For U.S. citizens and green card holders, the IRS maintains a taxing reach that ignores national borders. Even if you already paid tax in London, Tokyo, or Toronto, your U.S. obligation on the sale of foreign real estate is far from settled, and it is one of the most technically demanding areas of international tax.
How does the U.S. dollar functional currency rule affect a foreign sale?
The IRS does not recognize gains or losses in euros, yen, or pounds; all tax is determined in U.S. dollars using the spot rate at two points in time, the date of purchase and the date of sale. Because the dollar value of both your basis and your proceeds can move with the exchange rate, currency swings alone can change your U.S. tax result.
The Phantom Gain Example: Imagine you bought a flat in London for £500,000 in 2014 when the exchange rate was $1.60. Your U.S. basis is $800,000. Ten years later, you sell it for the same £500,000. In the UK, you have a break-even event with no tax. However, if the exchange rate is now $1.25, your proceeds are only $625,000. You have a $175,000 capital loss for U.S. purposes. (Conversely, if the USD had weakened, you could owe U.S. tax on a gain that never existed in local currency.)
What is the Section 988 mortgage payoff trap?
If you held a foreign-currency mortgage, the IRS treats the payoff of the debt as a separate transaction from the sale of the house, and that split is the most frequent surprise in this area. A currency move on the loan can generate ordinary-income tax independent of the property gain itself.
If the foreign currency weakened against the USD since you took out the loan, you are effectively paying back the bank with "cheaper" dollars. The IRS considers this a Section 988 Currency Gain, which is taxed at Ordinary Income rates (up to 37%), not the lower Capital Gains rates. Even worse, if you have a currency loss on the mortgage, it is generally considered a nondeductible personal loss.
How does depreciation recapture work on a foreign rental?
If your foreign property was ever rented, the IRS recaptures depreciation on sale, even depreciation you never actually claimed, at a rate up to 25%. Foreign residential rental property uses a longer recovery period than U.S. property, which makes the recapture math distinct.
- The 30-Year Rule: Foreign residential property must be depreciated over 30 years under the Alternative Depreciation System (ADS).
- Allowed or Allowable: Even if you never claimed depreciation on your U.S. returns, the IRS assumes you did. When you sell, you must recapture that missing depreciation at a tax rate of up to 25%.
- TS CPA Strategy: If you missed years of depreciation, we can often use Form 3115 (Change in Accounting Method) to catch up and claim those deductions all at once in the year of sale, significantly reducing your taxable gain.
Can the Foreign Tax Credit zero out your U.S. bill?
Not usually. You can claim a credit on Form 1116 for income taxes paid to the foreign country, but it is rarely a perfect dollar-for-dollar offset because of the items below:
- The NIIT Gap: The 3.8% Net Investment Income Tax (for high earners) is generally not offset by foreign tax credits.
- Basket Limitations: Credits from the sale of a house cannot always offset taxes owed on other types of income.
How does a foreign rental compare to a foreign primary residence?
The tax treatment differs sharply: a foreign primary residence can qualify for the Section 121 exclusion, while a foreign rental cannot and instead carries depreciation recapture. The table below contrasts the two.
What records do you need before closing on a foreign sale?
Accurate filing depends on documentation gathered before closing, since basis, currency, and foreign-tax figures all trace back to source records. Gather the following:
- Purchase & Sale HUDs: Including all legal fees and transfer taxes.
- Improvement Records: Only capital improvements (new roof, additions) increase your basis. General maintenance does not.
- Mortgage Statements: Specifically showing the balance on the date the loan was originated and the date it was retired.
- Foreign Tax Proof: Receipts or assessments from the foreign revenue authority.
Why does pre-sale modeling matter for foreign property?
The most expensive mistake is reporting a foreign sale after the fact, because the largest tax variables, currency timing, recapture, and credit planning, can only be managed before you sign. Modeling the transaction in advance lets you determine:
- If you should accelerate or delay the sale based on your U.S. tax bracket.
- How to maximize your Section 121 Exclusion through proper intent and use documentation.
- The exact USD impact of current currency volatility.
- Whether you qualify for Foreign Tax Credit and how to properly time them.
- How depreciation recapture will affect your total federal and state liability.
- Whether Installment Sale treatment makes sense for your situation.
- The impact of Net Investment Income Tax (NIIT) on your transaction.
- How state residency rules may affect your overall tax exposure.
- Whether a change in residency prior to closing could materially reduce tax.
- How the sale interacts with passive activity loss carryforwards.
- The reporting requirements for foreign bank accounts and proceeds, including FBAR and Form 8938 implications.
- The projected after-tax proceeds, so you know what you walk away with, not just the gross sale price.
This planning sits at the intersection of IRC Section 121, Section 988, and the Foreign Tax Credit, and is part of our international tax and cross-border tax work. If you also have unfiled foreign account reports, review our expat tax guide.
Have questions about the U.S. tax rules for selling foreign property? Contact TS CPA for a free consultation. We respond within the same day.