Foreign investment in property is common these days, both by Americans investing abroad and the other way around. If you are part of the former group, you may at some point find that you have to sell your foreign property. Generally speaking, that means paying capital gains tax. But can those taxes be avoided? Like most tax questions, the short answer is “maybe.” You may have to pay some tax, but with the right moves, you can significantly lessen your tax burden. However, there are certain rules you must follow to ensure the best possible scenario. This is a particularly complex problem, so consider getting help; you can find a financial advisor using SmartAsset’s free financial advisor matching service.
How Capital Gains Are Reported on Your Tax Return
Whether you have capital gains – or losses – you report them on Schedule D, which you attach to Form 1040. The form includes both net long-term and net short-term capital gains. Certain adjustments, such as those reported on Form 8949, can offset net capital gains.
In general, capital losses of up to $3,000 can offset capital gains on your tax return. Any losses beyond $3,000 can’t be used to reduce capital gains on your current tax return; however, they can be carried over to a future year (or a prior year).
Ways to Avoid Paying Capital Gains on Foreign Property
If you are looking to deduct or even completely avoid capital gains, there are a few possibilities, depending on your situation.
Capital Gains Exclusion
If you sell a foreign property, you may be able to deduct some or all of the capital gains. However, the home must qualify as your primary residence, which requires you to have lived in it for at least two of the past five years. If it qualifies, you can exclude up to $250,000 in capital gains (up to $500,000 if married filing jointly).
When you sell a foreign property and realize a capital gain, you might be able to offset them using the Foreign Tax Credit. This is because the sale is considered income; however, it isn’t earned income, which means the sale won’t be eligible for the Foreign Earned Income Tax Credit.
Avoid Short-term Capital Gains
Just like selling stocks, selling a property that you’ve owned for less than one year will be subject to short-term capital gains, which are taxed as ordinary income. These rates are usually higher than the long-term capital gains rate, which can be 15% or even 0% in some cases.
A 1031 exchange, also known as a like-kind exchange, may allow you to avoid capital gains under the right set of circumstances. With this type of exchange, you swap one investment property for another. If the properties are like-kind, you won’t be subject to capital gains when making the switch.
But there are several limitations to this strategy. Most importantly, you can’t swap a foreign property for a domestic property, and vice versa. In addition, this exception only applies to business or investment properties. If the property you want to exchange is for personal use, it won’t be eligible for a 1031 exchange.
Mortgage Interest Deduction
While this deduction relates to ownership rather than the sale of a property, it can nevertheless reduce your tax burden substantially. If you have a foreign property for personal use, you can deduct the first $375,000 of qualified mortgage debt for tax year 2022 on your first and second homes (or $750,000 if filing jointly).
This amount applies to properties purchased since Dec. 16, 2017. For properties purchased before that date, the previous deduction of $1 million applies. After 2025, the $1 million deduction limit will go back into effect.
The Bottom Line
In most cases, you should expect to pay capital gains tax when selling an investment property in a foreign country. While you can deduct capital gains on foreign property, it must qualify as your primary residence. For 1031 exchanges, the properties must be like-kind and used as investment properties. Hence, while there are some exceptions, most scenarios will lead to owing capital gains. If you have questions, though, it’s always best to meet with a tax professional first. That will ensure you are taking advantage of any and all possible exemptions before moving forward.
Tips on Capital Gains Tax
- A financial advisor can help you with all sorts of financial questions, including capital gains tax issues. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Use SmartAsset’s capital gains calculator to estimate what you owe if you have a capital gain.
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