Foreign income tax on rental property

[mpsingh08]

For tax residents of USA, no deductions are allowed in Spain for rental income which is taxed at a  flat rate of 24%. The same property shows a tax loss on the USA tax return because of the allowed deductions. Will I be able to take foreign tax credit against my USA income tax for the income tax paid in Spain? 

[tagteam]

@pk 

????

[mpsingh08]

Hello Sir,

You helped me last year with a similar situation in UK. I was under the impression that I could offset foreign income tax paid for a specific property only if if that property showed profit on the tax return in the USA. However last year I was able to take credit for UK income tax even though that property did not show a gain on USA tax return. I just want to make sure I understand the rule clearly before making an investment in Spain where income tax for non-residents is flat 24% of rental income. That property will show loss on the tax return in USA. Would I still be able to take credit for the income tax paid in Spain against my income tax liability in the USA? 

[pk]

@mpsingh08 , for federal tax purposes, IRS does not  distinguish  between  rental / income property located on the US or abroad, except for  depreciation   ( even that has been eroded  by the TCJA ).

(a) for Schedule E  --- you report  your gross rental income , allowable expenses  ( including  taxes that are based on property value, right to rent etc. )   & depreciation  (per US tax laws) . US will then use the net income as additional income on your form 1040 for computing taxable income and   your tax liability thereon.

(b) for form 1116 ( foreign tax credit ) -- for this you must have had your foreign tax filing completed/filed/finalized  so as to avoid having to file an amended return to update foreign taxes paid.  On this form your foreign income is the gross rental  and the foreign taxes paid is the actual amount paid.

(c) there is no requirement that the foreign rental property has to be generating profit ( per local tax laws  or US tax laws) for purposes of recognizing foreign taxes paid and  credit claim thereon.

Does this make sense? Do you need more help on this.

stay safe

pk

[Carl]

Will I be able to take foreign tax credit against my USA income tax for the income tax paid in Spain?

Yes. If I recall correctly, that's done outside of the SCH E. @M-MTax check me on this please.

Under the deductions & credits tab in the section for Estimates and Other Taxes paid, there's a sub-section in there for foreign taxes paid. For the total foreign taxes paid you include not only taxes paid on the income, but other taxes such as any foreign property taxes also.

I'm not sure if you have the option to also claim these taxes on the SCH E. But if you do that option and do claim foreign taxes on the SCH E, then you can not claim them in the Estimates and Other Taxes Paid section under the Deductions & Credits tab.

[pk · Accepted solution]

@mpsingh08 , having gone through @Carl reply I realized that I had not closed the loop on offsetting US income  with losses from a foreign  endeavor.

I think you are talking about Passive Activity Loss limitation.  Assuming that you are not in the business of realestate i.e. the rental properties that you own qualify as passive activity, you indeed  will be eligible  for aggregating incomes ( positive and negative ) all passive activities and recognize losses up to 25,000  ( filing status and AGI limitations apply )-- thus the net effect of losses from your Spanish properties against your world income from  all sources would be applicable and entered by TurboTax.  This will take place once you enter all the details of rental properties on Schedule -E  ( irrespective of where the property is located ).  Note that there is no linkage between your income returns filed in the source countries   ( in your case UK and Spain ) i.e. each country taxes incomes under its rules/laws. 

Where the same income is taxed by two jurisdictions  ( e.g.  US and Spain on rental income ),  treaty based  amelioration of the tax  ( double taxation ) is achieved by filing a foreign tax credit -- form 1116.   Note here that while US will recognize the total foreign tax dollar for dollar, the actual allowable amount of credit for the year is based  on a ratio of foreign income  in the source country to your world income being taxed by the USA.  This computation is a bit complicated but TurboTax does this for you -- shows up as a foreign tax  Credit on form 1040 schedules. The unallowed portion of the foreign tax credit can be carried back one year or carried forward for 10 years , as long as there is foreign income -- again TurboTax will do all this for you.

Also, all taxes, licenses,  etc etc levied on the property is correctly reported on Schedule E  ( whether the property is foreign or domestic ).  However, any income taxes  ( and only income based taxes  ) are correctly  entered ONLY on form 1116  for foreign tax credit. -- see my explanations above  

Does this answer your query ?

pk

[mpsingh08]

Thanks for taking the time to explain the intricacies of the tax code. I qualify as a real estate person because I spend more than 50% of my time with real estate investments. In general, each of my investments shows a tax loss in the respective country as well as in USA. I am considering an investment in Spain. They make USA tax residents pay a flat rental income tax equal to 25% of rental income (so, no adjustments allowed for mortgage interest, depreciation, other expenses). Of course, the investment in Spain will still have a tax loss on the income tax return in the USA. I think you have addressed my concern adequately whether I would be allowed foreign income tax credit for the income tax paid in Spain while showing a tax loss on that property in USA. However, you also stated, "The unallowed portion of the foreign tax credit can be carried back one year or carried forward for 10 years , as long as there is foreign income -- again TurboTax will do all this for you". I don't expect to have foreign income, only losses on my foreign real estate investments. Wondering if you meant to say 'foreign activity' or 'foreign income'.

[pk · Accepted solution]

@mpsingh08 , 

1. the only advantage /effect of being a realestate person when renting out properties is theat you losses are not limited i.e. Passive Activity Loss limitation does not apply. However, a business to remain  a business , in the eyes of the IRS   ( rather  than a hobby where effectively no loss recognition is extremely limited) must show profit in at least two of five years  { if my memory serves me correctly }.  

2. I think we are getting distracted by the term "income" --- IRS uses  Gross income   as income  which may be different  from taxable income.   Thus a rental property  could have a gross income of $12,000  on Schedule -E but the  taxable income may be  negative   i.e.  allowable expenses  plus  allowable depreciation exceeds  the gross income.  Thus when we are talking about foreign rental   it is the gross rents  that is counting as income for purposes  of foreign  income and for foreign tax credit on recognition on form 1116.   It is quite possible  that an investors  holds on to a foreign  income property even when  the property  does not pay for itself -- i.e.  a loss on cash flow basis because  of unrealized capital gain for future usage  or unrealized capital loss for use  against    gain  for other investments  for US tax purposes.  So let us recognize that when I said  "as long as there is foreign income" I really did mean  foreign gross income  ( from US perspective )  and  not taxable income --- US tax laws operate   without  effects of foreign  tax laws  except where  double taxation amelioration  occurs  due to  US - other country  tax treaty.

Does this make sense  and/or is there more I can do for you ?

Namaste ji

pk

[mpsingh08]

Thanks for the very clear explanation. You have answered all my questions. I will check on the requirement of having to show profit in at least 2 of 5 years to be classified as a real estate person. I hold on to investments for capital appreciation, and they shelter my other income by generating tax losses. 

[tagteam]

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@mpsingh08 wrote:

....requirement of having to show profit in at least 2 of 5 years

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It is three of five consecutive years.

See https://turbotax.intuit.com/tax-tips/small-business-taxes/when-the-irs-classifies-your-business-as-a...

See also https://www.irs.gov/pub/irs-utl/irc183activitiesnotengagedinforprofit.pdf