Tax Impact of Foreign Vacation Homes – Dos and Don’ts

November 2013

In many countries, U.S. citizens are not allowed to directly own real property.  For this reason, an individual often creates a foreign entity, such as a trust, corporation, or partnership to own the property on his or her behalf.  Generally, direct ownership of personal-use real estate (such as a vacation home not used for business) will not create filing requirements in the US; it is treated no differently than owning property located in the U.S.  However, if an entity is used, the type of entity selected can significantly impact the taxpayer’s U.S. federal tax filing obligations and tax consequences, and the purpose of this article is to provide an overview of those consequences. 
 
Entity Classification:

It is imperative that the taxpayer understands how the entity will be classified and taxed in the U.S., and that the taxpayer seek advice from a local attorney and U.S. tax advisor who can assist with the appropriate tax classification.  Generally, a corporation is a less desirable status than others.  A foreign entity with more than one owner with personal liability for the entity’s debts usually is considered a partnership.  A foreign entity without personal liability for the debts of the entity for its owners usually is taxed as a corporation.  Under the right circumstances, the taxpayer may elect pass-through status using Form 8832, Entity Classification Election.  However, if the entity is considered a “per se” corporation, it must be treated as a corporation.  A “per se” corporation is an entity that the IRS has identified as a corporation for which an entity classification election is not allowed.

Detailed information reporting may result from the use of corporate and other ownership structures.  However, in addition to information reporting, owning real estate in a foreign corporation can produce unfavorable tax consequences.  Ideally, for the reasons enumerated below, one should not contribute foreign real estate into a foreign “per se” corporation and instead should make an election to have pass-through status apply. 

Tax Consequences of Corporate Ownership:

For starters, capital gain treatment on an ultimate sale could be lost when a corporate structure is used.  Also, because the corporation likely is owned solely by the taxpayer or by the taxpayer’s family, the corporation is considered a “controlled foreign corporation” (CFC).  A CFC is a corporation in which US shareholders own directly or indirectly greater than 50% of the voting stock.  If the property produces income, the income is subject to special rules.  Ordinarily, income from a corporation is not taxable to the owners until it is distributed to them from the corporation.  However, with a controlled foreign corporation, a U.S. shareholder may have to include in income a portion of the CFC’s foreign source income even if a dividend was not paid.  (This often applies in a rental situation).  This income will be taxed at ordinary rates.  When the property is sold, the corporation will collect the sales proceeds and distribute the proceeds to the taxpayer.  The taxpayer will pay tax at ordinary rates on the gain from the sale of the foreign real estate in the year of sale, even if not distributed from the corporation.  Additionally, unlike most situations, any foreign tax paid on the sale of the property by the corporation cannot be used as a foreign tax credit to offset the taxpayer’s personal tax liability.  Much of this unfavorable outcome can be avoided if the transaction is structured as a sale of the corporation’s stock instead of the sale of the property within the corporation.  This would produce a more favorable outcome for the seller, but the terms would have to be agreed to by the buyer, who for tax purposes usually will be inclined to purchase the corporation’s assets, rather than its stock.

Information Reporting:

Holding property in a partnership or disregarded entity obtains desired pass through income tax treatment.  However, various detailed annual information returns must be filed, often regardless of entity structure.  Failing to file these required forms can result in very significant penalties.  Following is a list of annual information returns that could be required in a foreign vacation property setting:   

  • Form 8858 Information Return of U.S. Persons With Respect to Foreign Disregarded Entities
  • Form 8865 Information Return of U.S. Persons with Respect to Certain Foreign Partnerships
  • Form 5471 Information Return of U.S. Persons with Respect to Certain Foreign Corporations
  • Form 3520 Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts
  • Form 3520-A Annual Information Return of Foreign Trust With a U.S. Owner
  • Form 8938, Statement of Specified Foreign Financial Assets

If a taxpayer has failed to file the above forms, the taxpayer should seek to become compliant immediately to mitigate the potential for some very serious and disproportionately high penalties.  The IRS has several voluntary disclosure programs that the taxpayer may consider in becoming compliant.  The voluntary disclosure programs result in a reduction in penalties for noncompliance.

If you would like more information about U.S. International tax implications of owning foreign real estate, U.S. foreign reporting requirements, or any of the IRS Voluntary Disclosure Programs, please contact Stuart Lyons or your BNN tax advisor at 800.244.7444.

Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.