As a real estate investor, you may have chosen to expand your investment portfolio to include foreign rental real estate. If this is the case, you should be aware that the tax treatment of your foreign rental property is slightly different than the tax treatment of U.S. rental property. Specifically, the depreciation period for foreign rental property is slightly longer than for U.S. property. The good news is you can still claim this great tax benefit!
What is depreciation?
Depreciation is a process used in accounting, which allocates the original cost of an asset over the useful life of the asset. The useful life of an asset is the number of years the asset is likely to remain in service. Aside from land, depreciation can be taken on most classes of tangible property held by a trade or business for the production of income. Depreciation begins the day the property is placed in service and can be claimed for both residential and commercial rental properties.
Depreciation of residential rental property
In general, residential rental property is depreciated under the Modified Accelerated Cost Recovery System (MACRS). MACRS is used to recover the cost of business or investment property placed in service after 1986. Under MACRS, the recovery period for residential rental property is 27.5 years. If you own a foreign residential rental property, the property is depreciated over a 30-year period.
Depreciation of commercial rental property
The process of depreciating U.S. commercial rental property is similar to the process of depreciating residential rental property. The only difference is the depreciation period. Commercial rental property is depreciated over a period of 39 years. If this property is a foreign rental property, then it will be depreciated over a 40-year period.
Reporting foreign rental income
Any income you derive from your foreign rental property must be reported to IRS Form 1040 (Schedule E or Schedule C). This is because U.S. residents have an obligation to report their worldwide income and foreign financial information ( if they meet the threshold). This is the case, even if you are an expat and your tax home is in a foreign country.
This tax obligation only ends when and if you choose to renounce your citizenship or terminate your residency. If you ever make this decision, you will have to complete a final tax return, along with IRS Form 8854, Initial and Annual Expatriation Statement.
Conversely, if you're a U.S. non-resident who reports to IRS Form 1040 NR, you do not need to report any foreign-sourced income on your tax return. You are only required to report income derived from a U.S. source or income effectively connected to a U.S. trade or business. So, if you have income from a foreign rental property, you don't need to report that foreign rental income to form 1040 NR.
While generating income from a foreign source and paying taxes to a foreign nation, you can claim the Foreign Tax Credit (FTC). The FTC is calculated IRS Form 1116, Foreign Tax Credit. The credit then flows through to Schedule 3 line 1, which then flows to Form 1040 line 20. This nonrefundable credit helps alleviate taxpayers from being taxed twice on the same income.
In addition to the foreign tax credit, if you're a real estate professional with active income from rental activity reported to Schedule C and all other conditions are met, you may be eligible to claim the Foreign Earned Income Exclusion on IRS Form 2555.
Millionacres bottom line
Delving into foreign real estate investing can be a very lucrative investment. While lucrative, income generated from this endeavor does not come without reporting obligations. The great news is you can still claim depreciation on rental property when it's placed in service. Claiming depreciation can help you alleviate some of your tax burden. Since this tax benefit is so valuable, you should keep an eye on the IRS’s rules and regulations to ensure you're depreciating your property over the correct period. If you need assistance with this process, always contact your tax advisor to get the most accurate and up-to-date tax guidance.