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Cross-Border Tax Impact Of Gain From The Sale Of A Personal Home In The United Kingdom
The following is designed to provide general tax information for Americans residing in the United Kingdom and does not constitute legal advice. As with all legal issues, seeking tailored advice from qualified counsel is advisable.
Considering a challenging and overly burdensome tax landscape, American expatriates living in the UK will be pleasantly surprised to find that owning a personal residence remains a relatively tax efficient investment. Many who own homes in the United Kingdom will be able to effectively shield gains from both US and UK tax by using the tax benefits in place. But the tax laws in both countries are not identical, and the protection provided in the United Kingdom through personal residence relief can be substantially more favourable than the sale of home exclusion benefit provided in the United States.
The result is that some American expatriates who have been able to generate significant gains from the sale of a personal home in the United Kingdom could be facing a US tax bill. Given the tremendous performance of the UK real estate market in recent years, many American expatriates are in fact finding themselves in a position where the tax benefits in place for homeowners in the United States do not offer adequate protection. To complicate matters, the dynamic exchange rate between the US dollar and the Pound sterling over the past decade can also have the potential to materially impact tax attributes and create difficulties with UK mortgages.
For American expatriates who own or are considering purchasing a personal home in the United Kingdom, this article will provide a brief overview of the cross-border tax framework you will encounter and explain how the US tax treatment of foreign currency fluctuations can turn a foreign mortgage into a tax trap.
To illustrate these rules, we’ll consider the following scenario: • Elaine and John are American citizens who moved to London in 2011 and purchased a flat for £500,000, financing it with a mortgage of £300,000. The exchange rate at that time was £1 : $1.65.
They paid a stamp duty tax of £10,000 when the home was purchased and made no significant improvements • In 2021, after having lived in the property for over ten years, they accepted an offer to sell
for £1.1 million. The outstanding balance of their mortgage at that time was £100,000 and the exchange rate was £1 : $1.37 • Elaine and John are both taxed in the
United Kingdom as residents and they file a joint federal tax return in the United
States. The taxable income reported on their 2021 US tax return before any gain from the home sale was $280,000.
Under personal residence relief provisions, there is generally no limit on the amount of gain that can be protected from capital gains tax
UK TAX GUIDELINES FOR HOMEOWNERS Personal Residence Relief
Broad relief exists in the United Kingdom protecting homeowners from capital gains tax. To qualify for full relief, the property must have been a main home for the entire period of ownership, not been used for trade or business purposes, and not acquired as an investment. Limitations are also in place for properties larger than 5,000 square meters.
Under personal residence relief provisions, there is generally no limit on the amount of gain that can be protected from capital gains tax. And when periods of nonpersonal use have occurred subsequently, the portion of the gain allocable to the period of time the property was a main home will still be eligible for limited relief.
Given that Elaine and John have lived in the London flat for their entire period of ownership, they would qualify for full personal residence relief and would not be subject to capital gains tax in the United Kingdom from the sale.
US Tax Guidelines For Homeowners
Sale of Home Exclusion As a general rule, American taxpayers who have owned a residence that has been their main home during at least two of the five years prior to the sale will not be taxed on the first $250,000 of gain produced. This exclusion is doubled to $500,000 for married taxpayers filing a joint tax return, but periods of non-qualifying use that occurred in the five-year testing window prior to the two-year test being satisfied can result in a reduction of the eligible threshold.
The exclusion is available in full to Americans who reside overseas and own foreign property.
For Elaine and John, as they have owned and lived in the London flat for more than the two-year requirement, they would qualify for the full $500,000 exclusion available to married taxpayers filing jointly. However, given that the gain produced from the sale will likely exceed this threshold, tax will still need to be calculated for US tax purposes.
Currency Fluctuations
For US tax purposes, the sale of an asset will always need to be reported in US dollar terms. Therefore, when property is acquired outside of the United States, fluctuations between the dollar and the currency in which the transaction is denominated will be factored into the gain or loss calculations. Accordingly, in scenarios where a currency has fluctuated significantly against the US dollar during the period of ownership, a material impact on the gain or loss calculated from the sale of the property will result.
To figure the gain or loss from the transaction, the purchase price is converted to US dollars using the exchange rate in effect on the date the property was purchased. The sales proceeds are then converted using the rate in effect on the date of sale. Any capital improvements to the property would be added to the cost and converted to US dollars using the effective rate on the date the expenses were paid.
For Elaine and John, with the exchange rate of £1 : $1.65 in 2011, cost basis for calculating gain from sale would be $841,500 ($825,000 for purchase price plus $16,500 for stamp duty).
Gross proceeds from the transaction of $1,507,000 will result by applying an exchange rate at the time of sale of £1 : $1.37 against the £1.1 million received.
The result will be $665,500 in gain for US tax purposes. From this amount, $500,000 will be eligible for exclusion, leaving $165,500 of taxable gain. While a gain is still produced, the amount calculated does take into account a foreign currency loss attributable to the depreciation of the Pound against the dollar during this time.
Capital Gains Tax
Any gain produced beyond the $500,000 threshold will be taxed at long-term capital gains rates of either 0%, 15%, or 20%. UK capital gains tax paid on the sale of the property can be credited against US tax.
John and Elaine would qualify for a 15% long-term capital gains rate, resulting in a projected US tax liability of $24,825. As no tax is due from the transaction in the United Kingdom, there will not be a foreign tax credit available to reduce this amount.
Net Investment Income Tax
Additionally, the 3.8% Net Investment Income Tax (NIIT) will also be applicable to the taxable portion of the gain from the sale to the extent it exceeds the $200,000 ($250,000 for jointly filing taxpayers) threshold.
With Elaine and John having taxable income at $280,000 before accounting for gain from the sale, it is assumed that the entire portion of the taxable gain of $165,500 will be subject to NIIT resulting in an additional tax of $6,289.
Elaine and John’s total U.S. tax projected from the sale of the London flat in 2021 would be $31,114 ($24,825 in capital gains tax and $6,289 of NIIT).
While the US tax liability on gain from the sale of the UK home could very well come as a surprise, the foreign currency gain that could be produced by redemption of the mortgage encumbering the property will always be a bitter pill to swallow.
Complications Of UK Mortgages
Owning the home itself may be relatively straightforward from a US tax standpoint, but foreign currency denominated mortgages can complicate matters.
Mortgage Interest Deduction
for US tax purposes pursuant to normal guidelines. However, to claim the deduction for mortgage interest, a taxpayer must elect to itemise deductions, which is less common following the increase to the standard deduction in 2018.
Unfortunately, in most scenarios the positive impact from deducting UK mortgage interest will be nominal, though the deduction can be beneficial for American expatriates who still receive considerable US-sourced income or have significant itemised deductions. And mortgage interest deductions could also be beneficial if there were to be a plan in place to leverage foreign tax credit carryovers in future years on the US side.
No tax relief is available in the UK for mortgage interest paid on a main home.
No tax relief is available in the UK for mortgage interest paid on a main home
Impact Of Foreign Currency
The primary concern for American taxpayers with respect to UK mortgages relates again to the way the US tax rules view foreign currency-denominated transactions.
Two important considerations must be kept in mind: 1. Foreign currency gains are taxable, with the exception of “personal” transactions where the net gain is less than $200. This would generally cover gain attributable to any monthly mortgage payment but is unlikely to protect a redemption of the remaining principal balance when the property is sold. 2. Personal losses cannot be claimed. What this means is that even though currency gain over $200 from the redemption of mortgage on a personal home would be taxable, if the same transaction were to produce a loss, it would not offset the gain from the sale. The unfortunate result of this rule is that in many scenarios where a disallowed loss would be produced from the redemption of a personal mortgage, the gain calculated on the same property will encompass foreign currency gain that would be taxable if in excess of the sale of home exclusion threshold. And when a taxable currency gain is produced by the redemption of the mortgage, it will be taxed at ordinary income tax rates, not the reduced capital gains rates applied to gain from the sale of the property.
For American expatriates who currently hold UK mortgages that have been taken out for personal homes during the past decade, there is likely a risk of phantom income being produced upon redemption of the note due to how the currencies have performed in recent years. The phantom income is created by the fact that it now requires fewer dollars to pay off the mortgage than it would have when the loans were taken out initially.
For Elaine and John, while the $200 limit would likely have protected them from tax exposure for monthly payments made prior to the redemption, currency gain will be produced when the remaining £100,000 mortgage balance is paid off with the sales proceeds.
Considering the exchange rates in effect when the loan was taken and subsequently paid off, a currency gain of $28,000 is produced ($165,000 initially received and $137,000 needed to repay the balance in full). They will face an estimated $6,720 in tax from the foreign currency gains from the mortgage redemption assuming they are in the 24% tax bracket in 2021.
In total, for a property that more than doubled in value, Elaine and John can expect to pay no income tax in the United Kingdom but will owe an estimated $37,834 in total tax in the United States.
Undoubtedly, options will be available to American expatriates to help manage the potential tax risk associated with foreign currency mortgages and working with a lender who will understand this risk is crucial. Moreover, given the differences in tax rules, planning opportunities available to married individuals for owning or financing a personal home in the UK when only one spouse is American should not be overlooked.
The challenges identified in this article are largely unavoidable in many cases. Planning against the prospect of your personal home doubling in value can be challenging. Moreover, acquiring a home without mortgage financing is not financially realistic for the vast majority of American expatriates. Simply being knowledgeable of the differences in the rules impacting American expatriate homeowners in the UK and accounting for a potential US tax liability will be the most prudent course of action.
