June 17, 2016

Foreign Residence Sale

Could trigger unexpected U.S. Taxation!

June 17, 2016

As part of our Client Alert Series for recent domestic and international tax developments which may impact your international assignees’ personal tax situation, please find below a potentially significant U.S. taxation trigger related to the sale of a foreign residence and payoff of a related foreign mortgage that could adversely affect your global mobility program participants.

The U.S. Dollar has recently been appreciating significantly against other major currencies. A U.S. and/or State tax issue may arise when a U.S. person sells foreign real estate and repays a foreign currency-denominated mortgage.

Let’s start this discussion with an example.

Louis is a French national and worked for an U.S. affiliate in France. He moved to the U.S. in January 2016 as an inter-company transfer. He originally bought his primary home in France for EUR 500,000 in 2011 with an interest only loan of EUR 300,000 when the EUR to USD exchange rate was 1.48.

He sold his home for EUR 650,000 and repaid the mortgage balance of EUR 300,000 in May 2016 when the spot rate is 1.15. 

Purchased on 5/1/2011Amount in EURExchange RateAmount in USD
Purchase Price€ 500,0001.48$ 740,000
Mortgage Amount€ 300,0001.48$ 444,000
Sold on 5/1/2016Amount in EURExchange RateAmount in USD
Sale Price€ 650,0001.15$ 747,500
Mortgage Amount€ 300,0001.15$345,000

The sale of Louis’ property in France is considered two distinct taxable events from a U.S. perspective.

1.       Taxation of Capital Gain

2.       Taxation of Currency Exchange Rate Gain

Taxation of Capital Gain

For U.S. tax purposes, the basis of property is calculated using the functional currency – in this case the USD. The equivalent U.S. Dollar amount is determined by using the historical exchange rate at the time the property was purchased. The gain or loss from selling foreign real estate is calculated by subtracting the purchase price converted to the U.S. Dollar with the exchange rate at the time of purchase, from the sale price converted to the U.S. Dollar using the exchange rate at the time of sale.

In this case, the sale of his principal residence resulted in a gain of $7,500 ($747,500 – $740,000). Since Louis lived in the property for more than two out of the five recent years prior to sale, the gain from selling his principal residence is excluded from taxable income if the gain is less than $250,000 ($500,000 MFJ). If Louis recognized a loss from selling his home, the loss is considered a personal, non-deductible loss.

Taxation of Currency Exchange Rate Gain

The currency gain from paying off a foreign currency-denominated mortgage is treated as a separate transaction. The gain is calculated with the functional currency (U.S. Dollar) using the exchange rate at the time the loan was originated and paid off, respectively. In this case, Louis borrowed $444,000 in 2011, and he paid off the loan balance with only $345,000 in 2016. In USD, his loan payoff is $99,000 less than the amount he was originally “obligated” to pay. Therefore, he has an Exchange Rate gain of $99,000. The gain is taxed at the ordinary federal rates as high as 39.6% plus the applicable state tax rate in most cases.

Conversely, if Louis incurred a loss of the currency due to the depreciation of the U.S. Dollar at the time of repayment, he would not be allowed to claim any loss against his other ordinary income.

Can the Exchange Rate Gain be avoided?

The answer is possibly “yes” through proper tax planning and the facts being on your side.

GMT recommends the following actions:

  • Begin “tax consultations” for potential international transfers and assignments as early as possible for those foreign nationals coming to the U.S. with foreign residences. GMT can advise on the best strategies and timing for any eventual sale or mortgage payoff before moving to the U.S. and becoming a U.S. resident.  
  • If the foreign national cannot sell the property prior to becoming a U.S. resident, a possible “conversion” of the property to that of a rental property and electing “qualified business unit” status for the property in the first year may be another way to eliminate this taxable gain on mortgage payoff. The conversion to a rental property must qualify under complicated IRS requirements. GMT can help walk you through this process.
  • In some cases, tax treaties may be available to help in delaying the commencement of U.S. residency. Again, these rules are complex and GMT should be contacted to analyze them under the given situation.

Final Thoughts

U.S. and State tax laws in this area can be quite complex. A pre-assignment tax consultation with GMT would help foreign nationals with real property understand the filing options and potential tax consequences in this area. Please consult with our Tax Management Team today if this situation is relevant to your international employees.

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For 15 years, Global Mobility Tax, has been assisting startups and early growth companies to navigate the tax implications of a global workforce. We provide strategy, consulting, and tax services to organizations and individuals that relocate internationally.

Contact us for any of your global mobility questions or concerns.

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