Investment Constraints 2: Real Property

Last week we started a series of posts discussing the ways US tax laws constrain the investment choices of US taxpayers living in Australia. These are the areas we will be covering:

  1. Superannuation
  2. Homeownership
  3. Real Estate
  4. Australian Managed Funds
  5. Australian Shares
  6. Business Ownership Structures
  7. Investing in the US

This series (and everything on this website) is general information only. I am not a lawyer, tax professional, or financial planner, just someone who has learned about US tax and wants to pass on general knowledge. Many areas of tax law are interdependent, so changes in one area may have unintended consequences in another. You should consult a professional who can consider your own personal circumstances before taking any action.

2. Homeownership

In both Australia and the US, homeownership is a major savings vehicle for many households. Each country provides tax incentives for homeowners, but not the same tax incentives. In the US, home mortgage interest is tax-deductible and when the home is sold the first US$250,000 (per taxpayer) is excluded from taxable income. In Australia, all of the gain on a personal residence is excluded from taxable income. Australian-resident US taxpayers can be caught out by the differences. The US mortgage interest deduction is unlikely to reduce US taxes, as most expats will have sufficient FTC to reduce US tax to zero. Claiming the deduction, however, could help increase FTC carryovers, which could help reduce the US tax bill when the home is sold. Of course, for that to work, the house must be sold before the FTC carryover expires (carryovers last 10 years).Residential Property Index

Over the last decade, house prices in Sydney and Melbourne have more than doubled, and the average price of residential real estate in the capital cities has grown at an average rate of 5.8% per year. In Sydney and Melbourne, in particular, it is important to consider the US tax consequences of any capital gain realised. If a principal residence is owned jointly with a non-US partner, then only half of the total gain will show up on the US tax return. When computing the gain, you can add the cost of renovations (not repairs) to the original cost of the house, so be sure to keep records of the cost of renovations. Also, remember that all US tax computations are done in US dollars, so buying a home is a foreign exchange transaction. When computing the gain on the sale of any asset, the cost base and sales proceeds are converted to USD at the exchange rate from the date of each transaction. This can lead to phantom gains if the AUD appreciates over the period the house is owned. As stated above, the first US$250,000 per owner is excluded from US taxable income. If the gain is more than this threshold, then it is taxed as a capital gain and any US tax can be offset by FTC.

The sale of any real estate may also involve the repayment of an outstanding mortgage. This is another danger area for US taxpayers, because US tax is computed using the fiction that all transactions are in US dollars. If the Australian dollar depreciates between the time the mortgage loan is initiated (when the home is purchased), and the time the loan is extinguished (when the home is sold), the US tax code will treat this as a gain. In effect, the IRS thinks you’ve borrowed US$100,000 (when the exchange rate was USD1=AUD1) and paid back US$75,000 (when the exchange rate was USD1=AUD0.75) for a gain of US$25,000. Of course, since the loan is in AUD, you’ve really borrowed A$100,000 and repaid A$100,000 – no real gain or loss. And, since a principal residence is a personal use asset, the US tax code will only recognise gains on mortgage discharge; losses will be disallowed. For more background on this topic (and how Congress could have fixed the problem in 1986) see this post on The Isaac Brock Society.

3. Real Estate

Buying investment property is very popular in Australia. One of the big attractions is “negative gearing”. Essentially, this means that the Australian tax rules allow interest deductions on loans to purchase an investment property, even if the property is not making a profit. With depreciation deductions, it is possible for a rental property to have a positive cash flow, but generate a taxable loss that will offset other taxable income, including salary.

The rules are different on the US side. Unless substantial time is spent managing a rental real estate portfolio, rental real estate is considered a “passive activity”.  Under US tax rules, passive activity losses can only be deducted to the extent of passive activity income; that is, losses from rental real estate cannot be used to offset salary and other active income. Any losses that are disallowed are carried forward and used to offset future passive activity income. There is a special exception from the passive activity loss rules for rental real estate when you actively participate – this is defined as owning more than 10% of the property and making management decisions or arranging for others to provide services such as repairs. Under this exception, you can deduct as much as US$25,000 of rental losses against ordinary income UNLESS your filing status is Married Filing Separate. For those US taxpayers married to non-resident aliens, this exception is not available.

For US tax purposes, all transactions are converted to US dollars. This can generate phantom currency gains and losses when the property is sold and the mortgage is repaid. Since an investment property is not a personal use asset, unlike a personal residence, currency losses on a mortgage should be available to offset gains on the sale of the property.

 

These are just the broad outlines of US tax treatment of real estate owned either personally or for investment. As always, you should consult a professional advisor before entering into any significant transaction. Next week we will continue this series with an article on investing in shares, either directly or indirectly, and the consequences of the dreaded PFIC rules.

How do US Tax Rules Constrain the Investment Choices of US Taxpayers Living in Australia?

In the Facebook group last week, someone claimed that only the very wealthy are disadvantaged by the dual tax obligations imposed on US citizens and green card holders living in Australia. Certainly, for an Australian resident with only salary income, it is likely that foreign tax credits (FTC) or the Foreign Earned Income Exclusion (FEIE) will completely eliminate any US tax liability. However, for anyone who is considering investing for the future or running their own business, there are many pitfalls and traps in US tax law that need to be carefully considered. It seems like almost anything “foreign” is treated punitively by US tax law, and these xenophobic rules make it difficult for middle class US taxpayers to save effectively while living outside the US.

Over the next few weeks, I will be covering the following areas where US taxpayers living in Australia need to be particularly careful:

  1. Superannuation
  2. Homeownership
  3. Real Estate
  4. Australian Managed Funds
  5. Australian Shares
  6. Business Ownership Structures
  7. Investing in the US

This series (and everything on this website) is general information only. I am not a lawyer, tax professional, or financial planner, just someone who has learned about US tax and wants to pass on general knowledge. Many areas of tax law are interdependent, so changes in one area may have unintended consequences in another. You should consult a professional who can consider your own personal circumstances before taking any action. Continue reading “How do US Tax Rules Constrain the Investment Choices of US Taxpayers Living in Australia?”

When Tax Professionals Disagree

Walter B. Wriston (former CEO of Citicorp): “All the Congress, all the accountants and tax lawyers, all the judges, and a convention of wizards all cannot tell for sure what the income tax law says.”

Applying US tax law to “foreign” legal structures is problematic.1 This is one of the great frustrations of trying to comply with the US system of citizenship based taxation (and one of the reasons why this extraterritorial application of US law should be carefully considered by all countries who negotiate tax treaties with the US). Inevitably there will be differences of opinion as to how US law applies to particular foreign income or taxes – and these differences will lead to different US tax treatment of the same or similar items. There may be no single “right” answer, and we (or the tax professional we have hired) will have to choose how to interpret US tax law to determine our US tax liability on our foreign (home) income. Understanding how our local law meshes with the structures defined in the US tax code is the first step.

In Australia, we have two advantages relative to much of the rest of the world (especially those which are not part of the Commonwealth). First, our laws are written in English. While there are several Aussie colloquialisms that differ in meaning from American English, our laws and other formal writing are written in language that is mostly the same as US English (with a few extra vowels here and there, and the occasional “zed” that has been replaced by an “s”). Second, our legal system is derived from the British system, so many of the underlying principles are at least similar between the two countries. Even so, there are differences.

Continue reading “When Tax Professionals Disagree”