The 2017 Tax Cut and Jobs Act and foreign real property taxes
While the cap on the deductibility of state and local taxes (SALT) under Sec. 164 imposed by P.L. 115-97, known as the Tax Cuts and Jobs Act of 2017 (TCJA), has generated much controversy and even a lawsuit by several states (see "Tax Matters: States Sue Over SALT Deduction Cap," JofA, Oct. 2018), another of its changes to Sec. 164, denying any deduction for foreign real estate taxes paid, has been treated almost as a footnote. Yet this provision increases taxable income of the many taxpayers owning foreign real estate.
This column describes how certain of these taxpayers living in a foreign residence and earning wages abroad may be able to nonetheless claim an exclusion from gross income for foreign real estate taxes they pay or incur.
The TCJA added Sec. 164(b)(6) limiting the SALT deduction to $10,000 per year. Specifically, Sec. 164(b)(6)(B) states that for individuals in tax years 2018 through 2025, "the aggregate amount of taxes taken into account under paragraphs (1) [state, local, and foreign real property taxes], (2) [state and local personal property taxes], and (3) [state, local, and foreign income, war profits, and excess profits taxes] of subsection (a) and paragraph (5) of this subsection [the election to deduct general state and local sales taxes in lieu of state and local income taxes] for any taxable year shall not exceed $10,000 ($5,000 in the case of a married individual filing a separate return)."
New Sec. 164(b)(6)(A) states that "foreign real property taxes shall not be taken into account under subsection (a)(1)."
However, Sec. 911, the foreign earned income exclusion, allows certain U.S. citizens or residents who live outside the United States to exclude a portion of earned income from foreign sources for services they perform, if they meet certain qualifications. Additionally, Sec. 911(a)(2) allows the exclusion of part of the qualified housing costs for such individuals.
Qualified housing costs include:
the reasonable expenses paid or incurred during the taxable year by or on behalf of an individual for housing for the individual (and, if they reside with him, for his spouse and dependents) in a foreign country.
The term ... includes expenses attributable to the housing (such as utilities and insurance), but ... does not include interest and taxes of the kind deductible under section 163 or 164 or any amount allowable as a deduction under section 216(a) [a tenant-stockholder's proportionate share of real estate taxes and interest paid or accrued and allowable as a deduction by a cooperative housing corporation]. Housing expenses shall not be treated as reasonable to the extent such expenses are lavish or extravagant under the circumstances. [Sec. 911(c)(3)(A)]
Thus, this section includes most of the costs to operate a home except for mortgage interest and real estate taxes deductible under Sec. 163 or 164, or extravagant or lavish expenses. Additionally, domestic services are not included, but cleaning, landscaping, and maintenance performed by an outside company (not domestic servants) are included.
Regs. Sec. 1.911-4(b)(1) further defines housing expenses by what is generally included: rent, the fair value of the rental unit if it is provided in kind by the employer, utilities (other than telephone charges), real and personal property insurance, certain occupancy taxes, nonrefundable fees paid to secure the lease, the rental of furniture and accessories, household repairs, and residential parking.
This is not an inclusive list, so Regs. Sec. 1.911-4(b)(2) lists expenses that are specifically not considered qualified housing expenses. These include the cost to purchase or improve a house (capital-type expenditures); the cost of purchased furniture or accessories; domestic labor, such as maids or gardeners; amortization of mortgage principal; depreciation or amortization of housing or capital improvements to it; interest and taxes deductible under Sec. 163 or 164 or amounts deductible under Sec. 216; and the expenses of a second household, except as allowed under Sec. 911(c)(3)(B) and Regs. Sec. 1.911-4(b)(5).
Also specifically excluded are expenses for a pay television subscription and moving expenses claimed as a deduction under Sec. 217 (the deduction of the latter is suspended by the TCJA for tax years 2018 through 2025 with respect to individual taxpayers other than certain U.S. armed forces members).
The regulations clearly state that if the expense is deductible under another section of the Code (in this case, Sec. 163, 164, or 216), then the expense is not a qualified expense under Sec. 911(c)(3).
Again, Sec. 911(c)(3)(A)(ii) does not allow a deduction for interest and taxes of the kind deductible under Sec. 163 or 164, or any amounts allowable as a deduction under Sec. 216(a). The rationale (before the TCJA) for not allowing foreign real property taxes as a qualified foreign housing expense was that they were already deductible under Sec. 164 and could be deducted by the taxpayer on Schedule A, Itemized Deductions.
However, in light of the changes implemented by the TCJA, it appears that the foreign real estate taxes can now be considered a qualified housing expense for purposes of the foreign housing exclusion, because they are no longer allowable as a deduction under Sec. 164 but are a reasonable expense attributable to the housing.
This means that, while taxpayers will no longer be able to deduct foreign real property taxes as an itemized deduction on Schedule A, they still may be able to obtain some benefit by including them as a qualified housing expense on Form 2555, Foreign Earned Income, page 3, Part VI. These expenses and the resulting exclusion must also meet all other applicable requirements of Sec. 911, including limitations on the amount of housing costs that may be taken into consideration and on the overall exclusion amount.
So all may not be lost for these taxpayers. There may still be some tax benefit for the payment of foreign real property taxes.