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Tax Consideration
Mexican Capital Gains Tax (ISR)
Tax planning should begin when you BUY your Mexican home instead of waiting until you sell at a profit. There are two basic formulas for calculating ISR or Mexican Capital Gains: (1) the seller pays 25% of the sales price, or (2) the seller pays 30% of the net profit, after adjusting for an inflationary index and adjusting the basis for costs including construction and remodeling costs. There have been recent changes in the formulas used for calculating ISR. The factors that are considered include an inflationary index, the cost basis of the purchase price and costs for remodeling and construction, and the proportion of the land that is covered by construction. In an effort to stimulate the economy and encourage investment, the Capital Gains tax is scheduled to be reduced another 2% over the next two years. (29% in 2006, 28% in 2007). There is talk of further reductions, but at this point any prediction outside of two years is speculative. Maximizing your future profits starts when you purchase your property. Make sure that the full purchase price is recorded when you buy, because this becomes your initial cost basis for the calculation of capital gains. Many sellers and some Realtors will encourage you to record the basis as low as possible, claiming that you will save money on the 2% acquisition tax. While you may save a little money up front, in the long term you have allowed the seller to pass along the capital gains tax they should be paying to you. For example: You purchase a property for $300,000 but record the value of the transaction as $100,000. Initially you pay $2,000 in acquisition tax instead of $6,000. 3 years later you decide to sell the same property for $500,000. Your tax basis is $100,000 instead of $300,000 so the Tax assessor calculates your ISR based on a profit of $400,000 dollars, which is double your true gain. Now you are liable for an extra $200,000 in capital gains tax, (using the capital gains tax for 2005, 30% of $200,000 is $60,000). You saved $4,000 when you bought the property, but paid an extra $60,000 when you sold it.
Calculating Your Basis
You can add to your basis by keeping track of any improvements you make to your property. A common mistake is to fail to properly record all costs which could add to your cost basis, including costs of construction and remodeling. When you do any building, you must insist that the builder follow all of the tax rules, including paying social security tax (otherwise you, the owner, may be responsible for paying it long after the project is done). Also make certain that the full construction costs are recorded with the Registro Publico (the county recorder). This is easy to do, and will greatly reduce your cost basis, and therefore your ISR tax, when you eventually sell at a profit. A factura is a formal receipt used in Mexico. Every construction supply store and contractor has the forms for providing a factura. Make certain to keep facturas for all home improvements that might be added to your cost basis, including new fixtures, appliances and construction. Before selling your property, review your capital gains consequences before you enter into any contracts. If your cost basis is lower than the price you paid including all improvements you have made, start working on getting your property value manifested correctly. Figure out how much you will be paying in capital gains before you begin negotiating so you have a clear understanding of what you will net from the transaction.
Homeowners Exemption For ISR
Mexican law used to provide that a homeowner (and yes, if you are the beneficiary of a renewable 50-year trust, you are the homeowner, not a renter or lessee) is exempt from ISR upon the sale of their primary residence. Many people will tell you that this exemption applies to you, if you get an FM3 immigration document and provide two years of proof of payments of property taxes and utilities, even if your primary home is really in the U.S. Be aware that the tax laws have recently changed. Under the new tax law in place, it is unlikely that you will qualify for any exemption based on your residency.
Disclosure To The IRS
If you file a U.S. tax return, you need to tell your tax preparer that you own a foreign trust. If you own your Mexican real estate through a deed owned by your Mexican corporation (usually an S.R.L. or “Sociedad de Responsabilidad Limitada”) this should also be disclosed to the IRS, as well as any Mexican bank account that you have with more than $10,000. There are usually no tax consequences of these reporting requirements, but failure to file the proper forms can result in substantial penalties. The forms your tax preparer will probably use for the above disclosures are Form 5471, 3520, 3520A, and TDF9022.1
U.S. Capital Gains Tax
At the present time, the U.S. long term capital gains tax is only 15%, with an offset for foreign tax. This means that you generally will not have to pay U.S. capital gains tax on the profits from the sale of your Mexican house, although depending on the state you live in, there may be some state capital gains tax.
Mexican Inheritance Tax
Generally, there is no Mexican inheritance tax on the transfer of your Mexico house to your heirs. Be sure to have your heirs designated as your substitute beneficiaries of your renewable 50-year trust.
Renting Your Mexican Home
According to the La Tribuna de Los Cabos, one of the local Mexican newspapers, approximately 2,000 Americans and Canadians with homes in Los Cabos rent them, primarily on the internet. The local hotel industry is not happy about this illegal competition and the authorities may take action. To legally rent your Mexican home, you need to pay taxes on the profits of your rental income. Some real estate brokers and even some big time developers will encourage buyers to rent their homes or condos, and give you very optimistic predictions of the income flow. If you rent, you should do so legally, paying all required taxes. Second, if you do intend to rent legally (and some of the larger projects will rent your home or condo for you), you will be paying a large percentage of your rental income for management fees, as well as taxes. Third, before assuming that your net rental income will be as high as represented by the developer or broker, ask for records demonstrating income, expenses and vacancy rates for units similar to yours. Some properties make a lot more sense as rentals than others. If you keep your life simple and follow all the laws, you can relax and enjoy yourself.
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