Is This The Most Powerful Legal Tax Break in the US Code?

There’s an obscure rule that can save you a huge amount of tax when you sell a home abroad… the foreign home sale exclusion.

Under Internal Revenue Code Section 121, Americans can exclude capital gains when selling their primary residence: $250,000 gain if single, $500,000 gain if married.

But the key point many expats miss is that the property does NOT have to be in the United States. It can be abroad, too. The rule only cares that it was your primary residence.

To use the exclusion, you must have owned the home for at least 2 years, as well as have lived in it for at least 2 of the last 5 years. The years do not have to be continuous.

For example, let’s say you buy a home in Mexico. You live in the home from 2021–2024, rent it out from 2024-2026, and finally sell in 2027… free from capital gains up to the IRS limit.

Many people might think this might be irrelevant to them, since their profit on selling a foreign home in the local currency seems like nothing to write home about. But they’re forgetting that currency movements can create paper gains even if the price didn’t rise much locally.

For example, let’s say I buy a house in Cape Town for R3,000,000 when USD/ZAR = 15. I later sell it for R4,000,000 when USD/ZAR = 10. In South African currency terms, I’ve made a 25% capital gain. But from the IRS perspective, once you take currency movements into account, I’ve made a 100% capital gain.

In this case, it wouldn’t matter either way because my capital gain is only $200,000, below the primary home exclusion. But it’s not hard to imagine a situation where you could trigger capital gains taxes on the US side without even knowing it.

The lesson is that you absolutely must pay attention to your capital gains in US dollar terms when preparing to submit your taxes after selling a home abroad.

As always, the US tax code has a quirk most people don’t know about. You cannot combine the Foreign Earned Income Exclusion housing exclusion with the home-sale exclusion for the same period.

Under the Foreign Earned Income Exclusion, you can exclude certain housing expenses when you’re living abroad, including rent, some utilities, property insurance, and so on, up to a maximum of 16% of the FEIE itself. (Note that in some expensive cities, the IRS has a higher housing exclusion maximum.) That increases the amount you can exclude from your taxable income, paying no income taxes on it.

But here’s the catch: If you’ve used the FEIE housing exclusion during years when you owned a home abroad, the IRS considers that your housing costs have been subsidized by the US government. That means some of the time you used your home abroad is classified as “non-qualified use.”

Here’s a realistic scenario. You buy a house abroad for $300,000. You sell it for $700,000, making a profit of $400,000. You live in it for 8 years. For three of those years, you claimed the FEIE housing exclusion for the property.

The IRS will treat those three years as non-qualified for the purposes of calculating taxable capital gains. Three-eighths of $400,000 is $150,000. That is excluded from capital gains relief. So out of your $400,000 profit, $250,000 is eligible for the capital gains exclusion, and $150,000 is taxable.

In a related vein, any depreciation you claimed while renting a home out is taxable when you sell, even if the rest of the gain is excluded. For example, if you sold the house above for $400,000, after having claimed $50,000 of depreciation whilst you owned it, you’re only eligible for capital gains relief on up to $350,000 of profits.

Given all of this, how can us expats maximize our benefits from the US tax code? One way is to periodically reset your tax basis by living in a foreign home for two years, selling it using the capital gains exclusion, buying another property, and repeating the process. Done correctly, this can be one of the most powerful legal tax breaks in the US code.

The lesson here is that when you live and own property abroad, you’re dealing with a lot more variables than if you stayed in the United States. Those variables need to be factored into your tax filings, either to avoid penalties or to use tax benefits to which you are entitled.