IRS Tax Rules for Property Owned and Rented Abroad
When renting out your real property in a foreign country, as a United States citizen or permanent U.S. resident, one must not only comply with all tax requirements of that foreign country, but also report all rental information on your U.S. income tax return. The rules are similar as those for rental property located in the U.S., but with some variations.
Foreign rental property held in one’s individual name requires the taxpayer to report all rental income and expenses on Schedule E of your Form 1040. All of the allowable expenses are the same as for U.S. property.
Expenses deductible include management fees, interest, property taxes, utilities, repairs, maintenance, association dues, insurance, depreciation and other miscellaneous expenses.
Unlike property located in the U.S., one must depreciate the property over a 40-year period rather than shorter times allowed for U.S. property.
A credit against your U.S. federal income tax for income taxes paid to the foreign country on the net rental income after deducting all expenses. That credit is limited to the amount of U.S. federal tax paid on that rental income on the tax return. Any unused foreign tax credit can be carried over to future year.
Most states do not allow any credit for income taxes paid in foreign countries. Generally, a non-issue for Floridians.
Any taxes collected from the renter should be included as part of the rental income, but then deduct out those taxes so that no taxes are paid on those items.
The same restrictions and limited allowable deductions for “vacation homes” apply when one have occupied the property yourself part of the time and rented it out to third parties at other times.
Sale of a foreign-owned property that is held in your personal name will trigger net taxable capital gains. The capital gain will be taxed at the lower tax rate. Also, any foreign taxes paid can be claimed as a credit against U.S. tax.
If the property was used for the two years during the previous five 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 U.S. 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 U.S. income tax.
If your foreign real property is held through a foreign corporation, there can be adverse U.S. tax consequences while renting out the property and upon sale on your U.S. tax return. With the proper type of foreign corporation, certain elections can be made with the IRS, which will negate almost of these U.S. tax problems. These elections are only made for U.S. 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 U.S. Tax Forms That May be Required:
- Form 8865: If you own your foreign rental in a foreign partnership (if you own 10 percent or more) or LLC, you must file 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 on March 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 percent 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 U.S. 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 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.
Seema Jain, CPA, PA, can be reached at (813) 395-0089 or visit www.yourbizcpa.com
How to Handle an IRS Audit
If you or your organization is selected for an IRS audit, the first thing to do is remain calm. An audit is simply a review of the accounts and financial information that have a bearing on your tax return, not an inquest. A certain amount of anxiety is natural when the IRS takes an interest in your return, but it need not be considered a crisis.
Your initial response might well be to wonder why you were selected. It could be one of several reasons, including the potential presence of an error in your return. Many individuals and organizations are simply selected at random, based on a statistical formula used by the IRS. There may also be an inadvertent discrepancy within your forms, wherein the information reported in your return does not match the information on records and forms provided by the payer or payers. Finally, some people or organizations are chosen for an audit because they are associated with a business or businesses that also were audited by the IRS.
The most important factor to remember if you are selected for an IRS audit is that you do not have to go it alone. You have the absolute legal right to authorized representation by a CPA, an attorney, or an enrolled agent. At Reliance Consulting, we like to think of ourselves as guardians of our clients’ financial well-being, especially when and if they need help sorting out an IRS audit. It starts with reassurance that all steps will be taken to help the audit proceed as smoothly and expeditiously as possible.
A major source of the anxiety associated with an IRS audit is unfamiliarity with the process. You should know that the IRS specifically delineates the rights of a taxpayer, and in cases of an audit, certain of these rights are particularly important to remember. They include the right to professional and courteous treatment by the IRS, the right to privacy and confidentiality, the right to know why the IRS asks for specific information and how that information will be used, and a right to appeal to the IRS itself and through the court system.
Neither the notification of an IRS audit nor the audit itself will be conducted via e-mail. After notification by phone call or through the postal service, the audit may take place by mail, or in the form of a face-to-face interview and records review. Depending on the type and scope of the audit, the meeting may take place at your home, your place of business, an IRS office, or at the office of your CPA. The IRS is responsible for informing you in writing what documents and records are required for examination. Audits vary in length, based on the complexity of the records and accounts under review. An IRS audit is not like a court case in which the plaintiff who brings the suit carries the burden of proof. While the IRS will initiate the audit, the taxpayer must prove that the deductions and statements made on his or her tax return are true and accurate.
There are three conclusions possible in an IRS audit: no changes are necessary to the return; necessary changes are agreed upon by the IRS and the taxpayer; and necessary changes are not agreed upon by the IRS and the taxpayer. Obviously, if no changes are required, no further action is necessary on your part. If changes are necessary, and you agree with those changes, you will be asked to express your agreement by signing off on an examination report. You also will need to pay the additional taxes and accrued interest, if owed. If you disagree with the changes, you may enter mediation or request an appeal to resolve your differences without litigation. Involving the office of the Taxpayer Advocate at certain times is also beneficial, especially in cases involving financial distress, or when you believe that IRS did not follow due process, either in dealing with your rights or the application of law itself. The Tax Court, U.S. Claims Court, local U.S. District Court, the U.S. Court of Appeals and even the U.S. Supreme Court are options if you are unable to settle the issue through mediation or by appeal.
Recently, there have been instances where IRS agents have directly showed up at taxpayers’ houses or businesses and started conducting taxpayer interviews. Sometimes, even after presenting the agent with a valid Power of Attorney (FORM 2848), the agents have insisted that they deal with the taxpayers directly. Those IRS agents have been reprimanded for violating Section 7521(b)(2) of the Internal Revenue Code, which states that if the taxpayer clearly asks for lawyer or CPA representation during an interview, the agent shall suspend the interview regardless of whether the taxpayer may have answered one of more questions.
There is virtually no way to predict whether one tax return is more vulnerable than another to an IRS audit. One way to protect yourself is to rely on a well-established CPA for tax planning and tax preparation. The complexities of tax laws today make it impossible for the taxpayer to know all the intricacies that affect their tax situation. Having a competent CPA that can hold your hand and guide you through an IRS audit can go a long way in ensuring that your rights as a taxpayer are protected and the application of law is fair and balanced.