# Selling a rental property in the UK: USA tax implications? Seems deeply unfair.



## bertje1970

For a US/UK dual citizen, long term resident in the UK, married to a UK only citizen, any advice on how to declare US tax capital gains on BTL property?

If I understand it right, the USA taxes foreign rental property sales as follows

1) Rental roperty (the house, not the land) is depreciated on a 40 year linear time span (as opposed to 27.5 in USA)

2) You can therefore claim 2.5% depreciation each year agains rental income (but this is largely useless if you are already taxed on rental income in UK)

3) Upon a sale, you pay a 25% depreciation recapture tax on the gain. E.g. If you bought a UK house for £1M (ignore land for now), hold for 10 years, then sell again at £1.1M (assume for simplicity had no capital costs (improvements) invested in the property), then £250,000 is taxed at 25%, and the left over £100K at whatever the US CGT rate is (depending on your income, up to 20%). UK CGT would be a tax credit.

*Question 1:* This seems hugely unfair -- e.g. if you sold at £1M, there would be £0 UK CGT, but £62,500 in US depreciation recapture tax!
Is there a way around this?

*Question 2*: Depreciation only holds for the house, not the land. How on earth do you do work that out in the UK? Do you use a RICS rebuild valuation when the house is first put to use & then depreciate that?

*Question 3*: Can this be mitigated by gifting the non USA spouse a fraction of the rental property? In the UK there is no CGT (only potential SDLT if there is a mortgage). Unfortunately, gifting capital value in the property also means the same fraction of rents, which may be disadvantageous if one is a higher rate and one a lower rate tax payer.

*Question 4:* Any exchange rate gains we should be worried about?


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## Nononymous

If you're a dual citizen with little connection to the US, don't report the sale. Saves you from the whole Boris Johnson scenario.

#NeverFile


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## cathalmf

American tax system is unfair!! Shocker!!

Sounds like a fairly complicated situation which i suggest you seek actual legal advice rather than dealing with it youself. Mistakes on this have severe penalties in the USA. 

Maybe renounce your USA citizenship so you're not liable anymore?


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## bertje1970

thanks for the advice. There must be many US expats living in the UK who own BTL property here, so I am assuming that our situation is pretty common. But I can't find much out there (maybe my Google skills are deficient)


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## BBCWatcher

I see the usual suspects aren't trying to answer the questions you asked.  I'll try.



bertje1970 said:


> *Question 1:* This seems hugely unfair -- e.g. if you sold at £1M, there would be £0 UK CGT, but £62,500 in US depreciation recapture tax! Is there a way around this?


Maybe, or even probably. The U.K. taxes the rental income, so you'd take that as a Foreign Tax Credit (IRS Form 1116). Take depreciation on the U.S. side. That should mean you accumulate excess FTCs since the U.S. tends to be quite generous during the ownership period, i.e. assuming the U.K. tax rate is higher. Use excess FTCs as soon as you can (including on the prior tax year), but you can "bank" up to 10 years of excess FTCs and then spend them down on future tax, such as depreciation recapture tax. That assumes everything is within the same FTC income category -- probably -- but that's something to check. If I'm correct, though, it should all work well via the FTC. In fact, it might work better than well if you have other taxed income in the same FTC income category.



> *Question 2*: Depreciation only holds for the house, not the land. How on earth do you do work that out in the UK?


Publication 527 tells you how to do that. Look for the "Separating cost of land and buildings section." Basically you use fair market values (e.g. comparables) or, if unavailable, assessed values. Insurance might offer some clues if you're really out of ideas. You do the best, most reasonable job you can in the circumstances and hang onto documentation describing how you calculated the numbers.



> *Question 3*: Can this be mitigated by gifting the non USA spouse a fraction of the rental property?


If your spouse is a co-owner, on the deed, from the beginning -- if this is a marital asset -- then you don't have to do that. You just treat the property (and its income flow) as 50% yours all the way through. There's ordinarily no gifting implied in that simple arrangement. If, on the other hand, the property is now, already solely in your name, and you want to gift your spouse any portion of the property, you can, but you have an annual gift limit to a nonresident alien spouse. It's on the order of $144,000 this tax year, but I don't remember the exact number. Gift above that amount and you simply dig into your $5.5 million (approximate, current figure) blanket estate exclusion. Which you can do, but I'd at least give it some thought.

Oddly enough a nontrivial number of foreign spouses clock some U.S. residence time and naturalize as U.S. citizens as quickly as they can. Then they get to enjoy the unlimited spousal exemption on estates.



> *Question 4:* Any exchange rate gains we should be worried about?


The exchange rate will bounce around a bit, but that's a fairly stable currency pair. You could consider exchange rate factors in timing the purchase and sale dates, I suppose, but that won't be your only consideration.


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## Booth44

OP, I'm curious - have you been including rental statements in your US returns all along or is this just a hypothetical situation. 

I'm not an expert on US depreciation but I'm aware that it's a mandatory claim in this instance, so if you've shown the property on a rental statement I believe you are out of luck.

For sure exchange rates will enter the calculation of the capital gain. The proceeds and cost basis need to be calculated and expressed in $USD using the exchange rates in effect at the different times expenses were incurred & proceeds were received.


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## Nononymous

I had no idea there was such a thing as a "depreciation recapture tax". Sounds utterly bonkers. Since I happen to own a rental property, that's yet another good reason not to file US taxes...


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## maz57

Sorry to be the bearer of bad tidings Nononymous, but Canada has it too. I found out about it by surprise (i.e, the hard way). If the property is in Canada, its worthwhile to look into and understand before selling because it is possible to (legally) minimize the tax liability by advantageous timing and structuring of the deal.


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## BBCWatcher

Not "bonkers" -- far from it. Rental income is taxable practically everywhere there's an income tax. Depreciation reduces your tax on that income, plain and simple. But it does so under the theory that the asset is depreciating -- that it's getting "worn out." In other words, that part of the cost of that rental income is wearing out the asset that generates the income, so that cost should be factored into calculating the taxable income, as it flows.

OK, fast forward to the point in time when you sell the asset. What if the asset really didn't depreciate? What if, instead, you sell the property for more than you paid for it? In that case the depreciation wasn't real, didn't happen, so you have to unwind that tax savings at least to some degree.

Either way, you do OK. If you get unlucky, and the property really does get less attractive, you've pocketed the depreciation tax savings along the way, up front, and even get to take a capital loss (up to limits) on the sale. On the other hand, if the property gets more attractive, you'll pay a tax on that sale gain (less allowable costs) and a favorable recapture tax rate. Your tax has still been deferred, and some of it (due to the lower recapture tax rate) has been forgiven. And you're always paying taxes out of rental income flows and sales proceeds, so you shouldn't have any weird tax-related financing requirements. It all really does make sense. Even in the frigid north.

Now, if I'm correct, this all still works quite well when interacting with a U.K. tax code that's somewhat different, thanks to the Foreign Tax Credit. The tax savings should accumulate on the U.S. side as excess FTCs, and the excess FTCs can then take care of the recapture tax (and perhaps more than that, even). If I'm correct -- something to double check, obviously. But if I'm correct then this aspect of the U.S. tax code could give U.S. persons some financial _advantages_ investing in foreign rental real estate in comparatively high rental income tax jurisdictions, assuming they also hold other taxable investments. It simply depends on how much power and leverage they can get from their FTCs.


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## Booth44

There is no recapture depreciation tax per se in Canada in the same way it exists in US taxation. Depreciation in Canada is an optional claim and for rental properties most Canadian tax advisors will tell you to avoid claiming depreciation for properties that will likely increase in value - to avoid the very pitfall that the op now faces. Depreciation in the US is a mandatory claim - there is no choice in the matter.

To be sure, if you sell a rental property in Canada you will be forced to include recaptured depreciation as taxable income up as far as your cost basis - any excess beyond cost counts as capital gain. The recaptured depreciation is put back on the rental income statement and is taxed as such, at your marginal tax rate (not the straight 25% as per US rules).


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## BBCWatcher

Booth44 said:


> Depreciation in the US is a mandatory claim - there is no choice in the matter.


I don't think that's true, actually, but it might as well be true since it would be financially foolish not to take depreciation.

The 25% recapture rate is nearly always favorable, sometimes highly favorable. True, technically there are lower ordinary income tax brackets, but it's quite rare indeed for a rental property owner to be in those brackets particularly when he/she has a property-related capital gain. The lower tax brackets apply only to taxable income below $37,650 (Single filing status, 2016 figure), so that's really nothing to speak of in this sort of situation. In any event, tax is still deferred through depreciation/recapture, and the deferral is also valuable.

Did you ever wonder why hotel chains routinely recycle properties -- that a Sheraton for 25 years becomes a Hilton for the next 25, for example (after renovations of course)? This sort of stuff is part of the reason. Hoteliers are very good at understanding how to work the tax code, and it does work quite well.


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## Bevdeforges

The way the law/regulation is worded, you must figure all depreciation taken or allowed. So yes, in a sense, depreciation is "mandatory" - even if you didn't take it on your returns, you have to calculate the gain as if you had taken it.
Cheers,
Bev


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## bertje1970

that is super helpful. 

Here in the UK insurance is usually based on a "rebuild cost" which should roughly be the value of the building. 40 year depreciation sounds bonkers when you live in houses that are 100s of years old. The older the more valuable in general .... The rebuild cost also go up, there is a RICS index that gives you that inflation. Where it gets tricky of course is if you own a flat (appartment) ... I guess you just divide the rebuild cost by the number of flats and somehow normalise by square footage per flat. 

In London where property has climbed by 50% over the last few years by far the biggest gain must be in the land then, but the depreciation tax nevertheless can bite pretty hard. 

I believe other countries (e.g. Sweden) also have some kind of depreciation for rentals as well. For this system to work fairly, it would need the FTC to count against the depreciation recapture tax. I worry that the two categories (depreciation counts against income while deprectiation recapture tax is a kind of CGT) won't match up. So I now have a much clearer question:

*Do foreign tax credits (FCT) for deprecation against rental income count against depreciation recapture tax when you come to sell? *

My main point remains: Surely this issue must hold for almost all US citizens living abroad who hold rental property. Possibly millions of people. So why is it hard to find clear information?


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## bertje1970

Bevdeforges said:


> The way the law/regulation is worded, you must figure all depreciation taken or allowed. So yes, in a sense, depreciation is "mandatory" - even if you didn't take it on your returns, you have to calculate the gain as if you had taken it.
> Cheers,
> Bev


Thanks for that -- Yes, that is also my understanding. It is mandatory, even if you don't file for it. If you didn't include it when you file, I think that you can only backdate for a limited amount of years by filing amended returns.


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## bertje1970

In the UK it is common for spouses to hold investment property in non 50/50 ratios. The most common reason is that one spouse is a higher rate tax payer and the other isn't. For spouses rents are split according to the ownership ration. So by giving the lower tax payer a larger fraction of the rent, you can lower the total tax. The same is sometimes done on a sale to lower CGT (which is 18% for lower tax payers, 28% for higher tax payers). To do this you need to file a "form 17" with HMRC because the default assumption is 50/50. 

Interestingly, if you jointly own with someone who is not your spouse, no form 17 is needed. Just a valid declaration of trust. 

Where it gets tricky is if the lower income spouse is a USA citizen -- then the depreciation recapture tax may mean you want to lower their ownership fraction, while the UK rental taxes mean you want to increase their ownership fraction. 


(this needs to be filed


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## BBCWatcher

bertje1970 said:


> In the UK it is common for spouses to hold investment property in non 50/50 ratios.


You'll have to read up on the U.S. treatment. "Best guess" is that the default 50-50 assumption is controlling when both spouses' names are on the deed, and if you're going to try to argue otherwise then you have to start tracking contribution shares in some reasonable fashion -- and then you might stumble into gift limit issues.

It looks to me like everything related to depreciation, rental income, rental property capital gains, and recapture is within the FTC's passive income category. It does not appear that you have any income category limitations here. Double check me on that, of course, but it looks good to me.


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## Bevdeforges

Do check the regs on this. We've just had someone posting on another thread who says that the tax preparation software is set up to deny the FTC altogether if line 41 is 0. (Line 41 is AGI adjusted for the standard or itemized deduction, but not for personal exemptions). It may be a glitch in the software (though obviously the software company denies that).
Cheers,
Bev


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## Nononymous

Booth44 said:


> There is no recapture depreciation tax per se in Canada in the same way it exists in US taxation. Depreciation in Canada is an optional claim and for rental properties most Canadian tax advisors will tell you to avoid claiming depreciation for properties that will likely increase in value - to avoid the very pitfall that the op now faces. Depreciation in the US is a mandatory claim - there is no choice in the matter.
> 
> To be sure, if you sell a rental property in Canada you will be forced to include recaptured depreciation as taxable income up as far as your cost basis - any excess beyond cost counts as capital gain. The recaptured depreciation is put back on the rental income statement and is taxed as such, at your marginal tax rate (not the straight 25% as per US rules).


Thanks for the clarification. I've taken the simpler route and never claimed depreciation on the house. I was always able to find enough operating expenses to minimize the taxable profit. The overall property value will have increased by a reasonable amount. 

It wasn't really intended as an investment. Built a new house, discovered it was easier to rent the old one than to sell it. (That way we could still leave some of our crap in the garage...)


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## bertje1970

Thanks to the helpful comments. It helped me do better research into how things work. My understanding now is that:

1) If depreciation of a rental property is claimed, and not used (i.e. you make a paper loss), then it can roll over to subsequent years. To first order these losses qualify as passive losses, although you can in some circumstances claim up to $25,000 against normal active income. 
2) Once the property is sold, this accumulated loss can be used to offset other passive gains.

So for a standard UK BTL, to first order the situation would be:

A) Because rental income is already taxed in the UK (typically more heavily than in the US), this gives a foreign tax credit that will offset any normal US taxes. Further, the US based 2.5% per year depreciation can then be claimed to make a paper loss of at least that depreciation per year.
B) Once a property is sold, this accumulated loss should more or less offset the depreciation recapture. 

This doesn't solve problems due to currency fluctuations on a mortgage etc..., but at least seems more fair.

Of course you need to remember to claim the losses and carry them over.


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## BBCWatcher

You're rather underselling the value of the Foreign Tax Credits. Yes, they'll help year to year, but they'll probably do more than that. Excess FTCs accumulate and are spendable on recent past, current, and future U.S. tax liabilities in the same income category.

Run some simulated numbers and see what happens. You can use tax preparation software to run such simulations.


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