Overseas Home? Mortgage Interest, Foreign Real Property Taxes & New US Tax Law – Any Workaround?

Sweeping tax reform was signed into law by President Trump on December 22, 2017.  Now that tax returns are being prepared for the 2018 year, individuals are more keenly feeling the impact of the “Tax Cuts and Job Act” (“TCJA”).

I’ve had numerous calls on two questions by Americans overseas who own a foreign residence.  First, whether US persons living abroad having mortgage loans secured by their foreign residence can still deduct mortgage interest and second, whether they can deduct foreign real property taxes paid.

Briefly, yes, mortgage interest is still deductible under the new rules, but the deduction is more strictly curtailed.  Sadly,  under TCJA, foreign property taxes are no longer deductible at all.

If you are an employee living overseas and are being reimbursed by your employer through a housing allowance, all may not be lost, however.  More on this later in the blog post.  I carefully think through the tax rules and often come up with a sound workaround when things otherwise look bleak! Your tax advisor should be doing the same, if he or she is not, then it’s time reconsider advisors.

Here’s everything you need to know.

Mortgage Interest Deductions

Under pre-TCJA law, a taxpayer could take an itemized deduction for so-called “qualified residence interest”.  Generally, this is interest paid on a mortgage secured by what the tax law calls a “qualified residence”. A “qualified residence” is a principal residence (e.g., the taxpayer’s primary home) and one other residence owned and used by the taxpayer as a residence (think, vacation home). These rules remain the same under the new law, and it does not matter whether the residence is located in the United States or overseas.

“Acquisition Indebtedness” versus “Home Equity Indebtedness”

Under the old law, two types of interest were deductible – interest paid on so-called “acquisition indebtedness” of up to $1 million ($500,000 in the case of a married individual filing a separate return), plus interest paid on so-called “home equity indebtedness” of up to $100,000. Simply put, “acquisition indebtedness” encompasses any type of loan so long as the loan was used to purchase, build, or “substantially improve” any “qualified residence” of the taxpayer.

 Home equity indebtedness” is different and is any indebtedness that does not already count as acquisition indebtedness so long as it’s secured by a “qualified residence”.  While the debt must still be secured by a “qualified residence”, taxpayers were given complete discretion as to how the funds from the loan were to be used. Taxpayers could use the borrowed funds to finance a new car or pay tuition, or to pay off credit card debts.  It did not matter the purpose to which the funds were put, the interest was still deductible.

TCJA’s New Rules

1.  Mortgage Interest 

The rules change the deductibility of “qualified residence” interest, at least temporarily. For tax years beginning after December 31, 2017 and before January 1, 2026, the deduction for interest on “home equity indebtedness” is completely suspended (i.e., there will be no deduction permitted), and the deduction for mortgage interest on “acquisition indebtedness” is limited to underlying indebtedness of up to $750,000 ($375,000 for married taxpayers filing separately). Unless extended by Congress, these provisions of the new law will “sunset” (i.e., expire) on January 1, 2026 and the old law will be reinstated at that time.

As detailed below, the Act “grandfathers” certain mortgage loans for “acquisition indebtedness” providing them the benefits of the old law:

The new lower limit does not apply to any “acquisition indebtedness” that was incurred prior to December 15, 2017. There is no similar protection for “home equity indebtedness”, irrespective of when the loan was taken out.

“Binding contract” exception. A taxpayer who had entered into a binding written contract before December 15, 2017 to close on the purchase of a principal residence before January 1, 2018, and who purchased such residence before April 1, 2018, shall be considered to incur “acquisition indebtedness” prior to December 15, 2017. Under this provision, the taxpayer will be allowed the prior-law $1 million limit.

Refinancing. The old law’s $1 million/$500,000 limitations continue to apply to taxpayers who refinance existing qualified residence indebtedness that was incurred before December 15, 2017, so long as the indebtedness resulting from the refinancing doesn’t exceed the amount of the refinanced indebtedness.

The IRS has issued some guidance on the new rules “Interest on Home Equity Loans Often Still Deductible Under New Law“.

2.  Real Property Taxes

As mentioned, TCJA has completely done away with the deduction for foreign property taxes.  Let’s compare this scenario to when property taxes are paid to a US State with regard to a property within the State.  These State property taxes remain deductible on the federal income tax return (subject to dollar limitations).

So, the American citizen owning his home and paying property taxes on it to the foreign country where he resides cannot deduct those property taxes on his US income tax return at all, whereas his counterpart living in the US may deduct property taxes paid on the State-side property. This TCJA provision has not gotten much press, but it certainly unfairly increases taxable income of the many US taxpayers owning foreign real property.  This is but one of many examples illustrating how the US tax law discriminates against the US person living abroad. You can read of many more examples at my tax blog post here.

Foreign Housing Exclusion May Help!

BUT — There may be more than one way to skin a cat. This is a complicated discussion, somewhat simplified for purposes of this blog post.

If you are an employee living overseas and are being reimbursed by your employer for foreign housing costs through a housing allowance, all may not be totally lost despite TCJA’s changes. Americans abroad who own their own homes overseas (as opposed to renting them) are typically paying mortgage interest and foreign real property taxes. It may be possible for such an American to use the Section 911 foreign housing exclusion (FHE) provisions with regard to the excess mortgage interest and the foreign property taxes that are not deductible under TCJA.

For an overview of Section 911 see my discussion here. Typically, the American abroad who uses the FHE is renting his residence, rather than owning it.  Typically, the owner will be the party paying the interest and property taxes.

The FHE is available for certain amounts of overseas “housing expenses” paid or reimbursed by an employer; the employee need not pay tax on these amounts paid by his employer due to the FHE rules. Allowable housing expenses are the reasonable expenses paid for foreign housing.  The relevant Treasury Regulations provide a list of such expenses, but the list is not all-inclusive. See Treas. Regs. Sec. 1.911-4(b)(1). Examples of reasonable housing expenses include such items as rent, utilities (not including telephone charges), and real and personal property insurance. The expenses must actually be paid or incurred during the year by the taxpayer and reimbursed by the employer, or paid by the employer on the taxpayer’s behalf.

Certain items will not qualify, such as capital expenditures, the cost of purchased furniture, domestic labor and other items.  Section 911 also does not permit an exclusion for, among other things, interest or taxes of the kind deductible under Code Sections 163 (interest) or 164 (real property taxes).  Prior to TCJA, the reason for not allowing mortgage interest deductions and foreign real property taxes as a qualified foreign housing expense was because they were deductible under Sections 163 and 164, respectively.  (Looked at in another way, if the taxpayer could take a deduction and simultaneously exclude the amount under Section 911, a “double benefit” would result. Understandably, the tax law seeks to prevent this).

As discussed, mortgage interest deductions are now further curtailed under TCJA and the deduction for foreign real property taxes is no longer permitted. Since the excess mortgage interest and foreign real property taxes can no longer be deducted under Sections 163 and 164, the rationale for flat out denying Section 911 treatment arguably falls away.  In a nutshell, it may be possible that foreign real property taxes and excess mortgage interest that is related directly to the foreign housing itself (e.g., compare “acquisition indebtedness” with “home equity” indebtedness) could be treated as a “qualified housing expense” for purposes of the Section 911 foreign housing exclusion. This premise relies on the fact that they are no longer allowable as deductions under the tax rules, but they remain a reasonable expense directly attributable to foreign housing.

Example

With this general concept in mind, let’s take a simplified example involving foreign real property taxes and see how it might work. Assume you are an American living and working abroad, owning your home overseas and paying foreign real property taxes on it.  If your employer gives you a lump sum housing amount of say, $40,000 and you own your home in the foreign country, and must pay foreign real property taxes of $10,000, then you can possibly use Section 911 to exclude the $10,000 on grounds that these property taxes are reasonable expenses paid for foreign housing.  (You must include in income the balance of $30,000 provided by your employer since you did not use this amount on overseas housing expenses – such as rent).

Remember, as always this is not tax advice!

If you wish help with your foreign tax matters, email me to arrange a consultation.  In today’s tax world, there is no substitute for professional advice and planning that is carefully thought out by an experienced and highly knowledgeable advisor.

Posted: March 21, 2019

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Visit my earlier US tax blog “Let’s Talk About US Tax” hosted by AngloInfo since 2011, it contains all my old posts. Some hyperlinks to my blog posts on AngloInfo may have expired.  If you copy the expired URL, you can most likely retrieve the actual post by using the “Wayback Machine” which is an archiving service.  Simply paste the URL into the Wayback Machine search box. It will show you the archived post was saved on a specific date. Click on that date to retrieve the post.

 

 

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