1. If you have lived in and occupied your US primary residence for at least 2 years out of the five years prior to the date it is sold, under US tax law $500,000 of any gain on sale ($250,000 if filing as single or married filing separately) is exempt from US taxation. This is one of the last big tax breaks left in the US tax code which can allow you to take the equity from your house tax free and purchase a property in Los Cabos.
This same rule applies to US taxes on the sale of your primary residence in Mexico.
2. Though there are limits on the amounts of interest you can deduct for personal taxes on your personal residence mortgage (which is generally limited by the interest payable on the current amount of the morgage you used to purchase the property plus the amount of funds borrowed for improvements), you can always with a second mortgage or a line of credit borrow an additional $100,000 and still have the right to deduct all interest paid on this loan on your tax return. You can use this $100,000 as part of the purchase price of your new property in Los Cabos.
An additional limitation on the tax deduction of mortgage interest on personal real property is that the total amount of mortgage loans on your personal residence, line of credit and perhaps a mortgage on your vacation home cannot exceed $1.1million dollars. If the mortgages on these properties exceed the limits set forth above the interest on any mortgages above $1.1 million cannot be deducted for tax purposes.
The tax deductible interest rules of personal real estate loans are complex. See IRS Publication 936 at www.irs.gov for a full explanation of the limitations.
3. Though there are limits on the amount of interest you can deduct on your US tax return on your personal real property mortgages, if you convert your residence to a rental property you can then refinance the property to pull out the equity you have built up to purchase property in Los Cabos . Most often you can deduct all of that interest on your new mortgage as a rental expense on your tax return. Unlike the limits on deductible interest which exist for personal real estate, there is no limit on deductible interest on rental properties. And if allowed, you can use any tax losses produced by your rental property of offset other taxable income on your return.
So long as your modified adjusted gross inome does not exceed $100,000 on a joint US tax return you can deduct up to $25,000 of rental property losses on your tax return to offset your other income if you actively manage your rental real estate. If you modified adjusted gross income exceeds that amount the amount of losses you can use to offset other income is reduced. Any disallowed rental losses (called passive losses) carry over and can be used in the future. Read IRS Publications 527 and 925 at www.irs.gov to learn the important details of this limit.
As a side note, if you purchase property in Mexico ( whether personal or rental) and use a mortgage for part of the purchase price, the same US tax rules previously discussed apply to your property in Baja Sur.
Don Nelson is a US Tax Attorney (and a retired CPA) who has assisted Americans with their US taxes and returns in Baja Sur for over 25 years. He can be reached by email at firstname.lastname@example.org or at his US phone 949-480-1235 He is also in Cabo for about six months a year.
His website is at : www.TaxMeLess.com. Blogs with the latest news on US expat and international tax developments are at www.usexpatriate.blogspot.com and www.us-mexicantax.blogspot.com .