I am a green card holder and have been living in the US for 13 years - three years ago I have purchased a house in Poland for which I borrowed money from my father in Poland (he is Polish citizen only, not US resident in any manner). I have sold this house last year and I have reported capital gain on my 2010 return (sale price in PLN re-calculated in US$ based on exchange rate on date of sale - purchase price in PLN re-calculated in US$ based on exchange rate on the date of purchase) plus deduction for capital gain tax paid in Poland. Loan principal has been repaid to my father after sale. How this oversees loan would be treated by IRS? We did have a formal loan document written and signed on the day of purchase set with an annual set at 5% - does he need to pay any tax to IRS on those payments? Or it would better if we had an interest-free agreement?

You are paying the interest so you do not have any interest income to report.

You are paying the interest so you do not have any interest income to report.

Thanks for the response - I do understand that I do not have any interest income to report. However, I was questioning if my lender has to report any interest income to IRS. The entire transaction has been done in Poland (both loan and real estate transactions) and since he had clear this interest income with Polish tax authority we do believe he does not need to anything with IRS in the US - am I correct?

You are correct.

Your father has NO obligation to report ANYTHING to the IRS, and the U.S. has NO legal standing to tax him on that interest income.

Only Poland can assess any income tax on that interest income.

Thanks a lot

Right, you are paying the interest to a foreign recipient. How could it be taxable to you? It wouldn't make sense for interest, dividends, rents or royalties PAID BY U.S. persons TO foreign persons to be subject to U.S. tax. Only the foreign recipient should be subject to such tax. And since the foreign recipient is foreign, why would he owe U.S. tax?

IRS logic and laws do not always seem to follow a common sense :-)

Can I still deduct those interest payment on this overseas loan (actually a loan from a family member) on my Schedule A?

Thanks

On second thought, with regard to dividends, I suppose if the company were a U.S. company, the U.S. might assert a right to tax the dividends paid to nonresidents.

Or, for rental income, if real estate were located in the U.S. the U.S. might assert a right to tax the rental income paid to nonresidents.

Or, for royalty income, if intangible property were located in the U.S. the U.S. might assert a right to tax the royalty income paid to nonresidents.

I wonder how the U.S. might treat interest payments? With dividends, the focus is on the payer. With rents the focus is on the location of the property. With royalties, the focus is on where the property is used. I wonder if the rule for interest might be where the payer is resident? I wonder if it is possible for the U.S. to assert a right to tax the interest payments by U.S. residents to nonresidents? But of course, how would they enforce such a tax?

Yes, it could be a point if this property was located in the US.


But I look at this way - if I take a loan from a bank in country B to purchase a property in the same country B why would this bank be obligded to pay any taxes to the US on their earnings in the country B.

I suppose it would depend on whether U.S. tax law considered the interest income to be from U.S. sources or from foreign sources.

Only "U.S. source" income should be subject to U.S. tax.

If a U.S. resident borrowed from a bank in Country B and spent the money on a vacation in Country C, I wonder how the interest on the loan would be sourced? To Country C, Country B, or the U.S.

Suppose a U.S. resident borrows against foreign real estate and uses the funds to purchase a car in the U.S. Would you then say that the interest was U.S. source interest? I suppose I am saying that the interest income shouldn't necessarily be sourced to where the funds are used.

So, if a U.S. resident get a hair cut in Country A should U.S. tax that business for getting income from U.S. source (money earned in the U.S.)?

Different types of income are sourced under different rules. Services income is sourced where the services are performed. If the haircut is performed outside the U.S. it would be foreign source income.

Look at this case:

http://www.winston.com/siteFiles/Publications/Offshore_Fund_Client.pdf

In the above case IRS ruled that overseas lender is subject to U.S. tax because that business was actively involved in conducting business/services in the U.S.

That does not seem to be a case in my situation - my lender was not actively conducting or looking into doing any business in the U.S.

Here is another article that explain my case:

Withholding tax on foreign mortgages. | North America > United States from AllBusiness.com (http://www.allbusiness.com/business-finance/business-loans-interest-rate/354352-1.html)

I guess we need to pay US tax on that interest

Correction - it looks like we need to file 1042 but effective tax rate for interest income from U.S. obligor for PL residents is 0%

Interest is sourced per the residence of the debtor. So the interest is US source income but I agree that the treaty would reduce the rate to 0.