Investing in Mexican Real Estate: Taxes and Other Traps

With all the changes and opportunities that have opened up in recent years in Mexico, it is important to understand how to safeguard your investment from the extra taxes and other traps that can surface later.

The thing to remember is that no matter how alluring Cancun, Los Cabos, Puerto Vallarta and other places may be, nothing about buying real estate in Mexico is the same as a real estate transaction in America.

Tax Treatment and Traps

Below are some important points to consider when making an investment in Mexican real estate:

1. First, plan on an overall cost of 10% over the purchase price to cover notary fees, taxes and other miscellaneous charges.

2. If you wish to own property within the “Restricted Zone,” establish a Fideicomiso, a Mexican trust modeled similarly to the ones in Monaco. Too often foreign investors make the mistake of taking title to Mexican real estate by way of a private agreement. This is dangerous because the seller remains the legal owner of the real estate. The result can be costly and the source of lengthy litigation in the foreign country. To avoid this costly error, it is important to establish a Fideicomiso and execute every real estate transaction in Mexico before a notary public, which is expensive but it proves that the transaction took place.

3. Learn how the tax process works with a foreign investment. For example, make sure all prior taxes are paid before taking ownership. If a U.S. entity holding Mexican real property sells off more than 25% of its interest, this is a taxable event in Mexico under Article 151 of the Mexican Revenue Code as well as the International Tax Treaty between the U.S. and Mexico. A similar tax trigger could result upon transfer of the interest to another family member’s trust. The burden of the unpaid taxes will fall on the new owner.

4. Note that the capital gains tax process has special nuances in Mexico. As in the U.S., capital gains in Mexico are the spread between the selling price less what was paid for the real property and any improvements. However, in Mexico you cannot simply save receipts to add to the property’s cost basis. An owner must “manifest construction costs.” This is the process of actually recording the costs. Mexican law will not recognize the costs of improvements and add them to the cost basis. A notary public is needed to assist with this process.

5. Do not reduce your acquisition costs to reduce your acquisition tax. Upon purchase, a 2% acquisition tax is assessed based on the purchase price of the real estate. Often sellers and contractors suggest reporting a lower value for the purchase price to reduce the acquisition tax. This is a mistake because this value is the starting point for the purchaser’s cost basis that will be used later to calculate capital gains. A seller has two options to calculate gains in Mexico. Under option one, a 30% tax on net profits along with applicable deductions is assessed. Under option two, a 25% tax is assessed on gross sales. In most cases, option one provides the best result.

Double Trouble

Another trap to watch out for when you invest in any foreign real estate is double taxation. Under the U.S. Internal Revenue Code Section 61, a U.S. citizen is taxed on his or her worldwide income. Thus, the proceeds from any sale in Mexico are subject to capital gains tax again in the U.S. However, there is relief from this double taxation because the U.S. will allow a credit for the capital gains taxes paid in Mexico against what would have been owed in the U.S.

Mexican Income Tax

Mexico taxes an individual’s worldwide income based on residency; while the U.S. taxes such income based on citizenship. Therefore, careful planning and a review of the U.S.-Mexico Income Tax Treaty will be important for a U.S. citizen planning to set up his or her residence in Mexico. Any relocation to a foreign country should include advance planning and a review of the relevant country tax treaties.

Choice of Entity

For highly appreciating assets such as real estate, historically, the choice of entity selected to hold the investment is crucial to obtaining preferred U.S. tax treatment on both income from the real estate investment (i.e., rents, development sales) and a later sale of the capital assets (i.e., the sale of a house or apartment complex). In general, it is preferred to have real estate held in an entity that can be treated for U.S. purposes as a partnership. Thus, in Mexico the entity eligible for partnership treatment in the U.S. would be the Sociedad de Responsabilidad Limitada (“SRL”). (Be careful, other entities can sound similar, but they do not rate the same tax treatment in the U.S.) The SRL allows a credit for its taxes paid to the Mexican government thereby reducing dollar for dollar the amounts due in the U.S. The SRL may not always be appropriate for holding Mexican real estate, but generally this is the preferred entity.

We recommend that before making any purchase in a foreign country you check with your tax advisor or tax attorney to avoid problems like these later.