Owning a portfolio of offshore assets can be a headache thanks to the Foreign Account Tax Compliance Act (FATCA). FATCA requires both U.S. citizens and foreigners living in the U.S. to make extensive disclosures about overseas holdings on their tax returns or face stiff penalties. Foreign financial institutions also must report more detailed information on income earned by their U.S. account holders, or face possible U.S. tax penalties.

FATCA is the culmination of a three-year campaign by Washington to combat offshore tax evasion. It has its genesis in a 2009 settlement with UBS AG where the Swiss bank agreed to turn over to the U.S. the names of more than 4,000 U.S. taxpayers with hidden offshore accounts.

Form 8938’s reporting requirements apply to certain foreign financial assets, including stock of foreign companies and business partnerships, which didn’t have to be reported before.

Real estate held overseas may also become a headache. A day doesn’t go by that a client doesn’t ask me whether they must report their foreign real estate on Form 8938. The answer, as ambivalent as it might sound, is that it “depends.”

Foreign real estate owned directly by you is not a specified foreign financial asset that must be reported on Form 8938.[i] For example, a personal residence or a rental property need not be reported.

However, there is one exception. And that is when the real estate is held through a foreign entity, such as a corporation, partnership, trust or estate.[ii] In that case, the interest in the entity – and only the interest in the entity – must be reported as a foreign financial asset on Form 8938, so long as the total value of all your specified foreign financial assets is greater than the reporting threshold that applies to you.[iii]

Consider the following example. John, an unmarried U.S. citizen who resides in New Jersey, is the sole partner of International Real Estate Holdings (IREH). IREH is a partnership that owns a villa in Tuscany with a fair market value of $ 1,000,000 (USD). It does not own any other assets.

The first issue is whether John must report the villa on Form 8938? The answer, as confusing as it might sound, is “no.” What about the partnership? Must John report his interest in the partnership on Form 8938? The answer is a resounding, “yes.”

Why? Because the value of the real estate held by the partnership exceeds the reporting threshold that applies to John – that threshold being $ 50,000 for unmarried taxpayers living in the U.S. – by $ 950,000.

And this is where it is necessary to clear up some confusion regarding the reporting of offshore real estate on Form 8938. While John is not required to report the villa separately on Form 8938, that does not mean that the value of the real estate held by the partnership is meaningless. On the contrary, it serves a very important purpose.

What is that purpose? Very simply, the fair market value of real estate held by an entity is used to determine the value of a taxpayer’s interest in the entity. To illustrate how the value of real estate held by an entity directly impacts whether a taxpayer has a reporting obligation, consider an ironic twist. Suppose, for example, that the fair market value of the villa was less than $ 50,000. In that case, John would have no obligation whatsoever to report his interest in the partnership on Form 8938.

This means that a taxpayer with a portfolio of foreign assets, such as stocks and bonds, will have get more frequent appraisals, a process that can be costly.

Returning to the hypothetical, because the fair market value of the villa was $ 1,000,000, that becomes the value of John’s interest in the partnership. Therefore, when filing Form 8938, John must report a $ 1,000,000 interest in the partnership.[iv]

Up until now we have been discussing Form 8938 reporting obligations in the context of real estate holdings. What about gain realized through the sale of foreign real estate, such as an offshore home? Is that taxable? The simple answer is, “Yes.” U.S. expatriates and federal government employees working abroad must report any gain realized through the sale of foreign real estate. In other words, they are taxed just like they own domestic real estate, with the only difference being depreciation, which must be over forty years.[v]

Expatriates and federal government employees may claim the principal residence exclusion. In order to do so, the residence must have been owned and occupied for a minimum of two years out of the five years prior to its date of sale.[vi] While this is a strict rule, there are some exceptions.

Assuming that the taxpayer satisfies the threshold requirement (or one of the exceptions), how much can be excluded from the sale of such a residence? That depends on whether the taxpayer is single or married and if married, whether the taxpayer is filing jointly or separately. A total of $ 250,000 may be excluded from capital gains taxation if the taxpayer is single.[vii] But if the taxpayer is married and files jointly, a total of $ 500,000 may be excluded from capital gains taxation.[viii]

In addition to the foreign earned income exclusion, U.S. taxpayers working overseas may claim a foreign housing exclusion or deduction from gross income. In order to do so, they must satisfy the following requirements:

1. Live and work abroad;
2. Their tax home must be in a foreign country; and
3. They must satisfy either the bona fide residence test or physical presence test.[ix]

An important distinction must be made between the foreign housing exclusion and the foreign housing deduction. The foreign housing exclusion applies only to amounts paid for with employer-provided amounts.[x] The foreign housing deduction, on the other hand, applies only to amounts paid for with self-employment earnings.[xi]

Endnotes:

[i] Basic Questions and Answers on Form 8938, IRS web page (November 2014), Retrieved from http://www.irs.gov/Businesses/Corporations/Basic-Questions-and-Answers-on-Form-8938

[ii] Id., Footnote (1)

[iii] Id., Footnote (1)

[iv] Id., Footnote (1)

[v] Reeves, “US Tax Breaks for Offshore Real Estate,” web page (Nov. 2014), Retrieved from http://premieroffshore.com/us-tax-breaks-offshore-real-estate/

[vi] Topic 701, Sale of Your Home, IRS web page (November 2014), Retrieved from http://www.irs.gov/taxtopics/tc701.html.

[vii] Id., Footnote (6)

[viii] Id., Footnote (6)

[ix] Foreign Earned Income and Housing: Exclusion – Deduction, IRS web page (2014), Retrieved from http://www.irs.gov/publications/p54/ch04.html.

[x] Foreign Housing Exclusion or Deduction, IRS web page (November 2014), Retrieved from http://www.irs.gov/Individuals/International-Taxpayers/Foreign-Housing-Exclusion-or-Deduction.

[xi] Id., Footnote (10).