Foreign Property Schedule E

Client reported a foreign rental property on US tax return-Schedule E, is that ok and do I need to include any additional forms?

Guidance states attachment of Form 8873 but Drake only provides this input for Schedule C or F forms.

Any help would be appreciated.

The TCJA added Form 8858 with effect from the 2018 US return for reporting of foreign branch activities of a US person.

For a rental not held in an entity schedule E is sufficient.

Form 8858 most likely applies because the QBU's accounting is most likely done in Euros. And yes this applies to a foreign rental activitiy owned and operated in a taxpayer's own name (no entity).

This "new" form 8858 is a p-i-t-a as it is designed for much more extensive foreign business activities.

Gone are the days when a Sched E was sufficient... although even in the Big 4 world you'll see a lot of 8858 missing from their products.

Not sure why I said "in Euros". I meant to say: "in a functional currency different from the mighty US$".

As indicated by Guya, the rental income and associated foreign income taxes would be in the separate foreign branch basket, and go on a separate Form 1116.

The property would be depreciated under the ADS method over the class life. Section 987 gains/losses would be reported on the Form 8858 and included on Line 21, other income.

Is there a foreign mortgage on the property?

Is there a foreign mortgage on the property?

That doesn't drive the 8858 filing requirement.

Is there a foreign mortgage on the property?

That doesn't drive the 8858 filing requirement.

I agree. But if the individual lives in the US, and pays interest to a foreign person (such as a foreign bank), the interest would be US source interest, possibly triggering a Form 1042 filing requirement and possibly triggering a US tax withholding obligation on the FDAP paid to a foreign person.

And yes this applies to a foreign rental activity owned and operated in a taxpayer's own name (no entity)

How did you determine that?

(FDE)
An FDE is an entity that is not created or
organized in the United States and that
is disregarded as an entity separate
from its owner for U.S. income tax
purposes under Regulations sections
301.7701-2 and 301.7701-3. See the
instructions for Form 8832, Entity
Classification Election, for more
information.

I deliberately did not say that the rental property should be entered on the Foreign Branch basket on the 1116. The definition of "Foreign Branch" for 1116 purposes is a very different definition than for 8858 purposes. For the 1116 it is essentially the same as a QBU - so "separate books and records". Some rental activities run as a business will be a QBU.

We file protective 8858s for all our client's non-US rental and self-employment activities because looking at "all the facts and circumstances" the IRS might take a very different view from any of us as to whether an activity is a "foreign branch".

IRS instructions to Form 8858 https://www.irs.gov/pub/irs-pdf/i8858.pdf state that a US person must file Form 8858 if that person has a "foreign branch" based on these Regulations: https://www.law.cornell.edu/cfr/text/26/1.367(a)-6T.

Wow...that's wild! So, Joe inherits his English father's house and rents it out. Suddenly he's got a foreign branch of a business he didn't even know he had. Talk about overreach!

The definition of "Foreign Branch" for 1116 purposes is a very different definition than for 8858 purposes. For the 1116 it is essentially the same as a QBU - so "separate books and records". Some rental activities run as a business will be a QBU.

I would like to get your input on the requirement of “separate books and records” for a QBU to exist. I have to say I have had some trouble with coming to terms with this myself, but from your response it seems you may have a clear picture.

Let’s say I have a foreign rental property and at the end of the year I look at my rental deposits and rental expenses (i.e., my records), and I create a spreadsheet that adds up all of the rents I received during the year and all of the expenses paid to create an income statement (for Schedule E of Form 1040 and Schedule C of Form 8858) and I create a balance sheet for the rental property (for Schedule F of Form 8858). I feel like I have “books” and “records” that are separate from my other activities (such as my wages, self-employment income, investment income, etc.).

I guess I am trying to understand the factors that you believe would trigger or not trigger the “separate books and records” requirement in order to create a QBU. Do you feel that with foreign rental properties the records being relied on and the books being created are not “separate”, or do you feel that they are not books or not records?

If you don't treat the rental as a section 162 trade or business can it be a QBU?
If the US owner has no US rentals and only one foreign rental can there really be separate books and records? Seems like only one set.

Great discussion Gentlemen!

@Dellpaul: the rationale behind determining a gain or loss regarding remittances of cash or property from a QBU under section 987(3) is based on the understanding that when the operating income or loss of a QBU is determined in a functional currency (e.g., non-USD) other than the owner’s functional currency (e.g. USD) and then translated on a yearly basis into USD (what you are doing with a Schedule C or E), it results in layer upon layer of income or losses calculated at different exchange rates.

For foreign tax credit purposes, Foreign Branch Income category specifically excludes any amounts that qualify as passive income under §904(d)(2)(B). Although passive income typically includes rents, it does not include rents or royalties that are derived in the active conduct of a trade or business (Reg. §1.954‐2(b)(6)).
Rents are considered to be derived in the active conduct of a trade or business if such rents are derived from leasing of real property with respect to which the lessor, through its own officers or staff of employees, regularly performs active and substantial management and operational functions while the property is leased (Reg. §1.954‐2(c)(1)(ii)).

@Guya: totally agree. Curious: are your clients resisting the extra fees for this additional painful work? (keeping track of the accumulated earnings pool etc.) I am struggling to explain the benefit - and am only left with the minimum $10,000 penalty (form 8858) as ammunition in my discussion.

@HowardS: overreaching indeed. I made my millions thanks to the overreaching complexity of the US tax code... So i can't complain...

can there really be separate books and records?

I think you could have an argument meeting the MLTN standard that - in the case of a foreign rental property directly managed by the taxpayer (eg, US citizen managing her rental property in Spain by herself) - the books and records are not necessarily separate... I have no absolute answer to provide so here are the arguments:

The argument for: because you're paying the local property tax office, condo fees, cleaning, maintenance, utilities etc... in foreign currency these records are not in USD and therefore are separate. They are separated from your US income statement up to the point you convert to USD.

The argument against: it would take a systematic accounting entry process to create "separate books and records" such as in the case of a local property manager providing all financial reporting to the owner in functional currency.

See Reg §1.989(a)‐1 (e), example 6) - this IRS-provided example is specific to a foreign brokerage account. I have not yet seen anything from the IRS that specifically discussed rental properties. Guya - have you?

Curiously the $10,000 penalty does NOT apply here for 8858s for FBs as they don't fall under §6038(a). Some clients do indeed resist the additional fees though.

Syncrhos, Thanks. That makes sense. If you have a QBU, the rental income earned by it would be passive unless the active trade or business exception is met. If you don’t have a QBU, it would seem likely that the income is passive.

Whether you have a QBU is a separate question. However, it seems to me that if a mere brokerage account can be a QBU that a rental property should also be a QBU. In either case, if you have a QBU you should be computing 987 currency exchange gain or loss, and if you don’t, you should be computing 988 currency exchange gain or loss.

Curiously the $10,000 penalty does NOT apply here for 8858s for FBs as they don't fall under §6038(a). Some clients do indeed resist the additional fees though.

Brilliant!

Are you basing this statement on the definition of FBE further down under §6038(e)?

(e) DefinitionsFor purposes of this section—
(1) Foreign business entity
The term “foreign business entity” means a foreign corporation and a foreign partnership.