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Uncle Sam & Your Mexican Home
"If you qualify, the benefit of a $25,000 deduction can provide significant tax relief."
Like many a traveler, you've come to Zihuatanejo, lets say from from Portland, Oregon, looking for an escape from the cold and the office. A little romance in a tropical paradise would be nice too! What you did not expect was to fall in love with the city and its charms: the beaches, the ambiance, the view. Before you know it, you and your spouse are discussing the possibility of purchasing some property in "Zihua", as the city is known among the expatriate community. A myriad of questions come up in the conversation. One of the questions you should ask is: How will property ownership in Mexico affect my U.S. taxes? This article will be a brief rundown of what you can expect in this regard. In my next article I will touch on the Mexican side of the tax equation.
Use: Vacation Home
Once you have purchased your home, the use you give it will largely determine the tax consequences as far as the IRS is concerned.
After further discussions with your spouse, you decide that you cannot afford to move to Mexico just yet, but you will keep the house in Zihua for family vacations. If you use your property strictly as a vacation home, real estate taxes, casualty losses, and mortgage interest can be deducted on your federal return as itemized deductions.1
You may also decide that in order to help pay for the house you will rent the property out when not using it. In this case, there are special tax rules if you plan to rent your home to others for two or more weeks a year, as well as keep it for personal use at other times. How much of rental income is includable as income on your U.S. tax return, and how depreciation, maintenance expenses, operating expenses, mortgage interest, property taxes, insurance, and so forth, are allocated between personal use and rental use on you tax return, revolve around how many days the property is used for each purpose.2
Use: Strictly Rental Property
Several years after you purchased your Zihua property you can almost afford to retire to Mexico. However, you decide that you owe it to yourselves to check out other places for retirement before making a final determination. You therefore instruct your property manager in Zihua to rent the house out for at least 12 months.
If the property in Zihuatanejo is to be used strictly as a rental, then the usual rules that apply in the U.S. rental real estate apply here. You may take deductions on Schedule E of your U.S. return for mortgage interest, insurance, operating expenses, repairs, maintenance, etc. and offset those expenses against gross rental income.
Furthermore, if you actively participate in the management of the property, you may be able to use up to $25,000 of your real estate losses to offset other income on your U.S. tax return.3
If you qualify, the benefit of a $25,000 deduction can provide significant tax relief. The key is the definition of "active participation." To actively participate, you need to be involved in the management of the property in a bone fide manner, and own at least 10% of the property in question. You can have a property manager do most of the work, but you will have to make all major management decisions such as rental terms, capital expenditures, repairs, and approving tenants.
Use: Principal Residence
After trying out several other cities out for size you decide that Zihua is really it! You pack up and move to Zihua.
If your home in Zihuatanejo will indeed be used as your principal residence, the usual deductions that would apply to a principal residence in the U.S also apply as far as the U.S. tax authorities are concerned. You may deduct foreign property taxes,4 and mortgage interest expense5 if you itemize on your U.S. tax return.
Selling your Principal Residence
Eventually you may decide to sell the home in Zihua. Currently, you may exclude realized gains up to $500,000, for married couples filing jointly, and $250,000 for single taxpayers6. In order to exclude up to $500,000 in gains you will need to have owned and used the house as your principal residence for at least for two of the last five years.
In general, these exclusions may not be used more than once every two years. There is an exception to this rule if you move due to a new job, health reasons or other "unforeseen circumstances". In these cases the exclusion is prorated.
Estate and gift taxes are another two U.S. taxes to be aware of. Under current U.S. law, if you are a citizen or resident of the U.S., your Mexican real estate will be included in your gross estate for tax purposes if you hold title to the property, or if title is held through a Mexican trust.7
If you give your property away, say to a family member, or allow them to live there rent free, these are considered gifts. If the value of the gifts is greater than $10,000, you will be subject to gift taxes8.
As you can see there are several scenarios that you need to keep in mind depending on the use you give to the property. Please consider that this has been a very general discussion, and your particular situation could be more complicated. I urge you consult with your tax advisor in order to get the full picture based on your unique situation.
1 IRC 280 A(b)