Understanding U.S. Taxation on Foreign Real Estate Investments

04/09/2025

Industry Insights

U.S. citizens and residents are taxed on their worldwide income The tax adviser , so any gain on foreign real estate sales is taxable in the U.S. even if you paid taxes abroad. You must report these gains on your U.S. tax return (Form 1040) and pay federal capital gains tax. State taxes can apply too (for example, California taxes residents on global income regardless of treaties IRS ). Holding period matters: property owned over one year qualifies for long-term capital gains rates (0–20% plus possible 3.8% Net Investment Income Tax), while shorter holds are taxed at ordinary rates.

Global taxation of U.S. citizens

All U.S. persons (citizens or green-card holders) report foreign property income and gains on their U.S. returns. This “citizenship-based” tax system means foreign capital gains, rental income, and even foreign taxes paid must be included in U.S. filings . Foreign taxes paid on property-related income may be creditable to avoid double tax (see Foreign Tax Credit below).

Long-term vs short-term capital gains

Capital gains on foreign property are taxed like any other capital asset. If you owned the property for more than one year, the gain is long-term and subject to preferential rates (typically 0%, 15%, or 20% depending on income). Short-term sales (one year or less) are taxed as ordinary income (up to 37%). High-value transactions may also trigger the 3.8% Medicare surtax on net investment income.

FX impact and USD conversion rules

All transactions must be reported in U.S. dollars. The IRS requires converting foreign currency amounts to USD using a reasonable exchange rate at the date of each transaction IRS . In practice, this means recording your purchase price and sale proceeds in USD at the time of each event. Currency fluctuations can create additional gains or losses, so keep documentation of the rates used (for example, the U.S. Treasury’s yearly average rates are often referenced). Accurately accounting for FX is essential to avoid reporting errors.

Reporting Requirements and Compliance

Required IRS forms (1040, Schedule D, Form 8949)

When you sell foreign real estate, report it on your U.S. income tax return just like a U.S. property sale. List the sale on Form 8949 and then carry the totals to Schedule D of Form 1040 IRS . If you received a Form 1099-S for the sale or have any taxable gain, attach Form 8949 and Schedule D to your 1040. Even if you qualify to exclude some gain under the home sale exclusion, the IRS requires you to report the transaction on Schedule D if proceeds were reported to the IRS (IRS) .

FBAR and FATCA thresholds and penalties

U.S. taxpayers with foreign accounts or assets also face additional reporting. You must file FinCEN Form 114 (FBAR) if you have financial accounts (bank, brokerage, etc.) abroad exceeding $10,000 aggregate at any point in the year IRS . Separately, Form 8938 (FATCA) is required if the total value of your specified foreign assets (which generally includes foreign property interests) exceeds $50,000 for single filers or $100,000 for joint filers at year-end IRS (higher thresholds apply if you live abroad IRS ). Non-compliance carries steep fines – for example, failing to file Form 8938 can trigger a $10,000 penalty (up to $50,000 for continued failure) plus a 40% tax penalty on unpaid taxes IRS . Willful FBAR violations can incur penalties up to 50% of the account balance. It’s critical to meet all FBAR/FATCA deadlines to avoid these penalties.

Mitigation Strategies

Primary residence exclusion (limitations abroad)

The U.S. allows a home sale exclusion of up to $250,000 ($500,000 married filing jointly) on the gain of a primary residence IRS . If your foreign property was your main home and you meet the 2-out-of-5-year ownership and use tests, you may claim this Section 121 exclusion on your U.S. return. For instance, if you lived in a Portuguese villa or Mexican hacienda as your principal home, part or all of the gain might be excludable. Keep in mind the same eligibility rules apply: extended rental of the property or a gap in primary residency could reduce or eliminate the exclusion. No special IRS permission is needed for an overseas home, but you must carefully document that it qualified as your main home.

Foreign tax credit

Any foreign taxes you pay on property income or gains can usually be credited against your U.S. tax liability. By filing Form 1116, you can claim a dollar-for-dollar credit for foreign income taxes paid on the same income that is taxed by the U.S. IRS . In practice, this means capital gains tax paid to a country like Mexico or Portugal can offset U.S. tax on that gain. The IRS notes that it is generally advantageous to take the foreign tax credit rather than a deduction . Properly claiming the credit requires detailed records of foreign tax withholding and payments.

Tax treaty applicability

Tax treaties between the U.S. and other countries can modify how gains are taxed. Some treaties provide for reduced rates or exemptions on certain types of income for residents of the treaty country IRS . For example, the U.S.-Mexico tax treaty may affect withholding or provide tie-breaker rules on residency. However, many countries relevant to real estate investors (such as Portugal, Costa Rica, or the UAE) currently have no U.S. treaty. In those cases, U.S. taxes apply by default as if no treaty exists IRS . Note also that individual U.S. states often do not honor federal treaties; for example, California will tax foreign gains of its residents even if a treaty says otherwise . Always review the actual treaty text (if any) and consult international tax guidance before assuming treaty relief.

1031 exchange limitations for overseas assets

Under current tax law, like-kind (Section 1031) exchanges are limited to U.S. real property. The IRS specifically states that real estate in the United States is not like-kind with real estate outside the U.S. IRS . In short, you cannot defer U.S. capital gains by swapping a foreign property for another property abroad. Every sale of foreign real estate generally triggers recognition of gain or loss in the year of sale. This means international investors should plan for the tax hit, since the familiar 1031 deferral is effectively unavailable on offshore deals .

Property Type-Specific Guidance

Rental income and deductions

If you rent your foreign property, report that income on Schedule E (Form 1040) like any rental. You may deduct ordinary rental expenses: mortgage interest, property taxes, insurance, maintenance, and management fees. Depreciation is also allowed; note that IRS rules treat most foreign residential rental properties as 30-year assets (straight-line) instead of the 27.5-year period used in the U.S. country. Keep detailed records (leases, bank statements, improvement receipts) and convert amounts to USD at the correct exchange rate. Any foreign tax withheld on rental income can generally be credited on Form 1116 to offset U.S. tax.

Personal-use and vacation properties

Vacation homes or personal-use foreign properties have different rules. If you never rent out the property, you cannot deduct losses or depreciation against other income – only gains at sale are taxable. Mixed-use cases (part personal, part rental) require prorating expenses between rental and personal use. Importantly, losses on the sale of a personal residence (vacation home) are not deductible on your tax return. Still, any sale gain must be reported and taxed like other capital gains.

Inherited properties and step-up basis

Inherited real estate adds complexity. Generally, if you inherit a property from a U.S. person, your tax basis in the property is stepped up to its fair market value at the decedent’s death, often eliminating prior appreciation. However, inheritances from foreign (nonresident) decedents may not receive a U.S. basis step-up, meaning the property retains the decedent’s original basis. This difference can significantly affect the taxable gain when you later sell. It’s important to determine the decedent’s tax status and get a qualified appraisal at death to establish the correct basis.

Legal & Structural Considerations

Owning via foreign corporations or trusts

Many investors use offshore entities to hold property, but this raises U.S. tax issues. Owning real estate through a foreign corporation or partnership can lead to immediate U.S. tax on passive income (Subpart F or GILTI rules) even without a distribution. Selling the shares of a foreign entity instead of the property also has different U.S. tax treatment than a direct sale. Foreign trusts introduce another layer: U.S. beneficiaries and grantors must file Form 3520 (and Form 3520-A) to report contributions, distributions, and ownership of foreign trusts IRS . Failure to file these informational returns can carry its own penalties. In short, while entities can offer asset protection, they require careful tax compliance (like Form 5471 for a controlled foreign corporation or Form 3520 for foreign trusts) and often eliminate simple reporting.

U.S. estate and gift tax for foreign assets

U.S. estate and gift tax is also based on citizenship, not residency. U.S. citizens and domiciled residents are subject to estate and gift tax on worldwide assets . The federal estate tax exemption ($13.61M in 2024) applies to your global estate; any foreign real estate beyond that can incur up to 40% tax. Gifts of foreign property by a U.S. person similarly count toward the lifetime gift tax exemption. By contrast, nonresident aliens are only taxed on U.S.-situated assets. Given these rules, planning (such as holding property in a properly structured trust) is vital to minimize estate and gift taxes on large foreign holdings.

Cross-border trust strategies

Specialized trust strategies can sometimes defer or reduce tax, but they are complex. For example, a foreign grantor trust might defer U.S. income inclusion, but U.S. beneficiaries may still pay taxes on distributions or trust gains. Similarly, using a Qualified Domestic Trust (QDOT) can postpone estate tax on a U.S. spouse’s inheritance of foreign assets. However, the IRS imposes strict reporting on these structures (see Forms 3520/3520-A above), and mistakes can trigger immediate taxation. Always work with advisors experienced in cross-border estate planning to avoid unintended tax traps.

Pitfalls to Avoid

Non-reporting penalties

Failure to report foreign income or assets can lead to severe penalties. As noted, FBAR and FATCA violations carry hefty fines – FBAR can reach 50% of the account value for willful failure, and non-filing of Form 8938 starts at $10,000 plus additional tax penalties . Even a simple oversight can be costly. Always err on the side of disclosure: if you’re unsure whether a form is required, filing late or with an explanatory statement is better than omission.

Treaty misinterpretations

Many investors wrongly assume treaty benefits will automatically shield them from U.S. tax. For example, there is no U.S. tax treaty with Portugal, Costa Rica, or the UAE, so gains in those countries are taxed normally by both nations (subject only to foreign tax credit). Even with countries like Mexico that do have treaties, the provisions must be carefully interpreted. The IRS makes clear that if no treaty article applies, then standard U.S. tax law governs . Do not rely on a “treaty loophole” without a qualified analysis – mistakes here can lead to unexpected tax bills.

FX miscalculations

Currency conversion errors are a common slip. Always use the correct exchange rate on the dates of purchase, sale, income, and expenses . For example, using an average annual rate instead of the spot rate at sale can materially misstate your capital gain. Keep records of how you arrived at your USD amounts (for instance, by noting the source of each exchange rate). Proper FX accounting ensures your reported gain is accurate and defensible.

Practical Investor Checklist

Pre-purchase due diligence: Research local tax rates, any capital controls, ownership regulations, and whether a U.S. tax treaty applies. Understand the full acquisition and exit costs (including country-specific capital gains taxes). Consider residency or legal status requirements for foreign buyers.
Recordkeeping: Maintain detailed documentation for each transaction and expense. Keep signed closing statements, receipts for improvements, and accurate exchange rate records. Good books make U.S. tax reporting far easier and protect you in case of an audit.
Qualified international tax counsel: Engage a CPA or attorney who specializes in cross-border real estate and tax. Their expertise can help optimize structures (within legal bounds), ensure compliance with FBAR/FATCA, and update you on policy changes. Even experienced investors benefit from regular check-ins with tax professionals.