For the past couple of years, I have been unwinding the tax mess I created when I moved to the United States. One of the remaining pieces left was a rental property I had in Brazil. I bought it in 2012 and finally got rid of it in 2020.
It is not uncommon for immigrants to own real estate in their home countries. While there’s no problem whatsoever with that, you probably want to make sure you understand what you’re getting yourself into. In this article, I will share what I learned after holding onto my rental property for over eight years.
Tax Implications of Owning Foreign Real Estate
Owning real estate outside of the United States is not all that different than owning it domestically. Tax-wise, they are treated the same way. When you sell the property, you report it on your tax return as you would do if the property was located in the United States. You then have to pay taxes on the gain or you get to claim a deduction if you had a loss on the transaction.
Gains on the sale of the property are considered either short or long-term capital gains. The type is determined by how long you held the property. If you held it for one year or less, the gains would be considered short-term capital gains. This type of gain is taxed at your marginal tax bracket. However, if you held it for more than one year, the gains would be considered long-term capital gains. Long-term capital gains are usually taxed at a favorable rate.
While on one hand, you have the exact same tax obligations, on the other hand, you also get to enjoy the same tax breaks. Things like principal residence exclusion, mortgage interest deductions, and, in the case of rental properties, depreciation, to name a few.
Determining Your Adjusted Cost Basis
Before you calculate the gain or loss on a transaction, you first need to determine what your adjusted cost basis is. To put it simply, the adjusted cost basis is the cost to you of purchasing the property. This amount will later be subtracted from your sale price to calculate your gain or loss.
The method used to determine your basis varies depending on how the property was acquired. Below are some common methods of acquiring a property.
If you purchased the property directly, your cost basis starts with the price you paid for it. You then add any fees associated with the purchase, such as legal fees and closing costs. If this is a rental property and you had taken a depreciation deduction against it, you then also have to subtract all depreciation taken so far. The final number is your adjusted cost basis.
Here’s the math for my rental property, for example. I purchased it in 2012 for $98,079. I also spent $5,273 on legal fees and improvements to the property. Because I owned it as a rental property, I claimed depreciation between 2012 and 2020, when I sold it, totaling $19,748. My adjusted cost basis at the time of the sale was $98,079 + $5,273 – $19,748 = $83,604.
When you inherit a property, you receive what is called a stepped-up basis. What this means is, your adjusted cost basis is reset to the fair market value of the property at the time of the original owner’s death. Because property value tends to increase with time, receiving a stepped-up basis is usually a great thing.
For example, suppose your father purchased his home decades ago for $100,000. At the time of his passing, the house was worth $600,000. When you inherit this property, your adjusted cost basis would be the same $600,000. If you go ahead and immediately sell the house for this same amount, you would pay no taxes at all. Conversely, had you not received a stepped-up basis, you would be taxed on a $500,000 gain.
Things don’t always work this way though. Property value sometimes goes down with time and you might inherit a property whose fair market value is lower than the prior owner’s basis. When this happens, your basis also gets reset, but this time to a lower value. If you immediately sell the property, you still don’t pay any taxes. However, you also don’t get to deduct the loss.
Receiving a property as a gift can get tricky. This is especially true when we’re talking about older properties located outside of the U.S. When you receive a property as a gift, you don’t get a stepped-up basis. Instead, your adjusted cost basis will be the prior owner’s adjusted cost basis.
In Brazil, for example, it’s not uncommon for parents to pass down properties to their children while they are still alive. This is usually accomplished by gifting the property. Sometimes the property is being passed down as gifts for generations. Because gift doesn’t reset the cost basis, it can be challenging to determine the original cost basis being passed down. It could sometimes be impossible to do so.
The IRS puts the burden of proving the basis you’re using is indeed accurate on you, the taxpayer. If you don’t have documentation to substantiate the basis, the IRS can throw it away and call it $0. If this happens, you’d be taxed on the entire sale value. Definitely not a fun thing to deal with.
Calculating the Gain or Loss on a Sale
Now that you know how to calculate your adjusted cost basis, calculating the total gain, or loss, on a transaction is simple. All you have to do is subtract your basis and transaction costs, such as closing costs and commissions, from the sale price.
For example, you acquired a house for $100,000 and later sold it for $300,000. You also paid a 6% sale commission on the transaction and $1,000 in closing costs. Your gain would be $300,000 – ($300,000 * 0.06) – $1,000 – $100,000 = $181,000.
This amount is usually reported on Schedule D – Capital Gains and Losses and/or Form 8949 – Sales and other Dispositions of Capital Assets.
How Currency Exchange Affects the Math
So far I have only used values in U.S. dollars. When you’re dealing with real estate located in a foreign country, though, more often than not, you will be dealing with a different currency. And that’s when things get a little tricky. Before doing any math, you have to convert all values to U.S. dollars. For the conversion, you use the spot exchange rate on the day of each event.
I’ll use my apartment again as an example. I mentioned above that I purchased it for $98,079 back in 2012. I also said that I spent another $5,273 on legal fees and improvements. But in reality, I purchased it for R$170,000 (BRL – Brazilian reals) on 2/1/2012. I also spent R$7,320 in legal fees on 6/12/2013 and R$4,300 in improvements on 11/13/2013.
The table below shows a breakdown of the values and the exchange rates used to get to my final adjusted cost basis:
|Name||Date||Value (BRL)||Exchange Rate||Value (USD)|
Note that currency conversion does not apply to the depreciation I claimed. Depreciation was claimed directly on my U.S. tax return, in U.S. dollars.
Effects of Exchange Rate on the Sale
On 8/31/2020 I sold the property, and that’s when it got interesting. The exchange rate on that day was R$5.468266 and I sold it for R$250,000. I also paid R$15,000 in commissions. If you do the math in BRL, I made a profit on the sale:
R$250,000 – R$15,000 – R$170,000 – R$7,320 – R$4,300 = R$53,380. Yay!
Well, not so fast. Although I did in fact make a profit in Brazil, the numbers in USD are not so pretty. We have to convert the proceeds of the sale to USD using the exchange rate on the day of the sale. We then subtract my adjusted cost basis:
(R$250,000 – R$15,000) / R$5.468266 – $83,604 = -$40,629. Meh!
That’s right, I did make a profit in Brazil, but at the same time, I took a huge loss in the U.S. In fact, the loss listed above is for tax purposes only and the real loss was even higher. To calculate the true economic loss, we have to remove depreciation out of the equation: -$40,629 -$19,748 = -$60,377! That’s how much I actually lost on this transaction.
This difference between the profit in BRL and the loss in USD was due to the exchange rate moving against me during the period I held onto the property. When investing in real estate abroad, you need to take into account currency exchange rate fluctuations as they can materially affect numbers.
Properties Purchased Before Coming to the U.S.
One big surprise I had when discussing this with my CPA was the fact that you do NOT get a stepped-up basis when you move to the U.S. or otherwise become a U.S. person. What this means is, if you become a U.S. person today, and then you sell a property you purchased years ago in your home country for a nice profit, the IRS will want its cut on the entire profit.
For example, you bought a property for $100,000. Ten years later you moved to the U.S and became a U.S. person. On that same day, you decided to sell it for $350,000, pocketing a nice $250,000 profit. Well, you will have to pay U.S. taxes on the entire profit.
If you think this doesn’t make sense, you’re not alone. I told my CPA the same thing. Why would the IRS be entitled to taxes on profits you accrued long before you became a U.S. person? If anything, they should be entitled only to the profit accrued after moving to the U.S. Unfortunately that’s not how it works. I hate to admit but there might be some good reasons for it.
Depending on the country you’re moving from, once you cease being a tax resident, you no longer have to pay taxes to that country. If you would get a stepped-up basis when becoming a U.S. person, this could open a loophole where you could avoid paying taxes on the sale altogether. You don’t owe taxes to your country of origin anymore, and you had no profit in the U.S. Of course, the IRS won’t let you get away with it.
Check the Box Election
If you are smarter than I am and are doing pre-immigration tax planning, there are things you can do before you become a U.S. person. This could potentially reduce your tax burden. One of these things is called the Check the Box Election. This strategy can be used to give you a stepped-up basis on certain assets, such as real estate.
Basically, you set up the equivalent of an LLC in the foreign country where you own a property. You then transfer the property to the newly formed entity. Once the transfer is made, you file Form 8832 – Entity Classification Election requesting to classify your foreign entity as a disregarded entity. More often than not, this is not the default classification assigned by the IRS and this election will trigger an entity reclassification. Note that the reclassification would only be triggered if the entity was already relevant for U.S. tax purposes.
When an entity is reclassified for tax purposes, the entity is deemed to liquidate all assets and distribute them to the owner. This deemed liquidation is a taxable event. Because you would do this before becoming a U.S. person, this won’t create any tax liability. Regardless, this would give you a stepped-up basis, for U.S. tax purposes, on all assets owned by the entity.
Now, this strategy is a lot more complicated than it sounds and there’s a lot more to it than what I just described, especially the part about being relevant for U.S. tax purposes. My intention is to just make you aware of the existence of such a strategy. If this is something you think you would benefit from, engage an experienced tax professional to guide you through the process, or you will most likely get yourself in trouble.
Section 121 – Principal Residence Exclusion
If the house you just sold is qualified as your principal residence for tax purposes, you are allowed to exclude the profits of the sale from your taxable income, up to a certain limit. The limit is as follows:
- $250,000 if you are single, or married filing separately; or
- $500,000 if you are married filing a joint tax return.
That’s potentially up to $500,000 in gains you can shelter from income tax. You can only use this exclusion once every two years, though. Also, losses on the sale of your principal residence are not deductible.
For your house to qualify as your principal residence, as per the IRS, you must have lived and owned the house for at least two years in the five-year period prior to the date of the sale. The two-year period does not have to necessarily be continuous, as long as the sum of the periods adds up to two years.
Because the IRS doesn’t make much of a distinction between a house located in the U.S and a house located abroad, this rule also applies to foreign properties. This can certainly help to alleviate the tax burden of selling a property you left behind when you immigrated to the U.S.
Foreign Tax Credit
When you sell a property located in another country, you likely have to pay taxes on that country. On top of that, you also have to pay taxes to the IRS. If this sounds like double taxation, that’s because it is. But don’t worry, in most cases, you can catch a break. The IRS allows you to claim income taxes paid to a foreign country as a foreign tax credit.
The foreign tax credit topic is a complex, but generally speaking, you can subtract, dollar-for-dollar, the amount of foreign tax credit you claim from your U.S. tax liability. For example, you sell a property for $100,000 profit in Brazil and pay $15,000 in taxes. You can claim that $15,000 as a foreign tax credit and effectively reduce your U.S. tax liability by the same $15,000. A tax credit is much more valuable than a deduction. It lowers your tax liability instead of lowering your taxable income.
There are some limits to be aware of though. The amount of tax credit you can claim is generally capped to the maximum tax the U.S. would impose on that same income. Using the example above, let’s assume you held the property for over one year and you paid $25,000, or 25%, in taxes on the sale of the property. Assuming a 15% U.S. long-term capital gain tax rate, your U.S. tax liability on this income would be $15,000. Therefore, you would only be able to claim a maximum of $15,000 in foreign tax credit. The remaining $10,000 would be disallowed.
Another limitation to keep in mind is that you are not allowed to claim foreign tax credits on income excluded under the Section 121 Principal Residence Exclusion.
Owning real estate outside of the U.S. in itself does not trigger any reporting requirements. If you own it yourself, personally, and don’t derive income from it, you don’t really have to do anything.
However, if the property is owned by a foreign entity, such as a foreign corporation, partnership, estate, or trust, you might have to report the foreign entity on FATCA Form 8938. You would add the fair market value of the property when calculating the total value of the entity.
If you own a rental property, you will have to file Schedule E. You have to report your rental income and expenses and, of course, pay your taxes. Also, there’s a slight chance you will have to file Form 8858 – Information Return of U.S. Persons With Respect to Foreign Disregarded Entities (FDEs) and Foreign Branches (FBs), depending on how the property is managed and how the books are kept.
And finally, if you ever sell a foreign property, you will then have to report the transaction on your tax return and pay taxes on the gains, if any.
Things to Consider Before Moving to the United States
If you are in the process of becoming a U.S. person, you probably want to think about your options when it comes to any real estate you currently own. I sure wish I did. I most likely wouldn’t have bought mine in the first place, to be honest.
Below are some things to keep in mind if you are in this situation.
Sell the Property Before Becoming a U.S. Person
Sometimes it’s just not worth holding onto a property due to the tax liability it would create. For example, imagine you own a highly appreciated property and that your current country has a much lower tax rate than the U.S (or even no tax at all). It is probably in your best interest to get rid of this property while you don’t have to pay taxes in the U.S.
Wait to Sell the Property After Becoming a U.S. Person
On the other hand, sometimes it makes a lot of sense to keep the property and sell it after becoming a U.S. person. For example, you own a property that has decreased in value. If you wait to sell, you could use the loss to offset some of your U.S. income. Depending on the tax rate in both countries, you can come out ahead by waiting.
Another example, if you own a primary residence in a country that will not tax you on the sale once you are no longer a tax resident of that country, you should probably wait. If you do, you would avoid paying tax on the country the property is located in and will be able to claim section 121 exclusion on your U.S. tax return, effectively paying zero tax on the sale.
Make the Check the Box Election
If you own a property that is not your primary residence and your country will not tax you on the sale once you are no longer a tax resident, it might make sense to explore the check the box election. You could potentially avoid* paying tax in your country of origin as well as in the U.S.
* Please note that avoiding taxes is very different than evading taxes. I just wanted to point that out.
Owning real estate abroad is not a bad thing. In fact, it could be very profitable sometimes (it wasn’t for me). But, as it is with anything involving a foreign country, things can get a little complicated, tax-wise. Understanding how a foreign property is treated for tax purposes can help you make informed decisions. It can also potentially save you a lot of money.
And, of course, don’t act on anything you read on the internet, including this blog, without first consulting with a tax professional you trust to determine the best course of action, if any, for your specific situation.