Foreign Real Estate: U.S. Tax Treatment of Rental Income, Sales, and Deductions

U.S. taxpayers must report worldwide real estate income

U.S. citizens and residents are taxed on their worldwide income, which includes rental income from real property located outside the United States. A U.S. person who owns a vacation home in France, a rental apartment in Mexico, or commercial property in the United Kingdom must report the income from those properties on their U.S. federal income tax return — regardless of whether the income is taxed in the foreign country and regardless of whether the funds are ever brought back to the United States.

Reporting foreign rental income

Foreign rental income is reported on Schedule E of Form 1040, just like domestic rental income. The income must be converted to U.S. dollars at the applicable exchange rate — generally the exchange rate on the date of receipt, or the average annual exchange rate for the year if income is received regularly throughout the year. The IRS accepts Treasury Department exchange rates or other published rates, but consistency in the method used from year to year is important.

Allowable deductions against foreign rental income generally mirror those available for domestic rental property: mortgage interest (subject to applicable limitations), property taxes paid to the foreign government, depreciation, insurance, repairs, and management fees. Depreciation on foreign residential rental property is calculated over a 30-year recovery period (compared to 27.5 years for domestic residential rental property), and foreign non-residential property is depreciated over 40 years. The longer depreciation periods reduce the annual deduction compared to domestic property.

Foreign tax credits on rental income

When a foreign country also taxes the rental income — as most countries do — the foreign income taxes paid can generally be claimed as a foreign tax credit on Form 1116, reducing U.S. tax liability dollar for dollar up to the applicable limitation. The foreign tax credit for rental income falls into the general limitation basket. If the foreign tax rate on the rental income exceeds the U.S. effective rate, excess credits can be carried back one year and forward ten years.

In high-tax foreign jurisdictions — such as many Western European countries where effective tax rates on rental income can exceed 40% — the foreign tax credit often eliminates the U.S. tax liability on the rental income entirely. In low-tax jurisdictions, U.S. tax will be owed on the difference.

Selling foreign real estate: calculating and reporting gain

When a U.S. person sells foreign real estate, the gain or loss is calculated in U.S. dollars based on the difference between the dollar-denominated sales price and the dollar-denominated adjusted basis. Because the property was purchased and sold at different exchange rates, currency fluctuations can create gain or loss that is entirely attributable to exchange rate movements rather than actual appreciation in the property's value — a phenomenon that can surprise sellers who see no gain in local currency terms but owe substantial U.S. tax due to dollar strengthening.

Gain on the sale of foreign real estate held for more than one year is generally treated as long-term capital gain and taxed at preferential rates. The Section 121 exclusion — which allows up to $250,000 ($500,000 for married couples filing jointly) of gain to be excluded from income on the sale of a principal residence — is available for foreign principal residences, provided the taxpayer meets the two-out-of-five-year ownership and use requirements.

FBAR and FATCA considerations

Foreign real estate held directly — in the taxpayer's own name — is not itself a reportable foreign financial account for FBAR purposes and is not a specified foreign financial asset for Form 8938 purposes. However, if the property is held through a foreign entity (a foreign corporation, partnership, or trust), the entity interest is generally reportable on Form 8938 and may trigger additional entity-level reporting obligations. Foreign bank accounts used to receive rental income or hold sale proceeds are separately reportable on the FBAR.

Owning real estate abroad creates a range of U.S. tax and reporting obligations that are easy to overlook. Our cross-border tax attorneys can help you structure your foreign property holdings tax-efficiently and ensure your annual reporting is complete. Contact us to discuss your situation.