Question 1: How should these foreign properties and the associated rental income be reported on my son's U.S. tax return?
As a U.S. citizen, your son is required to report his worldwide income to the IRS, regardless of where the income is earned or where he lives. The rental income from the Korean properties must be reported on his U.S. federal income tax return (Form 1040).
Form/Schedule: Schedule E (Form 1040), Supplemental Income and Loss This is the primary form used to report income and expenses from rental real estate.
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Reporting Income: He must report the gross rental income collected from the properties. This should be the total rent paid by the tenants before any expenses are deducted by your relative in Korea.
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Reporting Expenses: He can deduct ordinary and necessary expenses paid during the year. These include, but are not limited to:
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Maintenance and repairs
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Management fees (including any implicit fees or amounts retained by your relative for managing the property)
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Property taxes paid in Korea
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Insurance
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Utilities paid by the owner
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Depreciation: This is a crucial deduction you may be overlooking. Your son can (and should) claim a depreciation deduction for the cost of the buildings. The IRS has specific rules for depreciating foreign rental property.
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Foreign residential rental property (the apartment) is generally depreciated over a 30-year period.
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Foreign nonresidential property (the commercial building) is depreciated over a 40-year period.
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You cannot depreciate the value of the land, only the building. You will need to determine the original basis of the property (generally, the fair market value on the date of inheritance) and allocate that basis between the land and the building.
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Currency Conversion: All figures reported on the U.S. tax return must be in U.S. dollars. The IRS allows you to use a consistent exchange rate, such as the yearly average rate or the specific rate on the day the income was received or the expense was paid. The IRS provides yearly average exchange rates on its website.
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Foreign Tax Credit: If your son paid or accrued income taxes in South Korea on this rental income, he might be able to claim a Foreign Tax Credit on his U.S. return using Form 1116, Foreign Tax Credit. This credit is designed to prevent double taxation on the same income.
Question 2: Which forms are required for compliance (e.g., FBAR, Form 8938, Form 3520, etc.)?
This is a critical area with significant penalties for non-compliance. Several forms may be required.
FBAR (FinCEN Form 114), Report of Foreign Bank and Financial Accounts
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What it is: This is not an IRS form but a report filed separately and electronically with the Financial Crimes Enforcement Network (FinCEN).
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Who must file: A U.S. person who has a financial interest in or signature authority over foreign financial accounts if the aggregate value of those accounts exceeds $10,000 at any time during the calendar year.
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Application to your son: If the rental income is deposited into a Korean bank account that is in your son's name (or that he has signature authority over), he is required to file the FBAR. The $10,000 threshold is for the combined highest balance of all his foreign accounts, not per account.
Form 8938, Statement of Specified Foreign Financial Assets
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What it is: This form is filed with the U.S. tax return (Form 1040).
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Who must file: U.S. citizens who have an interest in "specified foreign financial assets" and meet certain thresholds. For an unmarried individual living in the U.S., the threshold is having total assets of more than $50,000 on the last day of the tax year or more than $75,000 at any time during the tax year.
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Application to your son:
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Directly held real estate (like his apartment and commercial building) is NOT a "specified foreign financial asset" and is NOT reported on Form 8938. This is a common point of confusion.
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However, the Korean bank account that holds the rental income is a specified foreign financial asset and must be reported on Form 8938 if the value thresholds are met.
Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts
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This is extremely important for your son's situation. A U.S. person must file Form 3520 to report, among other things, the receipt of a gift or bequest from a foreign person (a non-U.S. citizen/resident) valued at more than $100,000.
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Application to your son: Your son inherited real estate from his biological mother, a citizen of South Korea. It is highly likely the value of the properties exceeded $100,000 at the time of inheritance. Therefore, he was required to file Form 3520 for the year he received the inheritance.
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Past Compliance: Since this happened while he was a minor, the responsibility to file would have fallen to you as his parent/guardian. If this form was never filed, he is currently not in compliance. The penalties for failing to file Form 3520 are substantial. You should address this immediately with a tax professional who can advise on options for late filing, such as the IRS Streamlined Filing Compliance Procedures.
Question 3: Does the fact that I have been managing the properties and receiving income on his behalf affect how they should be reported?
No, this does not change the reporting requirements for your son.
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Beneficial Owner: The IRS is concerned with who the beneficial owner of the asset and income is. Legally, the properties and the income they generate belong to your son.
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Agent/Nominee Relationship: You are acting as your son's agent or nominee. You are managing the assets on his behalf, but the tax liability remains with him, the owner.
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Reporting: All income and asset reporting (Schedule E, FBAR, Form 8938) must be done on your son's tax return under his Social Security Number. The fact that the money may pass through your hands first is an administrative detail; it does not shift the tax burden from your son to you.
Question 4: How should I handle reporting when income amounts are approximate and expense documentation is incomplete?
This is a common challenge with foreign activities. While the IRS requires accurate reporting, there are practical steps to take.
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Reconstruct Records: You must make a "reasonable, good-faith effort" to reconstruct the financial records. You cannot simply use an approximation given to you.
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Gross Income: The amount your relative sends you is likely the net income after they have paid local expenses. You need to determine the gross rental income. Ask your relative for bank statements or a ledger showing total rents collected from tenants.
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Expenses: Ask the relative to provide a detailed list of all expenses paid, such as maintenance, repairs, and management fees. Request any available receipts, bank transaction records, or invoices. Even if documentation is poor, a detailed list from the manager is better than a simple net number.
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Burden of Proof: The burden of proof for deductions is on the taxpayer (your son). If he were ever audited, he would need to substantiate the expenses he claimed. Document your efforts to obtain records.
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Establish a System Going Forward: To avoid this problem in the future, you must implement a better record-keeping system immediately. Ask your relative to use a simple spreadsheet to log every item of income and every expense as it occurs. Have them take photos or scans of all receipts and email them to you quarterly or annually. This is essential for accurate future tax filings.
I suggest working with your son and your relative in Korea to reconstruct the financial records for at least the last 3-6 years. You will need:
- Gross rents collected for each property.
- A detailed list of all expenses paid for each property.
- The fair market value of the properties on the date your son inherited them (to establish a basis for depreciation).
- Records of any Korean income taxes paid.
- Korean bank account statements to determine the highest balances for FBAR and Form 8938 reporting.
To make sure your son is filing correctly going forward your son must:
- Report all rental income and expenses on Schedule E.
- File FinCEN Form 114 (FBAR) annually if the $10,000 threshold is met.
- File Form 8938 with his tax return if asset value thresholds are met.
- File Form 1116 to claim a credit for taxes paid to Korea.
Helpful links:
What Is a Schedule E IRS Form?
Rental Real Estate and Taxes
2024 Instructions for Schedule E (2024)
About Schedule E (Form 1040), Supplemental Income and Loss
FBAR Compliance: Reporting Your Foreign Bank Accounts
How do I file an FBAR report (FinCEN 114)?
Do I need to file Form 8938, Statement of Specified Foreign Financial Assets?
Instructions for Form 1116 (2024)
Claiming the Foreign Tax Credit with Form 1116
Where do I enter the foreign tax credit (Form 1116) or deduction?
Form 3520: Reporting Gifts and Inheritances from Foreign Countries
Instructions for Form 3520 (12/2023)
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