Four Taxes To Understand Before Purchasing Real Estate Overseas
Transfer taxes, for example, can be considerably higher than in the United States.
On the other hand, one big benefit of diversifying into property markets overseas can be a much smaller property tax hit than you’d face if making a similar investment in the United States.
Here are four potential tax expenses to factor into your round-trip costs of a foreign real estate buy.
Transaction costs when buying a piece of real estate in the United States are nominal and related mostly to financing. Transfer taxes overseas can range from 1% to 10%. Include these in your purchase budget. If you have US$100,000 to invest and are buying in a market with a 10% transfer tax, you’re looking for a property selling for US$90,000 or less.
A true transfer tax isn’t recoverable. However, some countries—Nicaragua, for example—charge the seller a tax at the time of closing that is sometimes referred to as a transfer tax but that is really a capital gains withholding tax. While this fee is charged to the seller, he typically passes it on to the buyer.
When charged, this fee is a way for the country to make sure it gets paid at least some of the income tax due on the capital gains from the eventual resale of a piece of property. Governments of countries with active foreign property markets understand that most foreign buyers aren’t going to file tax returns when selling a real estate holding in that country. Charging the tax at the point of sale is meant to bring any eventual tax owed on any eventual capital gain forward. If the withholding tax is more than what the capital gains tax would be (usually it won’t be), you can file a tax return to try to get a refund of the difference.
Thanks to transfer taxes, buying and flipping for a quick profit is not common in most overseas markets. While you can buy a piece of real estate in the United States with a high LTV mortgage, do some work, then turn around and sell the property for, say, a 10% profit on your purchase price that equates to a 100% profit on your 5% down payment after paying the real estate agent, that’s not a viable strategy most places overseas, especially as high LTV financing isn’t easy to get as a foreigner.
An important tax consideration when investing in a rental property in another country is that many jurisdictions treat rental income like ordinary income for tax purposes.
Typically, you’ll have to file a tax return in the country at the end of each year to report your rental income and to show the tax owed. Some countries, though, have figured out that foreign property owners don’t always report rental revenues. This has led some countries to impose taxes on rental income at the source.
Practically speaking, this means that, in some places, your property/rental manager will hold out some percentage of the rental income you earn and hand it over to the government’s tax authority. These withholding rates are typically onerous, with the intent of motivating you to file a full and proper income tax return at the end of the year, hopefully to claim back some of the withholding as a refund.
Some governments have gone so far as to make the proactive presumption that any non-primary residence is a rental, then charge you tax on a presumed rental value/income for your property. Spain does this. So many foreign property owners use their coastal condos and villas in this country only part-time and rent them out otherwise, the government wants to be sure it’s getting a piece of all the rental income being generated within its jurisdiction.
The flaw in this approach is obvious. Not every non-primary residence is a rental and not every non-primary residence is rented out full-time.
Most countries allow you to deduct direct and related expenses against your rental income, including mortgage interest, management expenses, utilities if you’re paying them (this would be the case for short-term rentals, for example), and any other direct expenses. What most countries don’t allow you to deduct is depreciation. This is a U.S. accounting phenomenon that is also allowed for U.S. tax calculations but typically not elsewhere.
If you are a U.S. citizen holding a rental property in another country, it’s treated more or less the same as a U.S. rental property for U.S. tax purposes. You are allowed the same expense deductions, including depreciation (although you have to use a 40-year schedule for non-U.S. property) and the cost of travel to visit and check on the property. You report the rental income on a Schedule E, as you would U.S. rental income.
The complications for an American can arise from the tax liability in the country where the property is located. Without depreciation as an expense, you may have a profit in the foreign country and a loss on your U.S. taxes. The tax you pay in the foreign country can be used as a tax credit against tax owed to Uncle Sam for the same income. If you don’t have any net income in the United States, due to depreciation expense, then you have to carry forward the tax credit. Eventually, you may be able to use it. Note, though, that, if you’re an American holding foreign property in your own name, that’s really the only difference for your U.S. tax-reporting requirements.
Not all countries impose property tax, and, in those that do, the amount owed amounts to much less than you’re likely paying in the United States.
In Belize, for example, your annual property tax on a US$100,000 property might be US$10. It will cost you more in gas to drive to the government office to pay the tax than the amount of the tax. Fortunately, Belize allows you to pay years in advance. Keep your receipt in case the record of your early payment is lost. It’s Belize.
Property taxes in many countries are managed at the local level, by the municipality, which oversees collections and sometimes sets the rates. This means that, depending on the country, you may need to know where, exactly, you’ll be buying before you can know what your property tax rates might be.
Sometimes, a country exempts certain kinds of properties or certain kinds of purchases from property tax for certain periods of time, to incentivize investment. This has been the case in Panama over the past two decades, when the government offered a 20-year tax exemption to all new property purchases, though this exemption is no longer available on new properties. You can, though, assume the remaining property tax exemption on a resale property.
In many countries in Latin America, including Panama and Colombia, property taxes are paid quarterly. In Colombia, you’ll receive your property tax bill in the mail. In Panama, you won’t. You’ll have to go (or send your driver, for example) to the property tax office to review the bill and pay it. Colombia has an online payment option, but you’ll need a local bank account to take advantage of it.
France imposes two taxes related to property—the taxe foncière and the taxe d’habitation. The first is the actual property tax. The second is an inhabitant tax. You’ll pay both if you’re renting your property short term. However, if you’re renting long term furnished or unfurnished, your tenant is meant to pay the taxe d’habitation if they’re living in the apartment as of the 1st of January of that tax year.
Capital Gains Tax
Not all countries charge capital gains tax on real estate profits. New Zealand, for example, doesn’t tax capital gains at all, not on real estate or on anything else.
In France, the capital gains tax on real estate is reduced for non-residents by 6% a year starting with the sixth year of ownership. Own for 22 years or longer, and you owe no capital gains tax.
It’s France, though, so that’s not the end of the story. You’re also liable for a social charge on the gain that is reduced every year after the fifth year of ownership and reaches 0 after 30 years. Sell before five years, and you’ll be liable for 19% capital gains tax and 7.5% in social charges.
Of course, Americans are liable for capital gains tax in the United States on any profits when selling property overseas even if no capital gains tax is charged in the foreign country. However, you get a tax credit for whatever capital gains tax is paid in the country where the property is located. If the tax owed is greater in the foreign country than in the United States, you owe nothing on the U.S. side. If the tax owed in the foreign market is lower than the U.S. tax, you pay the difference on the U.S. side.
Speak with your U.S. tax preparer for details on how these foreign tax credits work. Bottom line, you shouldn’t pay more in capital gains taxes than the highest applicable tax rate. For example, if you’re taxed 10% on your gain in the foreign country and you fall into the 15% capital gains tax rate in the United States, you’d owe the IRS the 5% difference. Some deductions are allowed when calculating the gain.
While not all countries charge capital gains tax on real estate, most that do impose a special capital gains rate. A few, though, tax capital gains as ordinary income.
Some countries apply an inflation rate to adjust the gain calculation so it’s based on a current value of the original purchase price, and some have exemption amounts that reduce the taxable gains.