Ask the Tax Expert: Sell or Rent Your Home?

Since I moved to San Miguel de Allende, Mexico, I’ve rubbed elbows with former executives, diplomats, educators, athletes, authors, musicians, and global consultants. Despite these fellow expats’ sophistication and savoirfaire, even they are often stymied when it comes to issues of tax law.

I don’t blame them. As Katrina Haynes mentioned in last month’s overview of American tax law, the US is one of very few countries to tax their citizens overseas—and to make matters worse, these tax laws are incredibly complex.

As a former International Revenue Service (IRS) tax attorney, these are the most common tax questions I get from expats like you:

◼ I want to move overseas, but I’m not sure whether to sell or rent out my home in the US. Which is more tax-advantageous?

Answer: If you own a home in the US and are contemplating a move overseas, your decision to rent or sell your house should include considerations like the strength of the housing market, your ability to find reliable tenants, the viability of alternative investments besides real estate, and your appetite for being a landlord.

Selling your house can benefit you by moving a substantial debt (in the form of a mortgage) off of your balance sheet while also providing you with a lump sum of money to purchase a property in your destination country.

On the other hand, renting it to the right tenants can provide a steady stream of income.

By selling, you can also take advantage of a special IRS rule. If you’ve owned your home for two or more years during the five-year period ending on the date you sell it (thus fulfilling the ownership requirement) and lived in it as your main home for two or more years (fulfilling the use requirement), you can exclude up to $250,000 in gains from your income.

If both you and your spouse meet these tests, and you file a joint return, you can exclude up to $500,000 of gain. That’s an attractive tax break.

You’re not eligible for this exclusion if you used the rule to exclude gain from the sale of another home during the two-year period prior to the latest sale.

In this case, you must use Schedule D, Capital Gains and Losses, and Form 8949, Sales and Other Dispositions of Capital Assets, to report the gain.

If you receive an information document such as Form 1099-S, Proceeds From Real Estate Transactions, you must report the sale of the home even if you can exclude the gain from your income. IRS Publication 523, Selling Your Home, has information on reporting your sale on your income tax return.

Renting your house provides a different benefit, though not necessarily tax-related. When my wife Rebecca and I moved to Mexico in 2018, we weren’t eligible to take retirement distributions, and we liked the idea of having a monthly rental income to cover our daily living expenses.

Of course, we had to include our rental income on our tax return. And now that we’ve lived overseas for six years, we can’t take advantage of the housing exclusion because we haven’t lived in the house as our primary home for the required time. If we sold it now, we would have to include all of the gain in income.

Still, the housing exclusion isn’t completely off the table. Under the law, we could reset the five-year period critical to the use requirement if we decided to move back into the house.

In other words, if we moved back into the house as our primary residence for two years, we would be eligible again for the housing exclusion.

◼ I know I have to pay US federal taxes while I’m overseas… but what about state taxes?

Answer: States generally tax residents on all of their income, no matter where it’s earned. If you live in California, that tax could be as high as 13%. Hawaii has one of the highest state income tax rates at 11%. In New York, your income could be hit with an 8% tax, while on the other side of the country, in Oregon, the highest income tax rate is over 9%.

But you only have to pay state taxes if you’re a state resident.

The most common way to be a state resident is to live in the state. But, for tax purposes, residency goes beyond physical presence.

For example, New Jersey determines residency by looking at whether you have a domicile in the state. New Jersey defines domicile as the place you consider your permanent home—that is, a place you maintain as your principal residence and to which you intend to return to after a period of absence, such as a vacation, temporary work assignment, or for educational leave, like time spent at college.

If New Jersey is your domicile, you are considered a resident for tax purposes. If New Jersey is not your domicile, you are only considered a resident if you maintain a permanent home and spend more than 183 days there.

The majority of states view residency similarly: as your true, fixed, and permanent home from which, whenever absent, you intend to return. Thus, based on the standard that you can be physically present in one place and still have a domicile in another, your intent becomes important.

After I moved to Mexico, one of my first clients was still filing North Carolina state tax returns even though she had not lived in the state for the previous five years. When I asked her if she intended to go back to North Carolina to live, she said, “No way!”

If you’re not certain whether to pay state taxes, here are the general guidelines:

If (1) you intend to abandon your old domicile in a state and take actions consistent with that intent, such as actually moving out of that state, and (2) you intend to acquire a new domicile and take actions consistent with that intent, such as renting a house in Mexico, and (3) you are physically present in your new house in Mexico, then you have changed your domicile and are no longer a resident of the US state that you left.

That means you only have to pay state tax on income earned from sources within that state—like business performed in the state, or from rental property located there.

My wife and I lived and worked in Virginia for 20 years. During that time, we filed a state income tax return as residents and paid income tax to Virginia on our wages, investment income, and bank account interest.

In 2018, we left our jobs and moved to Mexico. We didn’t intend to move back to the US, but there was an element of uncertainty. When tax time came around, I determined that we were no longer residents of Virginia.

Since the business income we earned wasn’t sourced in the state, we weren’t required to report this income as Virginia source income. Additionally, our investment income and bank interest were not sourced in Virginia.

However, because we owned a house in Virginia that we rented to tenants, we were required to file a nonresident income tax return to report the rental income.

Filing as a part-year resident or nonresident generally requires that you pay tax only on income earned while resident in the state or from state sources (such as rental income from a property located in the state.)

If we’d only planned to be overseas as long as it took for our kids to graduate high school and then planned to move back, I would have taken the same position regarding our state residency. So long as we weren’t using our Virginia house as our home—in other words, going back and forth there during the year—and we lived and worked outside of Virgina, we had given up our residency.

What if we were only overseas for one year on a digital nomad visa? This is a little trickier, as the time period is shorter and it could be viewed as a temporary absence.

But if the same facts were present, and we had moved out of our Virginia home for the entire year and established ourselves out of the country, my opinion is that it would be reasonable to consider us as having established a new domicile for the year.

My advice to anyone in this situation is talk with your tax professional about your specific facts and circumstances.

◼ I’ve checked with my tax attorney and I’m technically not required to file my US taxes. Why do I keep hearing that I should anyway?

Answer: Reasons to file include: (1) to get a refund of any income tax that was withheld from your pay or your retirement account distributions, (2) to satisfy requirements to obtain a green card for a non-US spouse, if you plan to apply for a loan from a US bank, or (3) to get certain refundable tax credits such as the Additional Child Tax Credit for dependent children or the American Opportunity credit for higher education costs.

Refundable tax credits are essentially reimbursements from the government of a portion of what you spent on what it deems “qualified costs.” Even if you don’t owe any tax, you can receive these payments, but you have to file a return to claim them.

Another reason to file a return, even if you aren’t required to: doing so can help prevent identity theft. If both you and a fraudster file a return using your personal information, the Internal Revenue Service (IRS) will contact you about the duplication.

Following up with the IRS in this circumstance will help the agency to quickly resolve the fraud and issue you an Identity Protection Pin (IP PIN) to use on future returns. An IP PIN is an extra layer of protection to ensure the IRS processes only returns filed by you.