IRS. Even if you rent it out for $5,000 a night, you don't have to report the rental income as long as you didn't rent for more than 14 days. The house is considered a personal residence, allowing you to deduct mortgage interest and property taxes under the standard second-home rules, but not rental losses or expenses.
- You rent out the home for 15 or more days and use it for fewer than 14 days or 10% of the days the home was rented. In this case, the IRS considers the home a rental property, and the rental activities are viewed as a business. You must report all rental income to the IRS, but the good news is that this permits you to deduct rental expenses, such as mortgage interest, property taxes, advertising expenses, insurance premiums, utilities and fees paid to property managers. One notable difference between a rental property at home and one abroad: Your property abroad is depreciated over a 40-year period, instead of the current 27.5 years for domestic residential properties. In either case, you depreciate the value of the structure (the building) only; you cannot depreciate the value of the land.
- You use the property for more than 14 days or 10% of the total days it was rented. In this case, your property is considered a personal residence, and the rules for personal use apply. You can deduct mortgage interest and property taxes, but you cannot deduct rental expenses or losses. Keep in mind: If a member of your family uses the house (i.e., your spouse, siblings, parents, grandparents, children and grandchildren), it counts as a personal day unless you collect a fair rental price.
Selling the Property
If you sell your home abroad, the tax treatment is similar to selling a home in the U.S. – and differs depending on how the property was used. If you lived in the home for at least two of the last five years, it qualifies as your primary residence and you can exclude up to $250,000 of capital gains (or up to $500,000 for married taxpayers) from the sale. This primary-home sale exclusion does not apply if the home was not your primary residence, in which case you will owe the usual capital gains tax.
If you sell a rental property in the U.S., you may be able to make a 1031 exchange (also called a like-kind exchange), in which you swap one rental property for another property of equal or great value, on a tax-deferred basis. Many investors use this type of transaction to avoid paying capital gains tax.
A significant difference in the tax treatment of domestic versus foreign property, however, is that property in the U.S. is not considered like-kind to any property overseas. U.S. Section 1031 allows only domestic-for-domestic, and foreign-for-foreign, exchanges. The U.S. considers any property outside the U.S. to be like-kind with any other similar property outside the U.S., so it is possible to 1031 exchange a house in Panama for another in Panama, or Ecuador or Costa Rice, for that matter. It just can’t be considered like-kind with any property in the U.S.
If you operate your home abroad as a rental property, you will owe taxes in the country where the property is located. To prevent double taxation, you can take a tax credit on your U.S. tax return for any taxes you paid to the foreign country relating to the net rental income. There is a maximum allowable tax credit, however: you can’t take a credit for more than the amount of U.S. tax on the rental income, after deducting expenses.
The Bottom Line
When you buy abroad, you need to take extra care with planning and details. Many countries have rules and regulations about who can own a property, and how it can be used. If you buy a home overseas, make sure the transaction is conducted so that it protects your property rights. In the United States, homebuyers receive title to the property; this distinction is not as clear in all countries.
Also be aware that as a foreign property owner, you may be required to file a number of U.S. tax forms, depending on your exact situation. For example, if you rent out your home abroad and open a bank account to collect rent, you must file an FBAR (Report of Foreign Bank and Financial Accounts) form if the aggregate value of all your accounts is $10,000 or more "on any given day of the calendar year." Other forms include Form 5471 – Information Return of U.S. Persons with Respect to Certain Foreign Corporations (if your property is held in a foreign corporation); and Form 8858 – Information Return of U.S. Persons with Respect to Foreign Disregarded Entities (if your offshore property is held in a foreign LLC).
Because foreign property ownership and tax laws are complicated and change from time to time, protect yourself by consulting with a qualified tax accountant and/or real estate attorney both abroad and in the United States.