Taxation of Capital Gains on Sale of Real Property situated in Germany and German-American Estate Planning

Taxation of Capital Gains on Sale of Real Property situated in Germany and German-American Estate Planning

When a U.S. citizen/resident inherits property in Germany from a non-resident alien (“NRA”) and intends to liquidate such property, there is inevitably concerns and questions regarding capital gains taxation. The article outlines the taxation in Germany and the U.S. of Capital Gains on Sale of Real Property in Germany.

Taxation in Germany

Taxation Right of Germany under the Germany-U.S. Income Tax Treaty

Pursuant to Article 13 of the Germany-U.S. Income Tax Treaty, Germany may tax gains derived by a resident of the U.S. from the alienation of immovable property situated in Germany.

Imposition of German Income Tax on Capital Gains Derived from Sale of private Real estate

Germany taxes capital gains derived from the sale of private real estate if the period between acquisition and selling of the property does not exceed ten years. See § 22 Nr. 2, § 23 of the German Income Tax Act (EStG). Capital gains derived from the sale of a property used for residential purposes in the period between acquisition or completion and sale in the year of sale are tax exempt.  See § 23 (1) 1. EStG. If the owner dies within the 10-year or 3-year period, the time period does not restart but instead is calculated from the time when the decedent acquired the property.

The taxable capital gain is calculated by deducting from the sales price the acquisition costs (e.g.  purchase price + purchase costs) and the selling costs. The acquisition costs will not be indexed for inflation. As a result, inflation-related rises in the property value will be taxed in Germany. In contrast to U.S. tax laws, there is no stepped-up-basis available for inherited property under German tax law. The capital gain will be taxed in Germany at the regular progressive tax rate.

Taxation of Capital Gains on Sale of Real Property situated in Germany by the U.S.

Taxation Right of the U.S. under the Germany-U.S. Income Tax Treaty

Germany may tax gains derived by a resident of the U.S. from the alienation of immovable property situated in Germany, however the U.S. may still  tax U.S. citizen/residents on the same capital gains. See Art. 1 para 4. (a)  of the Germany-U.S. Income Tax Treaty.

Imposition of U.S. Income Tax on Capital Gains Derived from Sale of private Real estate

The U.S. taxes capital gains derived from sale of real estate.

As is the case in purely U.S. situs matters, capital gains on sale of real property situated in Germany are typically calculated by subtracting the sale price from the purchase price less any depreciation. When an individual inherits a property (e.g. it is distributed to the beneficiary and not sold by the estate) in the U.S. the individual receives a stepped-up basis. A stepped-up basis increases the beneficiary’s basis in the property to the fair market value as of the date of death. (IRC §1014).

Example: A U.S. resident, inherits from his mother a house, which was bought for $50,000 in 1970 and has a date of death market value of $1.5 million. The U.S. resident would have a stepped-up basis of $1.5 million and will only be taxed on the difference between the $1.5 million and the sales price.

When real property is sold in Germany an issue arises as to whether the real property receives a stepped-up basis thereby limiting the gains for the U.S. citizen/permanent resident beneficiary. Treas. Reg. § 1.1014-2(b)(2) provides that section 1014(b)(9) property does not include property that is not includible in the value of a decedent’s gross estate, such as property not situated in the United States acquired from a nonresident who is not a citizen of the United States. However, pursuant to Rev. Rul. 84-139, 1984-2 C.B. 168, IRC § 1014(a) is applicable and the U.S. citizen/permanent resident’s basis in the property will be the fair market value as of the date of death.

Avoidance of Double Taxation

Double taxation is avoided by offsetting the German tax (if any) against the U.S. tax (e.g. by filing form 1116). However, as Germany does not tax capital gains if the property was held 10 years, there is often no German tax that can be offset.

Capital Gains Taxes and German-American Estate Planning

German estate planners should consider advising clients to make lifetime gifts to children as the tax-free amount (EUR 400,000) “renews” every 10 years (gifts within 10 years are aggregated under § 14 of the German Inheritance and Gift Tax Act). However, if the beneficiary is a U.S. person, this may result in a high U.S. capital gains tax when the donee sells the property (what he often does if he lives permanently in the U.S.) as he may not qualify for the stepped-up basis. However, by using German estate planning instruments, e.g. a usufruct (Nießbrauch), a habitation right (Wohnrecht) or a revocation right (Widerrufsrecht), the stepped-up basis may also be available in case of lifetime gifts.

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