I get the feeling that many are confused right now regarding the new tax reform in Costa Rica, and the capitals gains tax law, which will come into effect this July 2019.
One investor friend of mine told me that he would like to wait until July before buying a rental property, because he heard from a friend that some tenants wouldn’t accept an increase of the nominal rent. This friend wanted to add this tax on top of the current rent instead of covering it with the already existing rent.
The tenants wouldn’t accept the increase because they said that the rental contract hadn’t defined an increase for taxes.
Another buyer I know, who wanted to purchase a house in Costa Rica, told me that he would also wait a bit and is somewhat unmotivated to buy due to the capital gains tax he would have to pay when he wants to sell the house in the future.
On the other side, there are sellers (long-term) expats who knew a different Costa Rica without a capital gains tax and IVA and all the other bureaucratic add-ons that came into being over several decades.
They are “not amused” and many feel the urge to sell now before July 2019 to avoid the capital gains tax.
From my local partners, I hear similar stories and I can see one common denominator in it – confusion and a lack of clarity. This confusion causes insecurity, which causes wrong assumptions, which causes wrong decisions.
Therefore, today, I will shine some light on the situation, getting rid of some myths and rumors on the web regarding the tax reform. I did some extended research on this with Ministerio de Hacienda, Deloitte, and asked my lawyer and my accountant targeted questions (which they couldn’t answer completely).
The result of this will hopefully be some strategies for you to deal with the tax reform and how to reduce the tax burden.
Habitual Residential Homes Are “NOT” Taxed with The Capital Gains Tax
I will start right away with some good news. The first residency you buy is NOT taxed with the capital gains tax.
What does this mean?
This means that when you, as a foreign or local buyer, buy a house in Costa Rica and it’s your first house (only in Costa Rica, not counting properties you have already in your country of origin), and sell it in the future, even at a profit, according to the new tax law, you won’t have to pay a capital gains tax on a potential profit resulting from a sale.
Sure, if you go into the market, to fix and flip and buy and sell properties on a regular basis, then yes you would be taxed with the capital gains tax.
The same is true when you like Costa Rica so much that, besides your primary residence, let’s say at the Pacific Ocean, you purchase a second residence in the Caribbean.
Because by the moment you buy the second home, it would be taxed with the capital gains tax, when you sell it in the future at a profit.
Because the tax ministry (“Ministerio de Hacienda”) could and probably would interpret the purchase of a second residence as commercial intent (e.g. repeating buying and selling).
The same happens even with your first residence, should you decide to rent it out.
By the time you want to rent it out, you would have to register the natural person or the legal entity under which it is registered with the tax ministry to be able to issue electronic invoices (if your tenant happens to need an electronic invoice).
This would make the tax man interpret it again as commercial intent.
The way you might avoid the capital gains tax, even if you rent it out, would be that once you decide to sell it, you unsubscribe the natural person or legal entity from the tax ministry on time and/or don’t continue to rent the property.
What is still unclear with this strategy is from which moment you would have to stop renting it out, or if there is a minimum rental period that triggers the capital gains tax, etc.
These are questions my accountant couldn’t answer yet.
How You Can Play Around with Your Taxable Property Value to Reduce the Capital Gains Tax
Compared to the US., you still pay way less property taxes per year in Costa Rica. This tax is 0.25% on the taxable value registered with local municipality.
The only state in the US that comes close to Costa Rica is Hawai, with 0.27% property taxes.
The thing is, you usually pay premium prices for houses there and have to deal with quite high living costs.
The average property tax in the US is 1.2%, and that’s still almost five times more than you pay in Costa Rica, and to compare it further to the US, there is not much wiggle room when it comes to registering the taxable value of a house.
In Costa Rica you had some wiggle room in the past. When a property was sold on the market for $250,000, you could register it with a tax value of $50,000 or less with the local municipality.
This “wiggle room” is basically non-existent in the US and now is reduced in Costa Rica with the new tax law.
The upside in the US is that you get good market data on Trulia or Zillow for the sales value of a house and have overall high market transparency. But you pay the property tax on the market value of the house (market value equals registered tax value).
How Is This Related to The Capital Gains Tax in Costa Rica and What Can You Do to Reduce it?
Let’s first explain how the capital gain is determined by the authorities in Costa Rica with the new tax reform.
The authorities determine the potential capital gain by looking at the registered tax value in the municipality, and also the sale deed from the past and when you sell the property. They look at the current tax value and the most recent sale deed. If they find a capital gain, a tax of up to 30 percent will be applied.
Four Ways of Reducing the Capital Gains Tax
1) Owners from the past have a one-time option to select a reduced tax rate:
There are expats and long-term property owners who bought land decades ago at a very cheap price. Let’s say they bought three acres for $5,000 thirty years ago.
This owner might be able to sell these three acres today for $100,000.
Theoretically, with the new tax law, they would have to pay 15% on the capital gain of $95,000 if they don’t buy and sell land on a regular basis with a commercial intent, or 30% if they do.
This would mean paying between $14,250 and $28,500 in taxes, and looks kind of ugly and understandably comes to most owners as shocking news.
Therefore, some have the urge to sell their properties fast before the tax reform comes into effect.
What they probably don’t know yet is that there is a transitional solution for property owners who bought their properties before the tax reform (before July 2019).
These property owners can decide if they pay capital gains tax or a one-time tax of 2.25% on the sales price.
In the above example, it would mean 2.25% on $100,000, which is $2,250. This amount looks much better than $14,250 or $28,500, but not as good as $0.
This can be done only once and applies only to owners who bought before the tax reform and sell after it becomes effective.
2) Sell the inventory of your house separately
If you have inventory and are not in the business of buying and selling inventory on a regular basis, selling inventory is exempt from the capital gains tax.
What does this mean?
Well, if you bought your house at a price of $200,000 several years ago, and now you can sell it at $280,000, in theory, there could be a capital gains tax on an $80,000 capital gain.
But what if your now $280,000 house has an inventory of let’s say $60,000.
You can sell the inventory separately for $60,000 and pay the capital gains tax on the remaining $20,000 capital gain.
What is not safe to say yet according to my accountants, is whether you could use the example above for an amount of $80,000 or more as inventory and the $200,000 for the property and sell at break even or a loss.
Time will show how the tax authorities will treat the cases and whether they even will accept a sale at a loss or break-even as valid.
Many tax authorities live in a “rainbow unicorn world,” where market values only go up, but never down.
3) Report all upgrades and additional work you did with your house
The same as in 2) is true if you had some major work done on your house (e.g., remodeling, new bathroom, etc.) that, of course, increased the value.
Besides the $60,000 inventory you already have with furniture, expensive kitchen appliances, lightning systems and alarm systems, etc., you might have spent $15,000 remodeling your bedrooms, repairing damage, etc.
This leaves us with a lower capital gain of only $5,000.
You might see where I am going here.
The important thing is that you or your accountant include all those repairs in the financial reports because this is what the authorities will take into account when determining the taxable capital gain.
4) Increase the taxable value in the local municipality
Now, there is a rather risky move you can do. Risky not because it will get you in legal trouble, but risky because you might end up paying more property taxes per year to the municipality.
As an owner, once you have a really, really serious buyer, you can go to the local municipality and increase the tax value of the property (the value of the past sales deed can’t be increased anymore, of course) maybe two weeks before the final closing date.
Since also the tax value is considered to determine the past and the present property value to calculate the capital gain, this increase can reduce it a bit further.
The downside is, if the buyer jumps ship at the last minute, the only thing you keep is an increase in the annual property tax and a happy municipality.
Once you get the increase, it will be close to impossible to decrease it again.
You can decrease this risk of the potential buyer jumping ship if you use an escrow account and you get this increase once the purchase option deposit becomes non-refundable.
You could also include a potential higher property tax in the amount of the option deposit based on your calculated value increase for the next 5-10 years.
This all, of course, depends on the terms you agreed on in the option to purchase agreement.
More Options for Owners of Rental Properties
If you plan to buy a rental property for investment purposes or already have one, and at least one employee is registered with the “Caja Costarricense del Seguro Social” (CCSS), the public health insurance, there will be another new tax in place on rentals with two options to choose from.
My first reaction was: “Oh no, another tax, seriously?”
But it’s not an additional tax. It’s an optional tax.
Usually you already pay a tax on corporate income. If this entity is a holding corporation of rental properties, then the income most likely comes from rent.
By the way, from July 2019, these will be the new rates for the corporate income taxes:
- 5% on the first CRC 5,000,000 (~$8,396) of annual net income.
- 10% on the excess of CRC 5,000,000 (~$8,396) and up to CRC 7,500,000 (~$12,595) of annual net income.
- 15% on the excess of CRC 7,500,000 (~$12,595) and up to CRC 10,000,000 (~$16,792) of annual net income.
- 20% on the excess of CRC 10,000,000 (~$16,792) of annual net income.
- 30% for companies with gross income over CRC 109,228,000 (~$183,422).
With the tax reform, and if you meet the condition of at least one registered employee (as mentioned above), you can now decide if you would “like” to keep paying the corporate income tax or the new tax on capital income.
This rate is 15% on the remaining amount of a 15% deductible.
Meaning, if you get rent of $600 per month, you can first deduct 15% from that, which is $510, and now you can apply the tax of 15% on the $510, which is an amount of $76.50 of capital income tax.
This would mean that you would have to pay $76.50 x 12=$918 in capital income taxes per year for this particular rental unit.
Let’s assume you don’t “like” to pay this new tax and remain with the corporate income tax.
In this case, you would have an annual rental revenue of $7,200, and for sure you would have some costs (make sure you have some, please) which are maybe 30% of that amount, meaning $2,160.
Thus, you would pay the corporate income tax on $7200-$2160=$5040.
Looking at the corporate income tax rates above, you would have to pay 5% on the $5,040, meaning $252, meaning also “hell no,” I’d rather stay with the corporate income tax rates for the next five years.
But you can see that once you are at a corporate income level surpassing $200,000 and having a corporate income tax rate of 20%, you might want to consider changing to the capital income tax rate of 15%.
Why five years?
With the tax reform, you have to commit to one of the two taxes for five years. You can’t change this on a year by year basis.
Can You, as the Owner, Add the new Value Added tax on Top of the Rent?
This is a tricky question, also according to my lawyer/notary.
Why is it a tricky question?
It is not clearly defined in the new tax law and collides somewhat with the urban rental law (ley de arrendamiento urbano).
According to the new tax law, the one who is providing the service or product needs to pay the value added tax (impuesto al valor agregado – IVA), meaning the owner would have to pay this tax, deducing it from the rent he received so far, if this wasn’t stipulated in the rental contract before the tax reform.
This would mean a nominal decrease of rental income for the owner in this case.
For new rental contracts after the tax reform, many owners will add this tax on top of the rent they would like to receive and will offer the tenants the rental price as “includes IVA.”
Doing this, he will be acting in accordance with the urban rental law (“ley de arrendamiento urbano”), which doesn’t mention rent increases by added taxes or other type of rent increases than the normal one, which can be done for residential homes and rents in dollars every three years and in colones each year.
The rents for commercial rental properties can be increased each year, despite being in dollars.
This means that after the tax reform in some market areas where rents are higher than 669,300 colones (~$1,132) or 1.5 of the base salary of the most recent year, rents will increase artificially and not because there is more demand from the market, hence tenants.
Why did I mention rents higher than 669,300 colones (~$1,132)?
There is also some good news for owners, though.
Rents up to 669,300 colones (~$1,132) per month (or the respective dollar amount) are exempt from the value added tax.
And should you happen to rent a large property at a price higher than that, you may know that very often, such a property is not rented by one single entity, but by several separate entities sharing the property (tax saving hint) using different areas.
What Does This Mean for The Real Estate Market in Costa Rica?
In my opinion, there will be three phases, and in each phase, the real estate market will react differently.
The three phases are first, the transition phase, the adaption phase and normality.
The Transition Phase
Right now, we are in the transition phase with quite a lot of insecurity in the market, where home buyers are less motivated to buy because they don’t know how this tax reform will play out, so they are sitting on the fence longer than normal until they might buy a property.
And sellers, on the other side, are in a hurry to sell their properties before the tax reform comes into effect because they too don’t know much about their options as property owners.
So, because of that, there might be some artificial price pressure downwards, which can be an opportunity for buyers who already know more about the new law than the sellers.
Owners of rental properties at a rental price higher than 669,300 colones (~$1,132) might want to try to add the value added tax on top of rentals, even though they legally can’t, or try to get current tenants out and new tenants in, so they can increase the rent accordingly to cover the IVA.
So, most of the market participants will keep themselves from taking action because they don’t yet know how the tax authorities will apply the law in practical terms and on a case by case basis.
Even my accountants couldn’t answer all of my specific questions because they don’t have any experience yet with this new law.
I estimate this phase to take one fiscal year (until December 2020).
The Adaption Phase
In the adaption phase, emotions cool down and market participants become more knowledgeable about their options within the new tax law (maybe my article helped a little with that).
Accountants and tax advisors may have gotten more experienced with the different ways of how the tax authorities, such as the tax ministry (Ministerio de Hacienda) will interpret the new law, and are able to consult with their clients in a more reliable way about how to reduce the tax burden under the new law.
The initial negative effects on demand begin to disappear, since the tax burden can now be reduced in a reliable way with different strategies.
What might also compensate for some of the negative market effects may be the reduced tax rates for mortgages, increasing the demand a bit.
Another scenario in this phase may be one or several lawsuits with the constitutional chamber (Sala IV), when some areas of the new tax law during practical application turn out to be not constitutional because, as already happened in the past with “smart” and “capable” legislators, very often, it wasn’t very well thought through.
I am sure the opposition to this law is already in the starting gates.
Further reactions from market participants, already starting during the transition phase, will be increased tax evasion and doing business the “unofficial” way where it is possible.
This phase might begin by January 2021 and might take the whole year.
Normality Phase, Or It Has Never Been Any Different
The name of this phase speaks of itself.
The majority of market participants are now used to the new law. Some areas of the law might have been ruled out as unconstitutional and many people won’t remember how the world was before the tax reform.
The market insecurities might have disappeared completely by now. This phase might start from 2022 onwards.
I hope I could help you understand the new tax law and its effects a bit better within the scope of what is possible with the information available at present and reduce some of your insecurities towards the changes to come.
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