US Tax Implications of Foreign Real Estate: What American Expats Actually Owe

# US Tax Implications of Foreign Real Estate: What American Expats Actually Owe

In 2019, an American couple sold their Paris apartment for fewer euros than they paid in 2008. They reported the loss on their French return. Then their US accountant delivered unwelcome news: because the dollar had weakened against the euro over those eleven years, and because they had paid off a euro-denominated mortgage along the way, the IRS treated the transaction as a **taxable gain** of more than \$60,000. The property lost value. The tax bill did not.

That outcome surprises many Americans abroad, but it follows directly from how the Internal Revenue Code treats foreign property, foreign currency, and foreign debt as three separate transactions. US citizens and green card holders are taxed on worldwide income regardless of where they live (IRS Publication 54), and foreign real estate sits inside a web of rules that most domestic tax software handles poorly or not at all.

This article walks through what actually applies: what you must report, what you can deduct, how depreciation works on a flat in Lisbon or a house in Mexico City, and where the unexpected tax traps sit.

Owning the Property: What Gets Reported

Direct ownership of foreign real estate held in your own name is **not** reported on FBAR (FinCEN Form 114) or on Form 8938 (FATCA). The Financial Crimes Enforcement Network has stated that real property itself is not a "financial account" (FinCEN, FBAR Reference Guide). The IRS Form 8938 instructions similarly exclude directly held real estate from "specified foreign financial assets."

What *does* get reported:

• **Foreign bank accounts** used to receive rent or hold the purchase deposit, if aggregate balances exceeded \$10,000 at any point during the year. FBAR is filed electronically with FinCEN by April 15 (automatic extension to October 15). Willful non-filing penalties can reach the greater of \$129,210 (2024 adjusted) or 50% of the account balance per year (31 U.S.C. §5321).
• **Form 8938** if you hold the property through a foreign entity and your total specified foreign financial assets exceed thresholds. For taxpayers living abroad filing singly, that threshold is \$200,000 on the last day of the year or \$300,000 at any point during the year; for married filing jointly abroad, \$400,000 and \$600,000 (IRS, Form 8938 Instructions, 2023).
• **Form 5471** (foreign corporation) or **Form 8865** (foreign partnership) if you placed the property in an entity. Penalties start at \$10,000 per form per year (IRC §6038).

A common mistake: buying through a local "SA" or "SARL" because a foreign notary suggested it. That structure may simplify inheritance under local law but can trigger Form 5471 filings and, in some jurisdictions, passive foreign investment company (PFIC) issues. Run the entity decision past a US-qualified advisor **before** closing, not after.

Rental Income: Schedule E, With Wrinkles

Foreign rental income is reported on Schedule E of Form 1040 in US dollars, converted at either the spot rate on receipt or the IRS yearly average rate (IRS, Yearly Average Currency Exchange Rates). Deductions mirror domestic rentals: mortgage interest, property tax, insurance, repairs, management fees, and depreciation.

Two wrinkles matter:

**Depreciation schedule.** Foreign residential rental property placed in service after December 31, 2017 is depreciated over **30 years** using the Alternative Depreciation System (ADS), per changes made by the Tax Cuts and Jobs Act (IRC §168(g)(2)(C)(iii), as amended by P.L. 115-97). Property placed in service before 2018 uses the prior 40-year ADS life. Domestic residential rentals, by contrast, depreciate over 27.5 years. Land is never depreciable—a land-versus-building allocation is required, and the local property assessment often provides a defensible split.

**Foreign tax credit.** Rental income taxed abroad can generate a credit on Form 1116 under the "passive category income" basket (IRC §904(d)). The credit is limited to the US tax attributable to that foreign-source income, so high-tax countries often leave no residual US tax on the rent—but the filing is still required, and unused credits carry back one year and forward ten.

The **Foreign Earned Income Exclusion** (Form 2555) does not apply to rental income. FEIE covers earned income only (IRC §911).

The Mortgage Payoff Trap: Section 988

When you take out a mortgage in euros, pesos, or yen and pay it off later, the IRS treats the debt as a separate transaction in "nonfunctional currency" under IRC §988. If the dollar weakens between origination and payoff, you have effectively discharged the debt with cheaper dollars—and that difference is **ordinary income**, not capital gain. The tax applies even if you sold the underlying property at a loss, and even if no cash changed hands beyond the refinancing itself.

Example: you borrowed €400,000 in 2015 when the euro traded at \$1.08 (debt basis: \$432,000). You pay off the balance of €350,000 in 2024 when the euro is at \$1.07 (\$374,500 equivalent). The remaining €50,000 principal reduction over the holding period was repaid with dollars worth more than at origination in some years—each principal payment is technically a separate §988 transaction. The math is ugly, and most tax software does not compute it automatically.

Takeaway: keep a payment log in both currencies, with the spot rate on each payment date. Without it, reconstructing the calculation at sale is painful.

Selling the Property

Gain or loss on sale is computed in dollars, using the exchange rate at purchase for basis and the rate at sale for proceeds. This is what produced the Paris apartment result in the opening paragraph: a local-currency loss became a dollar gain because the currency moved.

**Section 121 exclusion.** The \$250,000 single / \$500,000 joint exclusion on sale of a principal residence applies to foreign homes, provided you owned and used the home as your main residence for at least two of the five years before sale (IRC §121). Living abroad does not disqualify you. However, if you rented the property before or after your personal use, the exclusion is reduced by the portion attributable to "nonqualified use" periods after 2008 (IRC §121(b)(5)).

**Foreign tax credit on gain.** Capital gains tax paid to the foreign country on the same sale can offset US capital gains tax via Form 1116, but only within the passive category basket and subject to the overall FTC limitation. Countries with capital gains rates above the US rate (Germany, France in some scenarios) often leave the US with zero residual—but again, the filing is mandatory.

**Depreciation recapture.** If you claimed depreciation while renting, that portion of the gain is taxed at a maximum 25% federal rate under IRC §1250 and is **not** eligible for the §121 exclusion.

Estate and Gift Issues

Foreign real estate counts toward the US estate tax exemption (\$13.61 million per person in 2024, IRS Rev. Proc. 2023-34), but many countries impose forced heirship rules or local inheritance tax that do not coordinate with US planning. A US revocable trust may not be recognized in civil-law jurisdictions. Lifetime gifts of foreign real estate to non-US-citizen spouses are limited to \$185,000 in 2024 (IRC §2523(i), annually adjusted), compared to the unlimited marital deduction for US-citizen spouses.

Practical Action Items

1. **Before purchase:** Decide on direct ownership versus entity ownership with a US tax advisor. The local notary optimizes for local law, not the IRS.
2. **At purchase:** Record the exchange rate, purchase price in both currencies, and allocate basis between land and building using the local tax assessor's ratio.
3. **If financing:** Keep a spreadsheet of every mortgage payment with the spot exchange rate that day. You will need it at sale.
4. **Each year:** File FBAR if any foreign account (including the one collecting rent) exceeded \$10,000. File Form 8938 if thresholds are met. Report rental income on Schedule E with ADS depreciation.
5. **Before sale:** Model the dollar-basis gain, the §988 mortgage gain, and the §121 exclusion separately. The interaction often surprises people.
6. **Keep records for the full holding period plus seven years.** IRS audit of foreign property transactions frequently reaches back further than domestic ones because of the extended statute under IRC §6501(e)(1)(A)(ii) when foreign income is understated by more than \$5,000.

Conclusion

Foreign real estate is not uniquely punished by the US tax code, but it is uniquely *paperwork-heavy*. The rules that apply—worldwide taxation, separate currency accounting for debt, ADS depreciation, Form 1116 crediting—each make sense in isolation. Stacked together on a single transaction, they produce outcomes most Americans do not anticipate.

The next step for anyone currently owning or considering foreign property: pull your last two US returns and check whether foreign rental income appears on Schedule E, whether Form 1116 was filed, and whether FBAR was submitted for any account holding rent proceeds. If any of those are missing, the IRS **Streamlined Foreign Offshore Procedures** offer a penalty-free path to come into compliance for non-willful omissions—but only until the IRS contacts you first (IRS, Streamlined Filing Compliance Procedures, updated 2024).

Engaging a cross-border CPA or enrolled agent before the next filing season, rather than after a sale or audit letter, is the single highest-leverage move. The rules are stable; the traps are known; the cost of compliance is a fraction of the cost of fixing a missed disclosure.