7 Things Tax-Savvy Expats Learn Before Investing in US Property
With mortgage rates nearing an all-time low in the US, property investment has soared. Even for those who reside outside the US, investment opportunities abound. Whether it be a vacation property, second home or a rental property, your US real estate options are bountiful! But it is important to ensure you understand the possible tax implications, as well as how to deduct expenses to reduce your US tax liability. So let’s take a look at 7 things you need to know!
1. Maximize deductions
If you are purchasing a home for personal use, you are afforded the same deductions as someone who resides in the US. The interest on the mortgage is deductible and you can write off 100% of the interest you pay on up to $1.1 million of debt.
As far as improvements or repairs, if your home is not a rental home, repairs are not deductible. But if you plan to do some home renovations or improvements, one way to save on the costs is to make the improvements to the property at the time it is purchased.
If the mortgage you take out to buy a home includes additional money to make renovations, your acquisition cost for the home includes this amount. You can then deduct the interest on this amount part of your mortgage interest deduction. If you don’t wrap the renovation costs into your mortgage (or take out a home equity loan), the costs are not deductible.
2. Choose a Limited Liability Corporate Structure for Rental Properties
Many expats choose to buy US real estate primarily for rental properties. Even if you plan to spend some time in the home while visiting the US (or returning there from abroad), if it is rented out more than 15 days per year, it is classified as a rental property.
The advantage of purchasing the property under a Limited Liability Company (LLC) is that you are afforded a greater level of liability protection. If you buy the home as an individual and something serious happens to the renters (i.e. bodily injury or death), you are completely liable for any resulting damages. The LLC protects you from personal liability.
In addition, an LLC is relatively easy to set up and because an LLC is considered disregarded for tax purposes, all rental activities/income are reported on your individual tax return. So choosing an LLC buys you greater protection yet doesn’t increase your US tax reporting requirements significantly.
3. You Can Deduct Repairs on Your Rental Property
Repairs are classified as work on your property that simply restores it to its original state. Repairs are different than improvements, which are considered to be those repairs that increase the value of a property and prolong its life. Repairs to your rental property are 100% deductible in the year that they were incurred.
4. Improvements are Not Deductible
So, repairs are deductible against rental income but improvements are not. However, that doesn’t mean improvements are completely out of pocket. Improvements are capitalized and depreciated over a 27.5 year period.
This example may explain repairs vs. improvements. Carl’s rental property has a very leaky roof. He pays $2,500 to have it fixed. This fix didn’t improve the property’s value—it simply restored it to its original state. This is considered a repair and is deductible against rental income.
Now let’s say Carl’s roof suffered significant damage and had to be completely replaced. He spent $9,000 on his new roof, and this is considered an improvement because it is extending the life of the property.
5. There Are Other Deductible Costs for Rental Properties!
a) Start-Up costs: As you get your rental property prepared and ready for its first occupants, you may incur some start-up costs. The IRS allows you to deduct up to $5,000 in start-up expenses for your first year of business. Any expenses over $5,000 are capitalized and deducted in equal installments over the following 15 years. Here are a few of those expenses that would be considered deductible start-up expenses:
- Minor repairs required to prepare the property
- Licenses, permits and registrations
- Insurance premiums
- Costs for maintenance prior to offering the property for rent
- Professional fees associated with the establishment of business entities
b) Management Fees
If you choose to hire a management company to handle the day-to-day operations of your rental property, you can deduct any management fees from your tax return.
c) Home Office Deduction
This is only deductible if you a portion of your home is used exclusively and regularly for the purposes of actively managing your rental property. Such things as rent (or mortgage interest), taxes, utilities, insurance and internet are allocated on a square footage basis and deducted from the rental income.
d) Travel Expenses
Travel to the US for purposes of managing your rental property can get expensive! Fortunately, any expenses to manage the property can be deducted, so long as they are 100% attributed to the property management. Any side trips to visit friends and family are not deductible so it is important to clearly document your hotel stays, food, airfare, etc. If the IRS asks for proof that you traveled only to manage your property and you have no hotel or restaurant receipts because you stayed with family, they will not approve those deductions because they are deemed ‘personal’.
Expenses to travel to the US to purchase a property are different than management costs and would be capitalized with the property price and depreciated over 27.5 years.
6. You Will Likely Pay Capital Gains Tax When You Sell
If the sell the home you purchase, you can exclude up to $250,000 of your capital gains from tax (or $500,000 if you're married, filing jointly). However, you must have owned and lived in the home as your primary residence for at least 2 of the last 5 years before the sale to exclude that from capital gains. Since you likely are not living there primarily if you are reading this article, prepare to pay capital gains tax.
Assuming you hold the property for more than one year, you will be taxed the long-term capital gains tax. Those rates vary based on your tax bracket and range from 0% to 20%. Those who will pay the 0% rate include individuals in the 10% and 15% federal income tax brackets. The vast majority of Americans will pay the 15% rate, as that applies to those in the most common 25% federal income tax bracket. The highest rate of 20% is only applied to the highest-income earners who are in the 39.6% federal tax bracket. There is also a possibility you could be hit with the 25% capital gains tax, but how that is determined is a bit more complicated. We suggest you contact a tax professional to fully understand how your investment will be taxed.
7. Avoid Capital Gains with a Like-Kind Exchange
To avoid capital gains on your property, you can simply purchase another similar property—this is called a like-kind exchange. When you do this, you are required to find another piece of suitable real estate within 45 days after the sale of the first property. Then you must commit to buying this property in writing through a disinterested third party—in essence this party acts as an intermediary. (Note that the party can’t be your real estate agent, your accountant, your attorney, etc). Then you need to close on the new property within 180 days.
Sounds great, right? Well, there is one caveat. You cannot sell a US property and buy a foreign property and consider this a like-kind exchange. The US doesn’t see that as a similar purchase and therefore will charge you capital gains tax. So you would need to purchase a similar property in the US to avoid capital gains altogether.
We have a host of information on our site for US property investors, including a free downloadable guide for US property investors so please feel free to visit our site!
This post was written by David McKeegan, co-founder of Greenback Expat Tax Services. Greenback specializes in the preparation of US expat taxes for Americans living abroad. Greenback offers straightforward pricing, a simple, hassle-free process, and CPAs and IRS Enrolled Agents who have extensive experience in the field of expat tax preparation. If you’d like to speak to a Greenback accountant about buying or selling a US property, simply click here to get started. For more information about Greenback Expat Tax Services or filing US expat taxes, please contact us.