Q: I am a U.S. citizen looking to purchase a second home abroad, in Paris. It will be a very small apartment that I will rent out except for a few weeks of personal use. What are the tax implications of this?
Marshall, Paris
A: There's an interaction of several tax components here. The first is the worldwide taxation of U.S. citizens. The second is rules on rental properties. The third is the foreign tax credit. All three give you your answer...
Let's take them one at a time:
Worldwide Income
Unlike every other industrialized country, the United States does not tax income on a territorial basis. That is, they not only tax the income earned within U.S. territory, they also tax the income of U.S. citizens and residents earned abroad. This isn't quite fair, since there is often a double-taxation involved. However, as you'll see when we get to the foreign tax credit, there is some help. Suffice it to say for now, your rental income from this property is fully-taxable.
Rental Property Rules
You must report all income from the rental property. You can, however, take any rental property deductions, including but not limited to:
- mortgage interest
- property taxes
- homeowner's insurance
- homeowner's association fees
- utilities paid by you
- travel costs of servicing the property
- property managers
- depreciation (480 months SL/MM, since this is overseas)
This is likely to result in a tax loss. Since you will be renting out the property (or at least trying to) for 350 days during the year and living in it for a few weeks only, you will likely not exceed the "10% use" rule. This rule states that you can realize a rental loss provided you don't use a rental property as a personal residence for more than the greater of 14 days, or 10% of the time you rented it out.
In order to realize the loss, you must also "actively participate" in the management of the property. This involves things like interviewing renters, making landlord visits, etc.
Assuming that is met, there is dollar cap to the amount of rental loss you can take. In any given year, your maximum rental loss can only be $25,000 ($12,500 if married filing separately). Even this phases out based on income (ratably between $100,000 and $150,000 AGI, half that for married filing separately).
Interestingly, the foreign earned income exclusion does not need to be added back into income for those AGI calculations, so that might just bias you in favor of that tax break if you are also living overseas.
Any rental loss is not wasted if you cannot realize it. Rather, it's "suspended" and rolls forward to future tax years. It can be used when one or more of the following circumstances change:
- Your AGI becomes low enough and you otherwise still qualify for the loss
- Your rental unit starts running a tax profit, and the suspended loss sops it up
- You sell the property, at which time the suspended loss is immediately-realized
- You qualify as a "real estate professional" under the rules
The good news is that this rental property probably won't cost you any additional taxes. The better news is that it might even save you some.
Foreign Tax Credit
Here's where we get back to the "worldwide taxation" issue. Since the U.S. insists on taxing the worldwide income of its citizens and residents, these people often run into a double-taxation problem. In your case, the French government is going to want to tax that rental income the same as the U.S. government does. Fortunately, French tax rules also will allow deductions against this rental income. However, if and when you have to pay French tax on this rental income, you will be able to claim a tax credit for it on your U.S. return.
This would come under the "passive income" basket in the foreign tax credit rules, so you would have to allocate this income accordingly.
However, let's say that the French start taxing this income before the U.S. does (because of suspended losses or some other reason). You'd be paying French tax, but have no U.S. tax to pay down with credits. In this case, you can carry back the credit up to one year, and forward up to ten years.
Example
Let's say you live in the U.S. You have U.S. wages of $100,000, and net rental income of $10,000 (US$).
You pay French tax of $4,000 on the money. What do you do in the U.S. tax return?
On the Form 1116 Foreign Tax Credit, you check the "passive income" box. You list the country, the $10,000 in net rental income, your $5400 standard deduction, and you have double-taxed income of $9509 (rental income overseas that is not cancelled out by part of your standard deduction). You paid $4000 to the French. The $9509 is 9.1% of your AGI minus the standard deduction. You multiply this by your $27,500 in gross U.S. tax to get $2503, the amount of your foreign tax credit.
Thus, you would have no U.S. taxation whatsoever on your foreign source income.
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Posted by: James Williams | 2007.09.10 at 02:33 PM