For U.S. citizens and Green Card holders, the IRS maintains a “taxing nexus” that ignores national borders. While you may have paid taxes in London, Tokyo, or Toronto, your U.S. tax obligation is far from settled.
The sale of foreign real estate is one of the most technically demanding areas of international tax compliance. If you own real estate overseas and are planning to sell, you aren’t just navigating a local market, you are stepping into a complex U.S. tax minefield.
Here is everything you need to know to avoid the most costly pitfalls of selling foreign property in 2026.
Pitfall 1: The USD Functional Currency Rule
The IRS does not recognize gains or losses in Euros, Yen, or Pounds. All tax determinations must be made in U.S. Dollars (USD) based on the Spot Rate at two distinct points in time – the date of purchase and the date of sale.
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.)
Pitfall 2: Section 988: The Mortgage Payoff Trap
This is the most frequent “gotcha” in international tax. If you had a foreign currency mortgage, the IRS views the payoff of the debt as a separate transaction from the sale of the house.
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.
Pitfall 3: Rental Property & Mandatory ADS Depreciation
If your foreign property was ever rented, the compliance stakes are higher.
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.
Pitfall 4: Can the Foreign Tax Credit (FTC) Zero Out Your Bill?
While you can claim a credit (Form 1116) for taxes paid to the foreign country, it is rarely a perfect 1:1 offset due to:
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.
Comparison: Foreign Rental vs. Primary Residence
| Feature | Foreign Primary Residence | Foreign Rental Property |
| USD Basis | Purchase Price + Improvements | Purchase Price + Improvements – Depreciation |
| Section 121 Exclusion | Up to $500k (If qualified) | No |
| Depreciation Recapture | N/A | Yes (up to 25%) |
| Currency Gain (Section 988) | Applies to Mortgage Payoff | Applies to All Aspects |
| Reporting Forms | Form 8949, Schedule D | Form 4797, Schedule E |
Strategic Checklist: Before You Close
To ensure an accurate filing, you must gather:
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.
The TS CPA Advantage: Pre-Sale Modeling
The most expensive mistake you can make is reporting a foreign sale after the fact without a strategy in place. And reporting a foreign sale after the fact is “reactive” accounting. At TS CPA, we specialize in Proactive Tax Modeling before you sign the closing documents. We can help 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 exactly what you’re walking away with, not just the gross sale price.
Contact Us Today
Don’t wait for a surprise tax bill in April. At TS CPA, we focus on the intersection of IRC Section 121, Section 988, and the Foreign Tax Credit to ensure our clients don’t pay a penny more than the law requires. Contact us today to learn more about how to avoid these costly mistakes and stay ahead of your finances.