Taxpat's US Tax Blog

How is the Sale of a Foreign Personal Residence Taxed in the US?

One of the most common issues I see (and probably the one with the most impact) is the taxation on the sale of a foreign personal residence. 

US citizens (and greencard holders) are required to use the US Dollar as their "functional currency" for all "personal" transactions, including the purchase and sale of a foreign residence.  For most US expats, there are actually two separate taxable transactions that occur when you sell a foreign residence - "Capital Gain" from selling the residence, and "Exchange Rate Gain" from paying off a mortgage denominated in a foreign currency.

Taxation of Capital Gain:

The current tax rate on the gain from selling a personal residence is 15% (as long as you have held the property for at least a year).  The gain is calculated by translating the purchase price using the exchange rate at the time of the purchase, the cost of capital improvements using the exchange rate at the time the improvements were made and the exchange rate at the time of the sale, rather than by using the exchange rates at the time of sale in all three cases (C.J. Quijano v. US; 96-2 USTC P 50,441).  If you meet the requirements of IRC Sec. 121 (you owned and used the property for 2 of the 5 years prior to the sale or meet one of the exceptions), you are allowed to use the $250,000 ($500,000 if MFJ) exclusion available to properties located in the US.  If the result is a capital loss, this is considered a personal, non-deductible loss.

Taxation of Exchange Rate Gain:

The Exchange Rate Gain from paying off a mortgage denominated in a foreign currency is treated a separate transaction and is calculated by translating the amount of the loan using the exchange rate at the time the loan was originated and the exchange rate at the time of the loan was paid off.  The resulting "gain" is taxable as "ordinary income" using your marginal tax rate (maximum 35% for 2008).  Again, if the result is a capital loss, this is considered a personal, non-deductible loss.

Note that you cannot use the loss from the mortgage payoff (which is what most people have these days) to offset the capital gain from the sale of the home (Revenue Ruling 90-79, 1990-2 CB 187).

These rules may look harmless enough, but the results can be devastating and should be taken into account if you are considering selling (or before buying) a foreign residence. 

David Colvin is a CPA and CFP® based in Amsterdam, Netherlands since 1998.  His niche focus is serving high-net-wealth individuals with cross-border tax and financial issues.  He is also an advisor to Maxim Global Wealth Advisors, based in Amsterdam and Portland, Oregon.

Should you "revoke" the Foreign Earned Income Exclusion?

Based on the current US tax laws for expats, many taxpayers (mainly those in high tax countries) may be better off if they "revoke" one of the main benefits for expats, the Foreign Earned Income and Housing Exclusions.

Some background - the Foreign Earned Income and Housing Exclusions are not "optional".  If you don't want to claim the Foreign Earned Income and/or Housing Exclusions (after you have once claimed them on a prior tax return), you need to "revoke" them by attaching a statement to your tax return (see IRC Sec. 911(e)(2) for those of you who like to read the Internal Revenue Code).

Why the change now?  The Tax Increase Prevention and Reconciliation Act of 2005 (ironically) changed (by increasing) the way expats calculate the US tax on "non-excluded" income.  Prior to the 2006 tax year, expats would deduct the exclusions and then calculate the tax on the remaining income, so you got to use the lowest marginal tax rates.  As of 2006, you need to add back the exclusions before calculating tax, which means you generally "start" at a much higher marginal tax rate (the IRS calls this the "stacking rule"). 

Since Foreign Tax Credits are calculated based on average tax rates, but the income gets taxed at the higher "marginal" tax rates, you "lose out" when calculating you foreign tax credits  if you use the exclusion (and have sufficient foreign tax credits).

For example, a taxpayer in the Netherlands (without the 30% ruling) earning $200K might pay $75K in Dutch income tax.  If they use the exclusion, their US tax would be (roughly) based on $200K - $80K = $120K (less deductions and exemptions).  Let's say the "marginal" US tax rate is 30%, or $36K of tax before credits.  The tax after credits would be zero and the Foreign Tax Credit Carryover would be $9K ($75K Dutch tax paid less $30K allocated to excluded income less $36K used as a Foreign Tax Credit).

If the taxpayer did not claim the exclusion, the Dutch tax would remain the same, but the US tax would be based on $200K.  In this case the "average" tax rate might be (again very roughly) around 25%, or $50K (this is lower than the first example because you get to use the lower tax brackets to calculate the average rate).  After applying Foreign Tax Credits, the US tax would still be zero, but the Foreign Tax Credit Carryover would now be $25K ($75K less the $50K used as a Foreign Tax Credit).

Since "excess" tax credits carry over for 10 years, the taxpayer would be leaving $16K "on the table" by taking the exclusion (since the tax due in both cases is zero, but the carryover with the exclusion was $9K and without it was $25K).  In the event the taxpayer then moved back to the US (and continued to have foreign travel days), or to a no tax country such as Dubai, or a very low tax country such as many in Asia, they may have missed out on a huge benefit by unnecessarily using foreign tax credits. 

Sound complicated?  It is.  It turns out this decision is very complex for many taxpayers, not least because you need to know what you are doing for the next several years, because if you do choose to revoke the exclusion, you cannot claim it again until the sixth taxable year after the exclusion was revoked. 

Note:  If you have the "30% ruling" in the Netherlands, it probably doesn't make sense to revoke, but it doesn't hurt to do a quick analysis just in case (we currently do this analysis for all of our clients).

David Colvin is a CPA and CFP® based in Amsterdam, Netherlands since 1998. His niche focus is serving high-net-wealth individuals with cross-border tax and financial issues. He is also an advisor to Maxim Global Wealth Advisors, based in Amsterdam and Portland, Oregon.