US Tax Optimization for Foreign Real Estate Sales

Understanding Tax Treatment of Foreign Real Estate Investment

When US citizens invest in foreign real estate through local entities, they often assume these companies work like US LLCs for tax purposes. This assumption can lead to costly surprises, particularly when selling the property. Without proper planning, you could face up to 17% higher tax rates than expected.

Real World Scenario: Foreign Real Estate Investment In Costa Rica

A US citizen invested in Costa Rican real estate, operating multiple properties through local SRLs (Sociedad de Responsabilidad Limitada - the Costa Rican equivalent of an LLC). The investment portfolio included:

• Multiple rental properties
• Land development projects
• Properties held through separate SRLs for liability protection

Annually, the investor reports net rental losses on their US tax return and sells the property in 2024, anticipating long-term capital gain treatment (with a maximum tax rate of 20%).

Key Questions

1. Was it correct to report annual rental losses on the personal US tax return?
2. Will the sale be treated as a long-term capital gain, taxed at a maximum of 20%, rather than as ordinary income (up to 37%)?

What is a Check-the-Box (CTB) Election?

A Check-the-Box (CTB) Election is an IRS provision that allows eligible business entities to choose their federal tax classification. By filing Form 8832, entities can elect to be treated as a corporation, partnership, or disregarded entity for tax purposes rather than accepting the default classification assigned by the IRS.

In this context, understanding and utilizing a CTB election is essential. Without this election, foreign entities are typically classified as corporations by default, leading to less favorable tax outcomes. For example, entities classified as corporations cannot flow losses through to their owners' personal tax returns, and gains are often subject to higher ordinary income tax rates. Proactively filing a CTB election ensures income and losses are reported optimally for US tax purposes, unlocking benefits like the Foreign Earned Income Exclusion and avoiding Controlled Foreign Corporation (CFC) pitfalls.

The Problem: One LLC is not like the other.

The IRS treats a foreign entity that provides limited liability to its owners as a foreign corporation.

Worse yet, where a US citizen is the sole owner of the company (or has “control”), it is considered a “controlled foreign corporation”.

It also means that a sale of the property itself is subject to ordinary income tax rates (i.e., it is a sale of assets by a foreign corporation). There is a very nuanced way of getting there but essentially the gain gets caught up in the anti-deferral rules for controlled foreign corporations. The nuances of these rules are a separate topic in and of themselves but for this purpose I'll just point out that the gain is income to the foreign corporation which is taxable to the US shareholder regardless of whether that income is distributed thereto (i.e., anti-deferral).

• Losses and income don’t flow through to the owner’s personal return.
• Gains on the property sale are taxed as ordinary income, subject to anti-deferral rules for Controlled Foreign Corporations (CFCs).

The Solution: Retroactive Entity Classification Election

One strategy for avoiding this treatment is to make an entity classification election so that the non-US entity is treated as a flow-through. You do this by first checking to make sure it is an eligible entity.

Step 1: Understand the Default Classification

Under IRS regulations (IRC Reg. Sec. 301.7701-3), a foreign entity providing limited liability to owners is treated as a foreign corporation unless an election is filed.

Step 3: File Form 8832 for Flow-Through Treatment

An entity classification election allows the SRL to be treated as a disregarded entity or partnership for US tax purposes. This must typically be filed within 75 days of the entity’s formation. Filing late triggers a deemed sale, which leads back to the ordinary income world.

So the trick in this case is trying to make a retroactive entity classification election since the 90 days had passed. There is a way, but it is a narrow window.

Step 4: Leverage Revenue Procedure 2009-41

Revenue Procedure 2009-41 allows you to tack on 3 years to the 75 day rule as long as you have the following two factors.

1. Reasonable Cause: The taxpayer must demonstrate reliance on a tax professional or misunderstanding of the rules.
2. Consistency: The taxpayer must not have filed a return inconsistent with the intended flow-through treatment.

Reasonable cause is a term of art but, for this purpose, it can generally mean reliance on a tax professional or a reasonable misunderstanding of the rules. In my experience, the IRS is relatively lenient here for this specific purpose.

So if you have reasonable cause and the tax return due date has not passed, a retroactive election is possible. For example, you set up a foreign LLC to hold a rental property in July 2024 and in March 2025 you realize you should have made that election. At that point, you have not filed an inconsistent return so you can make the election and apply it to the 2024 tax year.

If reasonable cause is established, the election can apply retroactively to treat the SRL as a flow-through entity, allowing:

• Losses to flow to the owner’s US return.
• Capital gains treatment on the sale, avoiding higher ordinary income tax rates.

What if you already filed the return?

Here is where you have to get a little lucky. As a foreign disregarded entity, the taxpayer would have needed to file Form 8858 to show the flow-through of the rental activity. If that form was not filed, then he would not be considered to have filed returns “consistent with the intended treatment” and the Rev. Proc. would not apply.

In the real world, it is unlikely that someone knows of the requirement to file Form 8858 but does not know about making the correct election in the first place. But it does happen, you can get lucky. Otherwise, you have to look to the implications of a deemed sale which often is not a particularly tax friendly result.

Practical Considerations

When you are investing in real estate outside the US you have to understand the applicable rules in both the US and the local country.

1. File Form 8858: If the SRL was a foreign disregarded entity, Form 8858 must accompany the owner’s tax return to report the flow-through activity.
2. Coordinate Local and US Tax Compliance: Ensure the SRL meets Costa Rican legal and tax requirements while optimizing US tax outcomes.
3. Avoid Future Issues: Plan entity classification at the outset to sidestep costly mistakes and potential penalties.

• Engage Professionals Early: Cross-border tax compliance requires coordination between US and foreign tax advisors.
• File on Time: Late elections can be remedied, but proactive planning avoids costly pitfalls.
• Document Reasonable Cause: For retroactive elections, keep thorough records of professional advice and actions.

First, work with a legal professional in the local jurisdiction to make sure you are following the right local procedures. This includes processing the title work correctly and setting up entities if it makes sense locally.

Second, get a qualified professional in the US to help you understand what the impact is in the US based on local structuring advice. If that is a good outcome on both sides…proceed. If not, look into alternatives.

In most cases, it makes sense to make an election in the US to treat the non-US company as a flow-through. This is a figment of US tax imagination and has no impact on the actual legal company locally. The ultimate strategy here is very fact specific and there is no one size fits all.

Last, make sure you file the right forms in the US and locally as well as apply any applicable tax savings strategies.

Final advice for all foreign real estate investors

If you are new to investing abroad and you suspect your current advisors may also not have the requisite experience, I suggest finding a qualified professional or at least try to do your own research so you are asking the right questions.

It is hard to do effective tax planning going backwards and paying unnecessary penalties is painful.