by Brian Bagnall
Whether you currently own a U.S. property or are looking to invest given the current market conditions, gaining an appreciation of the U.S. tax consequences is important to help minimize your risks and manage your overall tax between Canada and the U.S.
Over the last few years, many Canadians have purchased a U.S. vacation property to take advantage of the strong value of the Canadian dollar and the depressed real estate prices in the U.S. Today, many more Canadians are considering whether they, too, should take a dip in the U.S. real estate market.
This article focuses on the U.S. tax consequences of ownership by a non-resident, non-citizen of the U.S. Different rules must be considered if either you or your spouse is a U.S. citizen or resident.
Canadian residents are taxable in Canada on their world wide income. Therefore, any net rental income from your U.S. property will be taxable to you in Canada. In addition, you will be taxed in the U.S. on the rental income (foreign tax credits can be claimed when filing your Canadian tax return, to avoid double taxation). Depreciation is mandatory for U.S. tax purposes, so the U.S. and Canadian returns should be done in conjunction with one another to ensure the full potential of foreign tax credits is achieved.
By default, you would have to pay a tax equal to 30% of the gross rental income. This makes little sense. Luckily, you have a choice.
In order to avoid the 30% gross revenue tax on your US property you must file form W8-ECI and provide a copy to the property manager. The W8-ECI completed by the renter and all tax returns must be filed with the IRS within 16 months of the date the tax return was due.
Filing this form will allow you to pay tax on a net profit basis. When you do this, you are required to file a US personal or corporate tax return to determine the amount of US tax owed. If you elect this option you will need to apply for a free US tax identification number. You must also attach a declaration to a timely filed U.S. income tax return (1040-NR).
CAUTION: You must timely file you tax return every year or you will lose the election and you will fall back into the 30 percent withholding. The U.S. tax regulations provide that if a tax return of a foreign national is not filed within 18 months of the original due date, the IRS will disallow all deductible expenses.
Some states assess their own level of tax in addition to the federal tax. In this case, separate tax returns may be required.
The net rental profit on your US real estate is calculated as the gross rental income less ordinary and necessary expenses.
The following is a list of the common expenses that are allowed.
• Auto and travel
• Cleaning and maintenance
• Legal and other professional fees
• Management fees
• Mortgage interest paid to banks
• Other interest
In the US, residential rental property is depreciated over 27.5 years on a straight-line basis. Unlike Canada, you must take depreciation expense on a US rental property. If you fail to take depreciation on a US rental property the IRS will still deem it to have been taken at the time the property is sold.
CAUTION: Failure to file an annual 1040 NR (as mentioned above) will result in double taxation for a Canadian investor when he sells U.S. real property. Under the U.S. tax code real property is automatically depreciated regardless of choice. Depreciation is a deduction in the year it was incurred or carried forward to future years. When investment property is sold, the depreciation is automatically recaptured and taxed at a flat 25%. If a Canadian investor does not file an annual return claiming the depreciation deduction, it will be lost to him but he will be forced to recapture it for tax purposes. Effectively this results in a double tax on the sale of the real property.
When you sell your U.S. property, any capital gains will be included in your income for Canadian tax purposes. As well, a U.S. federal return and possibly a state return will be required to report the gain. Canada will usually allow a foreign tax credit for U.S. tax paid so that you avoid double taxation.
If a Canadian sells real estate located in the U.S., a withholding tax of 10% of the gross sales price is normally payable under FIRPTA (the Foreign Investment in Real Property Tax Act of 1980). The tax withheld can be offset against the U.S. income tax payable on any gain realized on the sale, and refunded if it exceeds the tax liability.
Since Canada will also impose Canadian taxes on the sale of the foreign property, foreign tax credits for US taxes paid can typically be claimed in Canada to eliminate any double taxation. Canadian personal tax rates on gains are higher than US personal tax rates on long-term capital gain, typically resulting in a full foreign tax credit. Canadian corporate tax rates on gains are lower than US corporate tax rates on gains, frequently resulting in an excess foreign tax credit situation.
The FIRPTA that causes the 10% withholding will not apply if the property is sold for less than U.S. $300,000 and the PURCHASER intends to use it as a principal residence. The buyer need not be a U.S. resident. For this exception to apply, the purchaser must sign a statement and attest that they have definite plans to reside at the property for at least half of the time the property is in use during each of the two years following the sale.
Even in this scenario, the gain on the sale will still be taxable in the U.S. and a U.S. tax return must therefore be filed. Thus, if a Canadian is selling U.S. real estate, for less than U.S. $300,000 to a buyer who intends to occupy it as a principal residence, the seller will receive the full purchase price rather than having 10% withheld by the buyer and remitted to the IRS.
A deemed disposition for Canadian tax purposes will also take place upon death. The U.S. may levy federal and state estate tax, depending on the value of the property and the size of your estate. Only U.S. estate tax may be eligible for a foreign tax credit to offset any Canadian capital gains tax on the deemed disposition.
Generally, a Canadian is entitled to a $60,000 U.S. exemption on the value of the U.S. assets owned for U.S. estate tax purposes. A greater exemption and potentially complete relief (depending upon the value of the taxpayer’s worldwide assets) may be available by virtue of the Canada–U.S. Income Tax Treaty. The treaty generally results in an estate tax exemption if the deceased’s worldwide assets are worth less than US$5.43 million.
The number of days you spend in the U.S. matters. You will need to monitor your days or presence in the U.S. closely in order to avoid any unpleasant surprises since the U.S. imposes income taxes based on residency. There are specific rules to determine residency based on the number of days you spend in the U.S. Essentially, the test is the sum of the following:
• 100% of the days spent in the U.S. in the current year (eg: 2011)
• 1/3 of the days spent in the U.S. in the previous year (eg: 2010)
• 1/6 of the days spent in the U.S. from two years ago (eg: 2009)
If the total for this year cycle exceeds 182 days, you will be deemed a resident for U.S. tax purposes. If you are spending time in the U.S. on an annual basis, it only takes 122 days a year (approximately 4 months) to meet the test. Thankfully, you can file Form 8840 to claim that you have a closer connection to Canada, but the form needs to be filed by June 15th each year in order to apply.
I want to point out that I am not a lawyer or an accountant. I wrote this article based on the experience our past clients have had purchasing our properties. I did not include information that would not be relevant to other methods of investing in real estate (or different asset classes of real estate). So if you’re also doing other kinds of real estate investing, you should contact a professional.
Either way, Canadians should consult with a professional advisor to determine their exposure to the U.S. estate tax and whether any planning can be done to minimize the exposure.