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Reader Suzanne Herman, who says she’s Canadian with US citizenship, submitted this question:
What clever way could one avoid paying US capital gains on the sale of a real estate, and still retain the capital gains exemption on the sale of a principal residence in the country where one lives?
Jonathan Lachowitz of White Lighthouse Investment Management responds:
There are a number of ways to optimize one’s tax situation with respect to capital gains on the sale of a residence overseas, though individual circumstances will dictate whether any of these methods can be used, and many are applicable to domestic residences as well. From a US tax standpoint, all of the following will apply:
The first $250,000 in gains are not taxable as long as you lived in the home two of the last five years as your primary residence. $500,000 in gains are excluded for a married couple filing a joint return. This exclusion applies whether the residence is in the US or overseas.
This exclusion can be used once every two years.
If a US person is married to a non-US person, they may consider titling the house in the non-US person’s name.
If the overseas residence is jointly owned between a US and non-US taxpayer, then only half of the gain should be taxable in the US.
If any foreign taxes are paid on the capital gains from selling a foreign residence, these taxes can be used as a foreign tax credit to offset US capital gains taxes owed. Many countries do not have an exemption on 100% of the gains of a principle residence.
Don’t forget that any capital improvements that were made to the property from the time it was purchased until the time it was sold can be added to the cost basis. So, too, can realtor fees and other expenses related to selling the home. This will also lower US capital gains taxes.
If charitable giving is a big part of your estate planning, gifting appreciated property (as long as it is done properly) can also avoid capital gains taxes and provide a charitable deduction at fair market value.
A US person can gift $145,000 (2014 level) a year to a non-citizen spouse without gift tax or reporting requirements and/or they can use their lifetime limitation of $5.34 million (2014 limit). there is some ambiguity in the IRS regulations as to whether a gift of appreciated property from the US system outside of the US system (eg from a US taxpayer to a non-US taxpayer) would trigger a capital gains recognition. I would recommend getting an expert opinion before doing this.
Another way to avoid capital gains is to get a step-up in basis at the time of death of the owner or a double step-up in basis with proper planning in a community property jurisdiction. Proper planning and professional advice may be useful here and this may only make sense if there is no time pressure to sell the home; this is generally a long-term strategy. Professional advice should be sought to document the fair market value at the time it is inherited to take advantage of this step-up basis.
For advanced planning, where high-value property is considered, there are other techniques that estate-planning attorneys who can assist with such as putting the property into a trust or a family investment company and using various discounting techniques. But this is beyond the scope and need of most ordinary tax payers and may run afoul of regulations in other countries.
There are few other important considerations when selling a foreign residence:
Capital gains rules will factor in the US dollar price at the time of sale minus the US dollar price at the time of the purchase. Capital gains tax may be owed in the US only due to an exchange-rate move even if you have a loss in local currency.
Paying off a mortgage in foreign currency can also result in an unexpected nasty tax consequence since US individuals can’t use a foreign functional currency. They must do all of their accounting in US dollars. Here is an example:
A single individual X buys a home for 2,000,000 Swiss francs (at the time 1 US dollar = 1 Swiss franc) and takes on an interest-only mortgage of 1,000,000 Swiss francs.
Individual X lives in the home for five years (now the exchange rate is 1 US dollar = 1.3 Swiss francs) and the individual sells the home for 3,000,000 Swiss Francs.
X’s sale price in dollars is $2,307,692 - $2,000,000 purchase price, so there’s a capital gain of $307,692. Subtracting the $250,000 exclusion, $57,692 would be subject to capital gains tax.
However , there will be more taxes to pay. The mortgage was worth $1,000,000 in the year of purchase and only $769,231 at the time of the sale = a gain of $230,769. Exchange-rate gains are taxed at ordinary rates. If taxpayer X is in the top marginal rate, he could pay 39.6% on this gain, so an additional $91,384 and he may also be subject to the 3.8% Net Investment Income Tax on top of that. If instead the taxpayer has a loss due to the exchange-rate fluctuation, he is out of luck, because it would be considered a non-deductible personal loss.
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