The rules are exactly the same in that you still report any rental income and deductions on Schedule E, you can still take all allowable deductions against any rental income, and the standard capital gain or loss rules still apply.
The rules are different in that you can only do a Section 1031 like-kind exchange with other non-US real property, depreciation is straight-line over 40 years, and any non-US taxes paid on gain or rental income can be applied to reduce your US taxes on such income.
But, the above only considers one possible fact pattern—direct ownership of real estate. We can do a little better than that, can’t we? Let’s dive deeper.
Owning through a Non-US Corporation
Instead of owning non-US real estate directly, you may want to own it through a non-US corporation. Reasons for owning through a non-US corporation include the following:
- The property may be in a jurisdiction (like Honduras) that disallows direct ownership of certain real estate by non-locals but allows ownership through a local corporation.
- You may be planning to minimize local income tax and/or transfer tax on a later sale (i.e., by selling the stock of the corporation instead of the real property itself).
- You may want to protect your heirs from having to use a potentially cumbersome probate process to transfer title after your death.
- Finally, you may want the asset protection benefits offered by investing through a non-US corporation.
Owning through a non-US corporation requires different reporting for US tax purposes and different thinking about future strategies.
In certain circumstances (generally, where the real estate will generate passive income, you own 100% of the corporation, and the corporation is eligible to do so), it’s better for the corporation to elect to be disregarded as a separate entity from you for US tax purposes. By making this election, the tax reporting is much simpler, and you’re able to take the foreign tax credit for any non-US income taxes paid by the corporation. The election must be made within 75 days of the corporation’s formation to be effective as of the formation date.
If you can’t or didn’t make the election described above, the non-US corporation will be treated as a corporation for US tax purposes (i.e., a person separate from you). You’ll need to file an IRS Form 5471 with your tax return each year, and the IRS Form 5471 must include an income statement and balance sheet if you own more than 50% of the stock of the corporation.
Two additional implications of owning through a corporation are as follows:
- You’ll generally still be required to include any income from the real estate on your own tax return each year. Before tax reform was passed in late 2017, you could use a non-US corporation to defer paying US tax on active income from non-US real estate. After tax reform, that deferral is generally no longer possible.
- Holding through a corporation will disallow you from engaging in a Section 1031 like-kind exchange with respect to the asset.
Turning an Investment into your Principal Residence
Now let’s look at the US tax implications of moving outside the US to live in your former investment. If you hold the property directly or through a disregarded entity, the initial move doesn’t really have any distinct consequences—the asset simply disappears from your Schedule E and becomes a personal asset. However, if you hold the property through a corporation, moving into it could be a taxable event. Using the property as a residence would be treated as a distribution of the property by the corporation to you, which could cause you to realize a dividend and/or gain on the deemed sale of stock of the corporation.
On a later sale of the property, you can use the same ol’ home sale exclusion you’ve used in the US to avoid paying tax on up to $250,000 of gain ($500,000 for a married couple filing jointly) after you’ve held the property for 2 years (assuming you meet all the other rules). However, two special rules bear mentioning:
- under the “nonqualified use” rules, you won’t be able to exclude a fraction of the gain equal to the time you held the property before using it as your principal residence over the total time you’ve held the property, and
- under the “depreciation recapture” rules, you must pay tax at a 25% rate on gain attributable to prior allowable depreciation deductions.
Using Retirement Savings to Invest in Non-US Real Estate
Finally, to invest in non-US real estate in the first place, you’ll of course need the funds to do so. Let’s look at one tax-related structure that can actually increase your assets available for investment.
Most people think of their assets as being in distinct buckets: (i) retirement savings on the one hand (things such as a 401(k), IRA, and other such plans), and then (ii) outside assets on the other hand. The retirement savings bucket is typically held at a large brokerage firm and invested in public stocks, mutual funds, etc., and then the outside assets can be invested in any number of things (including non-US real estate).
Well, there’s actually a structure that allows you to place all or a portion of your retirement savings in the types of assets normally reserved for your outside assets. It’s called an “offshore IRA”—you can find more details about this structure here and here.
The bottom line is that you may have more assets available to invest in non-US real estate than you thought.
Want to know more? The Tax-Savvy Expat courses teach you everything you need to know about expat tax.