Tax Talk Thursday: Foreign Rental Real Estate: Depreciation and Recapture

Foreign rental property and depreciation

A lot of clients assume that once they know how to depreciate a U.S. rental property, they know how to depreciate a foreign one too. It's the same asset class, right — a rental is a rental. It isn't. The IRS treats foreign real property differently from the moment you place it in service to the moment you sell it, and the gaps show up in two places: a smaller depreciation deduction every year you own it, and a more complicated recapture calculation when you sell. Here's the full comparison.

The Core Difference: Method and Recovery Period

Domestic rental real estate is depreciated under the General Depreciation System (GDS), using straight-line over a set life. Foreign rental real estate is required to use the Alternative Depreciation System (ADS) instead — and ADS almost always means a longer recovery period and a smaller annual deduction.

Property Type	System / Recovery Period
Domestic residential rental	GDS — 27.5 years, straight-line
Domestic nonresidential (commercial)	GDS — 39 years, straight-line
Foreign residential rental (placed in service after 12/31/2017)	ADS — 30 years, straight-line
Foreign residential rental (placed in service before 1/1/2018)	ADS — 40 years, straight-line
Foreign nonresidential (commercial)	ADS — 40 years, straight-line, regardless of date

Why Foreign Property Is Stuck on ADS

Under IRC §168(g)(1)(A), any tangible property used predominantly outside the United States must be depreciated under ADS. This isn't a choice the way it sometimes is for domestic property. For foreign rental property, ADS is mandatory — there's no election out.

Two consequences follow from that:

•      No bonus depreciation. Property required to use ADS is excluded from bonus depreciation eligibility under §168(k). Even in a year where bonus depreciation is otherwise generous, it doesn't reach the foreign rental building itself.

•      Land improvements and personal property inside the unit (appliances, furnishings) may still have shorter ADS lives of their own, but they're still on the ADS table — not the faster GDS tables you'd use for a domestic property's components.

What This Actually Costs You Every Year

Take a $500,000 foreign rental building (excluding land) as an example:

•      Domestic equivalent (27.5-year GDS): ~$18,182/year

•      Foreign, placed in service after 2017 (30-year ADS): ~$16,667/year

•      Foreign, placed in service before 2018 (40-year ADS): ~$12,500/year

Over a 10-year holding period, that's the difference between roughly $181,800 and $125,000 in cumulative depreciation deductions for a pre-2018 property — over $56,000 less in deductions sheltering rental income along the way.

Recapture at Sale: What Stays the Same

Some things don't change just because the property is overseas:

•      The property is still §1250 property.

•      Because it's depreciated straight-line (both GDS and ADS are straight-line for real property), there's no “excess depreciation” to recapture as ordinary income under §1250's excess-depreciation rule.

•      What you do have is unrecaptured §1250 gain — the portion of your gain equal to depreciation taken — taxed at a maximum federal rate of 25% for individuals, same as a domestic property.

Recapture at Sale: Where It Gets More Complicated

This is where foreign rental property diverges from domestic in ways that catch people off guard.

1. Sourcing matters for the Foreign Tax Credit.

Gain from the sale of real property located outside the U.S. is generally foreign-source income under §862(a)(5). That's actually useful — it typically falls into the passive category FTC basket, which means foreign capital gains tax the client pays to the country where the property sits can often be credited against the U.S. tax on that same gain, avoiding double taxation. But it only works cleanly if the FTC basket and limitation are calculated correctly, and that requires knowing the gain is foreign-sourced in the first place.

2. The foreign country's depreciation rules almost never match the

U.S. ADS numbers.

The UK, for example, has its own capital allowances regime that doesn't mirror U.S. ADS lives or, in some cases, doesn't allow depreciation-style deductions on residential property at all. That means the “recapture” or gain figure the foreign tax authority calculates on their return won't match the unrecaptured §1250 gain on the U.S. return. You end up running two parallel calculations — U.S. basis and U.S. depreciation on one side, local-country basis and local rules on the other — and reconciling them for FTC purposes.

3. Currency translation can create a U.S. gain that doesn't reflect the

local economics at all.

Real property isn't personal property under §988, so there's no separate foreign currency gain/loss computation — but the basis and proceeds still have to be translated into USD using the exchange rate in effect on each date money changed hands (purchase, capital improvements, sale). If the dollar was strong when the client bought and weak when they sold, the USD-denominated gain can be dramatically larger than the gain in the local currency — sometimes even when the property barely moved in local-currency value.

Putting It Together: A Quick Example

A client buys a flat in London for £300,000 in 2016 and sells it for £320,000 in 2026 — a modest £20,000 gain in local currency. But:

•      Because the flat was placed in service in 2016, it's been depreciating on a 40-year ADS schedule the whole time — a noticeably smaller deduction than a U.S. equivalent would have generated.

•      If GBP/USD moved from roughly 1.45 at purchase to something lower at sale, the USD basis is higher than a straight conversion at today's rate would suggest, and the reported U.S. gain calculation depends entirely on the historical rates used at each transaction date — not just the £20,000 local gain.

•      The unrecaptured §1250 gain portion is taxed at up to 25% federally, and any UK capital gains tax paid can potentially offset the U.S. tax through the FTC — but only if the foreign-source gain and the FTC basket are set up correctly beforehand.

None of this is intuitive from the local-currency numbers alone, which is exactly why it needs modeling before the sale closes, not after.

Foreign rental real estate isn't a U.S. rental that happens to sit in another country — the depreciation rules are mandatorily slower, bonus depreciation is off the table, and the recapture math at sale carries sourcing and currency layers that most off-the-shelf tax software won't flag automatically. If you own — or are thinking about buying — rental property outside the U.S., this is worth a planning conversation well before the sale, not during return prep.

Have a foreign rental property and want to make sure your depreciation schedule is set up correctly? Email us at info@mkhstaxgroup.com.