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U.S. Tax Fundamentals for the Sale of Foreign Real Estate

This is a common question we receive often. Namely, a person owns property in a foreign country which has increased exponentially in value. Thereafter, at some time in-between the time they purchased the property, and the time they sell the property they became a US person.

How is the Foreign Property Basis calculated for IRS Tax purposes?

A Very Difficult Concept

We stress the very complicated nature of this topic, because to someone who only recently became a U.S. Person, it is nonsensical that they would have to pay U.S. Tax on gain that was accumulated on property after it was purchased but before the person became a U.S. Person.

For example, we represent numerous clients throughout Taiwan, and China. A common situation is many years ago in China, the government would provide land to an individual as “payment” for services they provided over a long span of their lifetime.

Typically, there is no “basis” for this property similar to U.S. Real Estate basis. In other words, the laws and regulations involving land in places like China can be very difficult at best.

Thereafter, if this person was to come to the United States later in life and then sell that property, which may now be worth in the neighborhood of $1,000,000+, is it fair for the United States to require the person to pay long-term capital gain when a majority of the “accumulated earnings” was generated before the individual was a US person?

The answer is no, but in reality that is how the IRS is going to tax the individual.

The Basics

Foreign Real Estate Basis & Becoming a U.S. person

Let’s take an example: Michelle is originally from Hong Kong. She is 70 years old and lived most of her life in Hong Kong until recently when her U.S.-based daughter gave birth to her first grandchild and Michelle is now a grandma (Congratulations, Michelle). As any parent will tell you, before Michelle’s daughter could hang up the telephone, her mom was packing up as fast as she can, and high-tails it to the United States. While in the U.S., Michelle is able to use her connections to obtain a Green Card.

The Property At Issue

Many years ago, Michelle purchased a property. The property was worth maybe $50,000 or $60,000 in US money at the time of purchase. Fast-forward to today, and the value of the property is nearly $1.5 million.

To put this example and a little better context lets use some dates:

• Michelle purchased the home in 1970
• Michelle became a U.S. person 2014
• Michelle wants to sell the home in 2017.

Question – What is the Basis?

Oftentimes, our clients will want to consider that the basis should be the date they became a US person. We would agree with that concept, as would nearly anyone. In other words, why should Michelle have to pay U.S. Tax on the gain that was accumulated during the time that she was not a US person?

In fact, looking at the current value is safe to say that at least 90% or more of that gain is presumably accumulated during the time. In which Michelle was not a US person.

A Typical Real Estate Sales Transaction

Forgetting any issues with a home being a primary residence and those types of exclusions, capital gain with real estate sales is relatively simple.

David purchased a home 2010 for $500,000. David sold the home in 2013 for $600,000.   David held the home for more than one year, so it is considered a long-term capital gain (LTCG).

David is not in the highest tax bracket and therefore David is taxed on the difference between the purchase value sales value – minus any expenses. Therefore, David will pay 15% of $100,000, or $15,000 on the gain. David is a US citizen, the property is located in the United States, and David has lived his entire life in the United States.

David is just thrilled he doesn’t have to pay 33% (his progressive tax rate) on the sale.

Can Michelle Change the Basis to 2014?

No. While it is not necessarily codified, there are various cases and memoranda from the IRS which provide the basis remains the purchase price at the time the person purchased it – even if it was purchased prior to becoming a US person.

We get it. It is ridiculously unfair, but from the IRS’ perspective, it also avoids other certain issues such as currency/forum shopping

Currency Exchange/Tax Forum Shopping

Let’s say Peter owns a house (non-primary residence) in his home country that he purchased many years ago for $150,000. The value of the home is now $400,000.

Peter decides to take advantage of an L-1 visa opportunity to have his company send him to the United States for a year. If Peter was to take advantage of this opportunity – and the basis of the property is deemed the value on the day he becomes a US person – he could maneuver to avoid all capital gains.

Example: Peter has a buyer in his home country willing to spend $400,000 for the house.  At the same time, Peter is up for a transfer to the United States. Moreover, Peter qualifies for an exception in his home country which says that any income he earned as a nonresident is only taxable the country in which he was residing at the time sold the property.

Therefore, Peter times the sale so that it does not complete until he meets the substantial presence test in the United States  — and therefore pays U.S. tax on his worldwide Income. Since Peter came to the United States in May, he waits to facilitate the sale until January of the following year.

Peter sells the home for $400,000, which is the property’s estimated value in his home country. Therefore, if the basis was changed to the date he became a US person, he would literally have no tax on the gain. That is because the house’s basis is now valued as of the value on the date he came to the United States ($400,000), and it sold for that same amount while he was a US person and therefore only subject to tax in the United States.

Since there was no gain, there is no tax. Thus, by Peter relocating to the United States for a year for work purposes, he is able to sidestep or circumvent any tax on the sale of the residence.

As you can imagine, this type of tax game is not something the IRS is fond of. 

IRS Offshore Voluntary Disclosure 

Oftentimes, when a person begins assessing U.S. Tax liability for foreign real estate, they come to the sobering realization that they may already be out of compliance for having not filed an FBAR, FATCA Form 8938, or other International Tax Forms — which could lead to excessive fines and penalties.