US IRS TAX RULES YOU MUST FOLLOW WHEN YOU OWN AND RENT OUT PROPERTY LOCATED IN A FOREIGN COUNTRY

By Don D. Nelson, Attorney, CPA

with over 20 years experience helping clients living and working abroad

When you are renting out your real property in a foreign country, as a US Citizen or permanent resident, you must not only comply with all tax requirements of that foreign country, but you must also report all rental information on your US income tax return.. The rules are almost the same as those for rental property located in the US, but with some variations.

• If you own the Mexican rental in your individual name, you report all of your rental income and expenses on Schedule E of your Form 1040. All of the allowable expenses are the same as for US property.
• Expenses you can deduct include management fees, interest, property taxes, utilities, repairs, maintenance, association dues, insurance, depreciation, and other miscellaneous expenses.
• Unlike property located in the US, you must depreciate the property (amount allocatable to the structure) over a 40 year period rather than shorter times sometimes allowed for US property.
• You can take a credit against your US federal income tax for income taxes paid to the foreign country on your net rental income after deducting all expenses. That credit is limited to the amount of US Federal tax you paid on that rental income on your tax return. Any unused foreign tax credit can be carried over to future year. Most US states do not allow any credit for income taxes paid foreign countries.
• Any Value Added Tax (VAT) or occupancy tax collected from the renter should be included in your rental income, but then you can deduct out those taxes so you do not have to pay any tax on those items.
• The same restrictions and limited allowable deductions for “vacation homes” apply when you have occupied the property yourself part of the time and rented it out to third parties at other times.
• When the property is sold (if it is held in your individual name ) your net gain is taxed in the US at the applicable lower capital gains rates, and you can claim a credit against your US tax on the sale for the foreign capital gains or income taxes paid on that profit to Mexico.

If the property was used for the 2 years during the previous 5 years prior to sale as your personal primary residence (you must actually live in it full time during that period), you may be able to exclude up to $500,000 of the gain from your US income taxes under the exclusion allowed for sales of personal residences. If the property was rented out part of that time, some of the gain on sale will be subject to US income tax.

If your foreign real property is held through a foreign corporation, there can be adverse US tax consequences while renting out the property and upon sale on your US tax return. With the proper type of foreign corporation, certain elections can be made with the IRS which will negate almost of these US tax problems. These elections are only made for US tax purposes and do not in any way affect the way your foreign corporation is taxed under the tax laws of its country of location.

Other US Tax Forms That May be Required:

Form 8865: If you own your foreign rental in a foreign partnership (if you own 10% or more) or LLC you must filed this form each year with your personal tax return to report the details of its income, expenses, etc.

Forms 3520/3520A: If you own your foreign rental property or personal residence in a foreign trust, you must file both of these forms each year. They are not filed with your personal tax return. One form is due 3/15 after the end of the calendar year and the other is due on the extended due date of your personal tax return. Failure to file these forms can result in extreme penalties.

Form 5471: If your Foreign real estate is held in a Foreign corporation, you must file this form each year if you own 10% or more of the shares (actually or constructively) in the corporation. This form is due on the extended due date of your personal return. The IRS can impose a $10,000 per year penalty for filing this form late or not at all.

Form TDF 90-22.1: This form reports your ownership in foreign bank and other financial accounts. It would include any accounts where your property manager or accountant is using to collect rents or pay foreign taxes and rentals. If the highest total of all of your foreign financial and bank accounts when combined together equal or exceed at any time $10,000 US per year, you must file this form to report details of all accounts. It is filed separately from your tax return and is due on June 30^th following the end of each calendar year. The due date cannot be extended. The IRS can impose a $10,000 penalty for filing the form late or not at all.

Ten Ways to Avoid IRS Income Tax Audit

Use of Corporations
Reduce Audits

The Wall Street Journal has reported 10 ways to avoid a tax audit. The most useful is to report your business income in a corporation or LLC which can avoid the use of a schedule C on your personal tax return. It states that using a schedule C to report your business income can result in your chance of being audited being 10 times higher using a corporation. Read here for other tips and recommendations.

US Estate Planning For Expatriates Around the World

You cannot ignore estate planning if you wish your US and worldwide assets passing to the heirs you desire. You also need to take the necessary steps to keep the costs and taxes at a minimum.  If you are an expat, that means you have to put the necessary documents in place in the country in which you reside and in the USA.  That also means you must coordinate the laws of two countries.

The US imposes its estate and gift taxes on your no matter where you live in the world and no matter where your assets are located in the world.

The US side involves Wills, Trusts, Powers of Attorneys and Health Care Directives.  It may also involve a program of gifting in order to keep the taxes down.  If you do it right, you can save tens of thousands of dollars in probate fees,and often a lot more in estate taxes.  We have been doing estate planning for over 30 years.  Read more and download your estate planning questionnaire.  After you fill it out, send it to us and we can help you implement a plan that achieves your personal wishes.

FOREIGN INSURANCE EXCISE TAX - SECTION 4371/FORM 720

Very few taxpayers are aware of the US Foreign Insurance Excise Tax.  That excise tax is in general paid on premiums paid for foreign insurance on US insured risks (the individual insured or the insured items is located in the USA) including US Citizens and residents.  The types of insurance this excise insurance applies to includes life insurance, accident insurance, casualty insurance, and annuities.  The US has in its tax treaties an exemption from this tax with only a few countries.

This tax is paid  with form 720 which is normally filed quarterly.  Read more about this Foreign Insurance Excise Tax

Governments Press U.S. to Ease Overseas Tax-Cheat Law

The foreign banks are protesting that the steps they may have to take to comply with the IRS program to catch tax cheats abroad will be too expensive and burdensome.  This Bloomberg article states the whole story.

New US Estate Tax Laws - for US Citizens Living Abroad or Who Own Assets Abroad

A US Citizen is subject to US estate taxes no matter where he lives in the world. The tax is calculated on the fair market value of his worldwide assets.  That tax can usually be offset by any estate taxes paid foreign countries on properties located there. 

We are writing this  to apprise you of the estate and gift tax changes in the recently enacted 2010 Tax Relief Act. Before the new law, there was no estate tax for 2010, but some beneficiaries could have faced higher taxes because there were less favorable income tax basis rules. Also, under the prior law, estate and other transfer taxes were scheduled to rise substantially for post-2010 transfers.

Overview of the new law. The 2010 Tax Relief Act provides temporary relief. Among other changes, it reduces estate, gift and generation-skipping transfer (GST) taxes for 2011 and 2012. It preserves estate tax repeal for 2010, but in a roundabout way: estates wanting zero estate tax for 2010 must elect that option, along with the less favorable modified carryover basis rules that were set to apply for 2010. Otherwise, by default, the estate tax is revived for 2010, with a $5 million exemption, a top tax rate of 35%, and a step-up in basis. Also, for estates of decedents dying after Dec. 31, 2010, a deceased spouse's unused exemption may be shifted to the surviving spouse. However, these generous rules are temporary—much harsher rules are slated to return after 2012.

Lower rate and higher exemption for 2011 and 2012. For estates of individuals dying in 2009, the top estate tax rate was 45% and there was a $3.5 million exemption. The top rate was to rise to 55% for estates of individuals dying after 2010, and the exemption was to be $1 million. For 2011 and 2012, the 2010 Tax Relief Act reduces the top rate to 35%. It also increases the exemption to $5 million for 2011 with a further increase for inflation in 2012. But these changes are temporary. After 2012, the top rate will be 55%, and the exemption will be $1 million.

Special tax saving choice for 2010. The 2010 Tax Relief Act allows estates of decedents who died in 2010 to choose between (1) estate tax (based on a $5 million exemption and 35% top rate) and a step-up in basis, or (2) no estate tax and modified carryover basis. Basis is the yardstick for measuring income tax gain or loss when an asset is sold. With a step-up in basis, pre-death gain is eliminated because the basis in the heir's hands is increased to the date of death value of the asset. On the other hand, with a modified carryover basis, an heir gets the decedent's original basis, plus certain increases, which can be substantial. Even so, if the decedent had a relatively low basis and significant assets, some pre-death gain may be taxed when the heir sells the property. These concerns factor into the special choice for 2010. The executor should make whichever choice would produce the lowest combined estate and income taxes for the estate and its beneficiaries. This would depend, among other factors, on the decedent's basis in the assets immediately before death and how soon the estate beneficiaries may sell the assets.

Gift tax changes. Years ago, the gift tax and the estate tax were unified—they shared a single exemption and were subject to the same rates. This was not the case in recent years. For example, in 2010, the top gift tax rate was 35% and the exemption was $1 million. For gifts made after Dec. 31, 2010, the gift tax and estate tax are reunified and an overall $5 million exemption applies.

GST tax changes. The GST tax is an additional tax on gifts and bequests to grandchildren when their parents are still alive. The 2010 Tax Relief Act lowers GST taxes for 2011 and 2012 by increasing the exemption amount from $1 million to $5 million (as indexed after 2011) and reducing the rate from 55% to 35%.

New portability feature. Under the 2010 Tax Relief Act, any exemption that remains unused as of the death of a spouse who dies after Dec. 31, 2010 and before Jan. 1, 2013 is generally available for use by the surviving spouse in addition to his or her own $5 million exemption for taxable transfers made during life or at death. Under prior law, the exemption of the first spouse to die would be lost if not used. This could happen where the spouse with resources below the exemption amount died before the richer spouse. One way to address that was to set up a trust for the poorer spouse. Now, the portability rule may make setting up a trust unnecessary in some cases. But there still may be other reasons to employ credit shelter trusts. For example, a credit shelter trust may protect appreciation occurring between the death of the first spouse and the death of the second spouse from being subject to estate tax. Such a trust also can protect against creditors. Plus, the transferred exemption may be lost if the surviving spouse remarries and is again widowed.

Conclusion. The estate tax relief in the new law is substantial, but it is temporary. Estate planning to reduce taxes remains an important consideration. Even if taxes are not a concern because an estate is below the exemption level, it is important to have a proper estate plan to ensure that the needs of intended beneficiaries are met. Please schedule an appointment with us to discuss how you and your family can make the best use of the new estate and gift tax rules.