How to Avoid Capital Gains Tax on Foreign Property
Capital gains are the profits earned from selling an asset, like property or stocks, for more than its original purchase price.
When you sell a foreign property, you may be able to reduce or even eliminate the capital gains tax. This process is particularly straightforward if the property is your primary residence. Let’s explore how this works! Let’s talk about how it works!
Key Takeaways
- When you sell a foreign property, the IRS requires you to report it on your US tax return.
- If the foreign property is your primary residence, you can exclude up to $250,000 (single) or $500,000 (married filing jointly) of capital gains from taxation.
- To minimize capital gains tax on such properties, consider employing strategies like claiming the Foreign Tax Credit, utilizing a tax-free 1031 exchange for like-kind properties, or retaining the property long enough to benefit from lower long-term capital gains tax rates.
How Capital Gains Are Reported on Your Tax Return
All capital gains made by a US citizen are taxable. If you sell a property, you have to report the sale on your US tax return. This is true regardless of where the property is located. Here’s how to go about reporting your gain or loss:
- Determine the cost basis of the asset: Calculate the original purchase price plus improvements; this is your cost basis.
- Calculate your gain or loss: Subtract the cost, including expenses to sell the property, from the sale price to determine your capital gain or loss.
- Factor in exchange rates (if applicable): Convert foreign currency amounts to US dollars using exchange rates on purchase and sale dates to calculate gains or losses.
- Determine if your capital gains are short-term or long-term: Short-term gains (held less than one year) are taxed as ordinary income. Long-term gains (held longer than one year) are taxed at reduced rates.
- Report your capital gains or losses on your expat tax return: Use IRS Form 8949 and Schedule D to report on your annual tax return.
If you deposit the proceeds from the sale into a foreign bank account, you will almost certainly need to file a FATCA report and a Foreign Bank Account Report (FBAR). Failing to do either when required can result in severe penalties.
The good news is that the requirement to report your capital gains doesn’t always mean you have to pay the tax. The IRS provides options you can use to avoid paying the capital gains tax on a foreign property.
How to Avoid Paying Capital Gains on Foreign Property
There are several strategies that can help you avoid or reduce capital gains tax when selling foreign property.
1. Primary Residence Exclusion
If the foreign property is your primary residence, you might be eligible for the Section 121 exclusion, which allows you to exclude up to $250,000 of capital gains from taxation if you’re single, or $500,000 if married and filing jointly. To qualify, you must have lived in and owned the property for at least two of the last five years before the sale. You can qualify for these significant savings even if the time you lived in the property was not for a consecutive 24 months. This is not a one-time exclusion. It can be used every two years.
2. Foreign Tax Credit
The Foreign Tax Credit can help you avoid double taxation by allowing you to offset your US tax liability with taxes paid to a foreign government on the same income. This credit is a dollar-for-dollar reduction in your US taxes, ensuring that you aren’t taxed twice on your capital gains. However, it’s important to note that this credit applies only to foreign taxes paid on the gain and not to taxes on any other income.
3. 1031 Exchange
For those who own investment properties, a 1031 exchange is one way to defer capital gains taxes by reinvesting the proceeds from the sale into a similar property. While this strategy is more commonly used for domestic properties, it can also apply to foreign properties, provided the exchange is between properties located outside the US. However, a 1031 exchange cannot be used to swap foreign property for domestic property or personal-use properties.
4. Hold for Long-Term Gains
By holding on to the property for more than one year before selling, you can benefit from the lower long-term capital gains tax rates, which range from 0% to 20%, depending on your income level. This is significantly lower than the rates for short-term gains, which are taxed at your ordinary income tax rate and can reach as high as 37%. This strategy is straightforward but effective, especially for those who do not need to sell the property quickly.
5. Use a Trust or Other Entity
In some cases, holding foreign property through a trust or a legal entity can offer tax advantages, especially in reducing or deferring capital gains taxes. This approach may also provide benefits in terms of estate planning and asset protection. However, the use of trusts or entities can complicate the tax situation, so it’s advisable to consult with an international tax expert to explore this option.
If possible, plan to sell your property during a year when your income is lower. This could place you in a lower tax bracket, reducing the rate at which your capital gains are taxed.
Still Have Questions? Greenback Has the Answers!
We hope this guide has helped you understand how capital gains taxes impact Americans living abroad. Of course, the most common use for this information will be buying and selling property overseas.
Contact us, and one of our customer champions will be happy to help. If you need very specific advice on your specific tax situation, you can also click below to get a consultation with one of our expat tax experts.
