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.

Self Employed Expatriates Must Set Up 401K Pension Plan by End of Year

As a self employed US Expatriate you have until 12/31 to set up a Keogh 401K self employed pension plan to use for  the 2010 tax year if you have not previously established one. You do not have to make the contribution until the extended due date of your personal tax return for 2010.  You can only make a deductible contribution (or any contribution) if the net profit from your self employed business exceeds the foreign earned income exclusion which is $91,500 for 2010.

Best places to set up a 401K plan in short time remaining is on line with Fidelity,  Charles Schwab, Etrade or  other on line broker.

The same rule holds true if you have a US corporation or LLC operating your business but you work for it abroad. Any corporate pension plan must be set up by 12/31, though the contributions need not be made until the extended due date of the entities return.

New Tax Reduction Bill Now Passed by Both Houses of Congress - Details Below

The Bush tax cuts were extended for two more years, with some modifications. The new tax law includes the following. 


* Provides a two-year AMT patch
* Provides a one year tax cut on Social Security taxes for individuals
* Increases the estate tax exemption from $3.5 million to $5 million
* Decreases the top estate tax rate from 45% to 35%
* Extends the deduction for school teacher expenses
* Extends the deduction for state and local general sales taxes
* Extends the deduction for qualified tuition and related expenses
* Reinstates the research and development credit
* Extends the credit for energy-efficient appliances
* And more!

Further details about the Tax Relief Act of 2010 is available at the following web sites.


* http://mail.cchtaa.com/t/138601/455109/9443321/0/ 
* http://www.journalofaccountancy.com/Web/20103669.htm
* http://www.csmonitor.com/USA/Politics/2010/1217/House-passes-bipartisan-tax-cut-deal-first-of-Obama-administration
* http://www.bloomberg.com/news/2010-12-17/house-votes-to-debate-obama-s-858-billion-tax-cut-deal-with-republicans.html 

IRS COMMISSIONER ANNOUNCES POSSIBLE NEW OFFSHORE DISCLOSURE PROGRAM

The IRS Commissioner has announced the IRS is considering  instituting a new Offshore Disclosure Program which will allow taxpayers with offshore assets, etc. to come forward and not risk criminal prosecution and impose lower penalties for their previous failure to report or disclose foreign assets, or file certain required forms for foreign corporations, bank and financial accounts, foreign trusts, partnerships, etc.  He did state that the terms of that possible new program would not be as favorable as the previous six month program which expired October 15, 2009, in which approximately 15,000 taxpayers came forward and entered the program.

Current Status of IRS Offshore Voluntary Disclosure Program and Possible Future Program

The IRS has told the Wall Street Journal about the current  status of their initial Offshore Voluntary Disclosure Program.  The IRS has  also stated there may be a future program with  higher penalties than the original program which expired of October 15, 2009. Click here to read the Wall Street Journal Article 

2010 Year End US Income Tax Planning

Its time to try to reduce your taxes for 2010 by doing year end tax planning.  Our year end tax planning letter is on our website. Click Here to Get Year End Tax Planning Ideas

IRS PRESSURES FOREIGN BANKS TO DISCLOSE DATA ON US TAXPAYERS

The Financial Times reports that the IRS and the US Justice Department are aggressively pushing Foreign Banks to disclose information on US Citizens who have accounts and may be evading taxes. Read More Here

See How Your IRS Income Tax Payments Are Spent by Federal Government

The House of Tax and Spend

Fidelity Investment has done a great job of showing how your US income tax payments are spent by the Federal Government.   Fidelity Investments - How Your Tax Dollars are Spent.   It is easy to see where many items could be cut back.

Remember, at the Internal Revenue Service, the Revenue comes before the Service

YOU MUST NOTIFY THE IRS OF YOUR ADDRESS CHANGE WHEN YOU MOVE ABROAD TO AVOID PROBLEMS

When you move to Mexico or other foreign countries you MUST notify the IRS of your new address. The IRS is not responsible to keeping its records up to date with your new address, you are!  You should notify them using Form 8822.  If you fail to notify them of the address change, any notices they send to your previous address are deemed received under the law, and various time limitations, assessments, etc. , may expire even though you are not receiving the IRS notices.

One client who failed to notify the IRS of her new address  was erroneously assessed a large sum of money and only learned about it many years later when the IRS took levied and took all of the money out of her bank account.  It was very expensive and time consuming to finally convince the IRS of their error and get her money refunded.  The problem would have never happened if a Form 8822 had been filed.  The error could have been corrected immediately when the initial erroneous assessment was made.

Due to poor mail delivery in many countries, it is wise in some situations to keep using a US mailing address of a friend or relative, so your IRS notices will be delivered to a competent person who can then forward the mail by fax, email or a private delivery service.

US EXPATRIATE OFFSHORE ESTATE PLANNING

If you have assets or live outside of the USA you need to plan your estate carefully. You most likely need to do a will or,  if applicable, a trust in the country in which you live (or own the asset) which provides for the disposition of your asset in the event of your death. You also need to determine what type of taxes (inheritance or transfer tax) your heirs may incur upon your death.  In some foreign countries failure to do a will or trust could result in your offshore assets being distributed under that country's laws and could result in people inheriting the property other than those you would prefer.  Some countries may honor your US will or trust and others may not.  It is easier often have specific instruments drawn up in each country you own assets that comply with local law by a local attorney to avoid potential problems and expense later if that country does not or has difficulties honoring a US will or trust.

Remember, if you have executed a power of attorney appointing someone to handle your affairs, in most countries that document will expire upon your death. Therefore do not rely on that document to handle the disposition of your foreign assets after your death.

Of course, you must also prepare to US will or  living trust (which avoids probates and a lot of expense and time) to cover the disposition of your US assets and which also states the disposition of your foreign assets the same as a foreign trust or will you have had prepared.

The US will impose its estate tax on your worldwide assets, though it will allow a credit in most situations for any foreign inheritance tax you had to pay on assets located outside of the US.  Until Congress amends the law, starting in 2011 all estates in excess of $1 million will be subject to US estate tax which are high.  If you are married special provisions can be inserted in your US will or trust to secure estate tax savings.

Additional Extension of Time for Taxpayers Out of the Country

All taxpayers are generally entitled to an automatic 6-month extension of time to file their returns by filing Form 4868, Application for Automatic Extension of Time To File U.S. Individual Income Tax Return, also available en español, with the Internal Revenue Service. In addition to this 6-month extension, taxpayers who are out of the country (as defined in the Form 4868 instructions) can request a discretionary 2-month additional extension of time to file their returns (to December 15 for calendar year taxpayers). To request this extension, you must send the Internal Revenue Service a letter explaining the reasons why you need the additional 2 months. Send the letter by the extended due date (October 15 for calendar year taxpayers) to the following address: Internal Revenue Service Center Austin, TX 73301-0215 USA You will not receive any notification from the Internal Revenue Service unless your request is denied for being untimely. The discretionary 2-month additional extension is not available to taxpayers who have an approved extension of time to file on Form 2350 (for U.S. citizens and resident aliens abroad who expect to qualify for special tax treatment).

Mexican Fideicomisos Requirement to File Forms 3520 & 3520A As a Foreign Trust

In Mexico Fideicomisos hold title to  certain real property owned  by non-Mexicans citizens. A Mexican bank is designated as the Trustee and the wording of the Fideicomiso document is clearly that of a trust.  The IRS has never made a written pronouncement or ruling that excludes Fideicomisos from the requirement that they file annually  Forms 3520 and 3520A.  Penalties for not filing these forms or filing them late are huge and can be up to 15% of the value of the property in the trust.

A Texas attorney recently has been widely circulating a  written opinion she wrote and a copy of her  email alleging that Mexican Fideicomisos may not be foreign trusts and  are not required to File Forms 3520 and 3520A. Her email cites a situation where the IRS informally agreed that her client did not have to file Forms 3520/3520A or pay any penalty for not filing.

We have checked with an IRS representative who directly deals with these issues.  They stated it is very unlikely that in the near future the IRS will ever issue any written ruling or opinion that Fideicomisos do not have to file these foreign trust reporting forms or are not foreign trusts.  

Informal decisions made by the IRS by law cannot be cited as authority by other taxpayers by law. The law also states  written private letter rulings in almost every circumstance cannot be cited as authority by other taxpayers.  Therefore reliance on a privae attorney's written opinion or an informal decision by the IRS can be very risky and will offer no protection in the event you fail to comply with currently accepted IRS filing requirements.  Filing the 3520/3520A form also would be significantly cheaper than going to Court to fight the IRS on this issue when you cannot even cite the informal decision as authority.

Until the IRS (if ever) declares in writing that  Fideicomiso's are exempt from the foreign trust filing requirements or are not foreign trusts, all owners of property in Mexico which hold their title through Fideicomiso's  should continue to file Forms 3520 and 3520A each year to avoid being assessed large monetary penalties by the IRS.

Court says government failed to establish that taxpayer "willfully" concealed offshore account

United States v. J. Bryan Williams; No. 1:09-cv-00437

The U.S. District Court for the Eastern District of Virginia, September 1, 2010, found that the government had failed to meet its burden to establish by a preponderance of the evidence that a taxpayer willfully failed to report his interest in a foreign bank accounts that were omitted from the individual's 2000 tax return as the record indicated that the accounts had been frozen in November of the previous year at the behest of the U.S. government.

Facts. In 1993, the defendant, J. Bryan Williams, opened up two Swiss bank accounts in the name of ALQI Holdings, Ltd., and over the course of seven years deposited in excess of $7 million in assets.

On Williams' 2000 tax return, the foreign accounts were not disclosed, nor was a Form TD F 90-22.1 (Report of Foreign Bank and Financial Accounts) (FBAR), filed by the June 30, 2001, deadline (for the 2000 tax year).

In January 2002, the defendant disclosed his financial interests in the offshore accounts to an IRS agent, based on advice received from his tax attorneys and accountants. Further disclosures were made:

·       Upon the filing of his 2001 tax return (October 2002);

·       In an application to participate in the Offshore Voluntary Compliance Initiative (February 2003);

·       In amended returns for 1999 and 2000 (filed February 2003);

·       While pleading guilty to tax fraud (May 2003) as well as to conspiracy charges and tax evasion for the offshore funds from 1993 to 2000 (June 2003); and

·       Upon filing his filing of form TD F 90-22.1 for tax years 1993 through 2000 (January 2007).

The facts also indicated that Williams met with Swiss authorities in 2000 and that his Swiss accounts were frozen on November 14, 2000, "at the behest of the U.S. government." Although the government had earlier stipulated to November 14, 2000, as the date the accounts were froze, it appears that government sought to disavow such stipulation and sought to argue that the accounts were not frozen until a later time.

Court's opinion. The government sought to enforce its assessment of two FBAR penalties against the defendant for willfully failing to report his interest in his offshore accounts for the tax year 2000.

The government argued that the defendant's signature on his Form 1040 was prima facieevidence that Williams knew the contents of his tax return.

The court found, however, that while Williams had in fact not disclosed his offshore account on his original 1040 for the 2000 tax year, such actions occurred after he found out that the U.S. and Swiss authorities found out about the ALQI accounts. Thus, in the court's view, Williams was aware that the authorities knew about his offshore accounts by the fall of 2000, long before the FBAR deadline of June 30, 2001.

The court said that such evidence demonstrated that Williams lacked any motivation to willfully conceal his offshore accounts on his 2000 tax return, and thereafter.

"Williams' subsequent disclosures throughout 2002 and 2003 corroborate his lack of intent," the court said. "Though made after the June 30, 2001 deadline, Williams' disclosure of the ALQI accounts to John Manton of the IRS in January 2002 indicates to the Court that Williams continued to believe the assets had already been disclosed. That is, it makes little sense for Williams to disclose the ALQI accounts merely six months after the deadline he supposedly willfully violated."

Treasury Inspector General Finds 10% of Foreign Earned Income Exclusions claimed in 2008 Are Invalid or Erroneous

TIGTA Finds Significant Loss in IRS Revenue Because of Erroneously Claimed Foreign Earned Income Tax Exclusions

WASHINGTON - The Internal Revenue Service (IRS) lost an estimated $90 million in revenue for Tax Year 2008 because of erroneously claimed foreign earned income tax exclusions, according to a report publicly released today by the Treasury Inspector General for Tax Administration (TIGTA).

The foreign earned income tax exclusion allows a taxpayer to exclude up to $91,500 of foreign earned income. A taxpayer qualifies for this exclusion if he or she has foreign income and a home in a foreign country. An eligible taxpayer designates this status by filing Form 2555 (Foreign Earned Income) with the IRS.

TIGTA conducted a performance audit to assess the IRS's ability to ensure the accuracy of these exclusions. TIGTA reviewed 231,277 tax returns from Tax Year 2008 and found that 10 percent (23,334) of taxpayers claiming the exclusion either failed to qualify for the exclusion or inaccurately computed the exclusion. The income erroneously excluded totaled $675 million. The estimated tax avoided totaled $90 million.

"This is very troubling. Over five years, the estimated revenue loss to the IRS could total more than $450 million," said J. Russell George, Treasury Inspector General for Tax Administration. "Improvements must be made to reduce erroneously claimed foreign earned income tax exclusions," he added.

TIGTA made seven recommendations to the IRS in this report, and the IRS agreed with four of the seven recommendations.

To review the report, including the scope and methodology, go to: http:www.treas.gov/tigta/auditreports/2010reports/201040091fr.pdf.