Rental property ownership abroad can be a profitable investment and a popular choice for expats looking to increase their income streams. Foreign rental properties owned by US citizens abroad are largely treated the same as domestic rental properties. However, there are a few caveats so read on to find out the facts about foreign property ownership you need to know!
Foreign Property Fundamentals
Generally, the property owner collects rent from tenants, which is treated as taxable rental income. Any expense associated operating the rental property is used as a deduction against taxable rental income. This is simple to follow in practice, so let’s look at an example.
Let’s say a taxpayer collected $30,000 of rental income for a given year and the expenses to maintain and operate the rental property were $10,000. The taxpayer has taxable income of only $20,000 (the $30,000 rental income less the $10,000 in rental property expenses). A detailed list of income and expenses are located on Schedule E and are ultimately reported under the income section of Form 1040. With few exceptions (such as foreign tax credits to avoid double taxation and changes to depreciation) a foreign rental property is treated the same as a domestic rental property.
Depreciation and Foreign Property Rentals
One of the differences in owning foreign property rentals abroad versus domestically is depreciation. Depreciation is an accounting method of allocating the cost of a tangible asset over its useful life and is used to account for declines in value. In other words, the IRS allows a depreciation expense against rental income based on the cost of the rental property.
Let’s run a hypothetical calculation to see how this works in practice. If the cost of your domestic rental property were $275,000, the depreciation expense would be $275,000 divided by the IRS allowed 27.5 years of useful life (for residential real estate) for an annual depreciation expense of $10,000. The $10,000 depreciation expense offsets your rental income and ultimately reduces any associated tax liability connected with the rental income.
However, foreign rental properties follow a different set of rules. Under IRC Section 168(g)(1)(A), any tangible property which is used predominantly outside the United States during the taxable year must use the alternative depreciation system. This part of the Internal Revenue Code (Section 168(g)(2)(C)) specifies a period of 30 years. Prior to the 2017 Tax Cuts and Jobs Act, the length of time was 40 years. Simply put, rather than using the 27.5 years described in the above calculation the specified time is increased to 30 years.
For example, if the cost of your foreign rental property were $275,000, the depreciation expense would be $275,000 divided by the IRS allowed 30 years (the useful life of the property per the Alternative Depreciation System) and arrive at a depreciation expense deduction each year of $9,167.
Foreign Tax Credits and Foreign Property
Another significant difference between domestic and foreign property rental ownership is the use of the foreign tax credit. If you operate your home abroad as a rental property, you will often pay foreign taxes on your foreign rental property income, while the same income is subject to tax here in the US. Luckily, taxes paid or accrued to a foreign country or US possession on income that is also subject to US taxation are typically taken as a tax credit in the US.
For example, if you paid or accrued $100 of income tax in a foreign country, you can typically deduct $100 from your domestic tax liability. There is a maximum allowable tax credit, however. You can’t take a credit for more than the amount of US tax on the rental income, after deducting expenses.
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