Top 5 Tax Issues: Canadians with U.S. Vacation Property

November 13, 2020
U.S. Vacation Property

Many Canadians own U.S. vacation property and look forward to winter when they can spend time in their sunny second homes. Canadians that own U.S. real property need to understand the U.S. and Canadian tax issues on the rental or sale of their property. This article considers the top 5 tax issues that Canadian resident owners of U.S. real property face. For the purposes of this article, Canadians do not include U.S. citizens or U.S. residents who have different consequences than those identified below.

Note: All amounts in U.S. dollars unless otherwise noted.

Topics:

  1. U.S. Federal Estate Tax
  2. Earning Rental Income
  3. U.S. Tax on Sale
  4. Canadian Tax on Sale
  5. U.S. Individual Taxpayer Identification Number

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1.  U.S. Federal Estate Tax

The Issue?

Canadians are subject to U.S. federal estate tax on their U.S.-situs assets including ownership of U.S. real property. U.S.-situs assets include U.S. real property, securities issued by U.S. persons and other property located in the U.S. Currently the U.S. federal estate tax exemption is $11.6 million for U.S. citizens and domiciles. Generally, Canadians receive a proportionate exemption based on the ratio of the value of their total U.S.-situs assets to the value of their worldwide estate. Also, generally, Canadians with a worldwide net worth less than $11.6 million are not subject to U.S. federal estate taxes. This exemption is scheduled to be reduced after 2025 to approximately $5 million ($5 million adjusted for inflation to 2026).

Why Does it Matter?

  • U.S. federal estate tax applies to the net fair market value of U.S. real property owned by Canadians on the date of their death, a much different concept than Canada’s tax on only the property’s appreciation up to the date of death. Many high net worth individuals are surprised to learn of their U.S. federal estate tax exposure starting from the first day they own U.S. real property.
  • U.S. federal estate tax will reduce the value of the decedent’s estate available to beneficiaries if it cannot be claimed as a credit against Canadian taxes payable on death.

Scenario 1: Canadian Owns Home in the U.S.

A Canadian purchases a $1,000,000 U.S. home. Her worldwide estate is $25 million. The day after she purchases the property, her U.S. federal estate tax exposure is approximately $400,000.

Scenario 2: Canadian’s Net Worth Increases Over Time

Assume in Scenario 1 her worldwide estate is $5 million. Furthermore, the U.S. home in Scenario 1 isn’t her only U.S. asset as she owns $500,000 of U.S. securities. Today, she has no exposure to U.S. federal estate tax. However, assume ten years later her net worth is now $10 million, her U.S. home is worth $1,400,000 and she owns $600,000 of U.S. securities. Because of the reduction of the U.S. federal estate tax exemption after 2025, in 2026 and future years she now has U.S. federal estate tax exposure of approximately $300,000.

What is the Solution?

  • Use of Canadian entities like corporations, partnerships and trusts, non-recourse debt and life insurance can reduce or avoid U.S. federal estate taxes. Some of these solutions have their own limitations and adverse tax results. There is no one perfect solution for all situations. The optimal structure requires an analysis of the individuals’ situation including such items as their net worth, planned length of ownership, use of the property and family involvement.
  • Canadians that do not own U.S.-situs property on their death are not subject to U.S. federal estate taxes. While not always a practical planning strategy, selling U.S. property before death would avoid U.S. federal estate taxes.

2.  Earning Rental Income

The Issue?

U.S. Federal and Canadian income taxes apply to U.S. rental property. State tax may also apply. Additional U.S. and Canadian tax reporting is required.

Why Does it Matter?

  • Canadians with U.S. rental property who have never filed U.S. tax returns in the past are recommended to file these returns to lower their U.S. tax liabilities and carry-forward any losses to future years. Ignoring the filing of annual U.S. federal income tax returns will expose them to additional tax on the depreciation that reduces the property’s U.S. tax basis even though it was never claimed.
  • Under U.S. tax law, U.S. properties are required to claim depreciation annually even where losses arise. Failing to do so will still result in a reduction of the property’s U.S. tax basis. Canadian tax law allows discretionary claims for depreciation and no claim when losses arise.   This difference may impact the computation of the gain or loss on sale of the property’s sale.
  • Canadians are required to disclose rental and other property outside Canada that exceeds C$100,000 in aggregate cost. Penalties may be assessed for failure to timely file. Canada Revenue Agency is increasing its audit efforts in this area to ensure Canadians comply with the law.
  • Canadians who used their U.S. property as their personal vacation home and then changed its use to rental are subject to a deemed disposition of their property at fair market value. Where the property has appreciated in value, Canadian income tax is assessed on the gain. Personal use of the U.S. property may also impact their ability to claim deductions for U.S. tax purposes.

Scenario 1:  Canadian Earns Rental Income Through Agent

Canadians puts their Hawaii condo in the rental pool through the property’s agent. They do not wish to file U.S. income tax returns. The agent withholds 30% in U.S. federal taxes from rental income, an amount likely far in excess of any actual U.S. federal income tax liability on the net rental income after deducting expenses (mortgage interest, property taxes, property manager fees, depreciation, insurance, etc.). Canada may also deny some or all the U.S. tax as a credit where there would be a loss for Canadian tax purposes or the U.S. tax paid is viewed as being a voluntary tax.

Scenario 2: Canadian Buys U.S. Property for Personal Use, Then Begins to Earn Rental Income

Assume a Canadian buys a U.S. property for $200,000 in 2012 when the dollar was at par and only used it personally from this date until 2020 when they start to earn rental income. In 2020, the property is worth $400,000 and the U.S. dollar is worth C$1.30. Canada’s change in use rules apply to switch from personal use to business use, resulting in a deemed disposition of the property for its fair market value. The property has increased in value C$320,000 ((US$400,000 x 1.30) – C$200,000) resulting in Canadian capital gains tax liability of approximately $80,000. Where the U.S. property is sold after 2020, the U.S. federal and state income tax on the gain could not be claimed as a foreign tax credit in Canada for this deemed capital gains tax, resulting in double taxation.

What is the Solution?

Canadians can elect on their Canadian income tax return to defer the deemed disposition of their U.S. property when they change the use from personal to rental income.

Canadians can file annual U.S. federal and state income tax returns to claim expenses, eliminate U.S. federal withholding taxes and carry-forward losses to future years to offset U.S. taxes on gains.

3.  U.S. Tax on Sale

The Issue?

Canadians selling U.S. real property are subject to U.S. federal and, where applicable, state income tax on gains on the sale of property.

Why Does it Matter?

At the top marginal tax rates, U.S. federal tax on long-term capital gains (properties held for more than one year) is 20%, while short-term capital gains (properties held for one year or less) is 37%. State income taxes may also apply.  

Under the Foreign Investment in Real Property Tax Act (FIRPTA), the buyer of a Canadian’s U.S. property is required to withhold 15% U.S. federal income tax from the gross selling price of the property. Depending on the sale price, exceptions apply to lower or eliminate the withholding tax if the buyer plans to use the property as their residence.  Since the U.S. withholding tax does not account for the seller’s adjusted cost basis, it often exceeds the final U.S. federal income tax liability on the gain. California and Hawaii also impose withholding tax on sale of real property in their respective states by non-residents of the state.

Scenario 1:  Canadian Seller – Short Time of Ownership

A Canadian purchased a U.S. property on December 7th of the prior year for $200,000.  They are negotiating to sell the property by the end of November for $320,000. The buyers plan to use the property as their residence.  Without any planning, the sale will be subject to a U.S. federal tax withholding of $32,000 ($320,000 x 10%) on closing with the $120,000 gain subject to U.S. federal tax at ordinary income tax rates higher than the rate for long term capital gains.

Scenario 2:  Canadian Seller – Buyer’s Use of the Property

A Canadian has a contract to sell their California property for $800,000.  They purchased the property twelve years ago for $950,000 and made $100,000 of improvements to the property. They have a mortgage on the property of $700,000. The buyers do not plan to use the property as their residence. As closing date approaches, the escrow agent tells them the total U.S. Federal and state withholding taxes will be approximately $146,000 (U.S. Federal $800,000 x 15% plus California $800,000 x 3.33%), leaving them with a shortfall of cash on closing. 

What is the Solution? 

Sellers can negotiate closing dates to ensure their gain on sale is a long-term capital gain subject to lower U.S. federal tax rates. 

Exemptions under U.S. federal law can reduce or eliminate the 15% U.S. withholding tax on closing where the selling price is $1,000,000 or less and the buyer plans to use the property as their residence.

Where the actual U.S. federal income tax on the sale is less than the amount otherwise required to be withheld, the seller can obtain a withholding certificate from the Internal Revenue Service to reduce the tax withheld. The withholding certificate must be timely-filed. 

Where the actual California income tax on the sale is less than the amount otherwise required to be withheld, the seller can complete California Form 593 at closing to calculate the final tax liability and reduce or eliminate the state withholding tax required at closing.

4.  Canadian Tax on Sale

The Issue? 

Canadians selling U.S. real property that realize gains are not only subject to U.S. federal and state income tax but Canadian income tax as well.

Why Does it Matter?

Canadians are not only subject to real property gains on sale but any foreign exchange gains where the Canadian dollar depreciated against the U.S. dollar during the ownership period. Claiming foreign tax credits in Canada requires individuals to file U.S. federal and state tax returns to determine the final U.S. tax liability. Canadian tax law won’t allow foreign tax credits for withholding taxes on sales of U.S. real property.

Scenario 1 – Foreign Exchange Gain

A Canadian purchased a Nevada property for $225,000 in 2012 when the Canadian dollar was at par with the U.S. dollar. In 2020, when the U.S. dollar was worth C$1.30, he sold the property for $250,000 to an individual who planned to use it as their residence, resulting in no U.S. federal withholding tax deducted on closing. After paying legal costs and commissions, he realizes he breaks even on the property, so he doesn’t bother to summarize the property improvements he made the last eight years. He has a foreign exchange gain of C$67,500 ((US$225,000 x 1.30) – C$225,000) subject to Canadian tax.

Scenario 2 – Foreign Tax Credits

A Canadian sold an interest in her Florida timeshare for $50,000, resulting in a U.S. federal withholding tax of $7,500. She paid $30,000 for the timeshare 20 years ago, using it only for personal use the entire time. If she doesn’t file a U.S. federal income tax return, she won’t get the U.S. tax refund for US$7,500 she is owed. The U.S. tax rate on capital gains of less than $40,000 for married individuals filing separately is 0% in 2020. She also cannot claim a foreign tax credit in Canada for the $7,500 of U.S. federal tax withholding, resulting in double taxation on the gain.

What is the Solution?

  • Summarizing capital improvements including amounts paid and dates incurred will determine the adjusted cost basis to arrive at the correct capital gain for Canadian tax purposes which likely lowers the overall Canadian tax liability. 
  • Preparing and filing U.S. federal and state income tax returns determines the actual U.S. tax liability which can be claimed as a foreign tax credit on the Canadian tax return to ensure no double taxation on the gain.

5.  U.S. Individual Taxpayer Identification Numbers

The Issue?

Sellers who use the property solely for their personal use may not have U.S. Individual Taxpayer Identification Numbers. 

Why Does it Matter?

Sellers will need to file a U.S. federal income tax return to report the sale of U.S. real property regardless of whether the sale results in a gain or loss.  Filing a U.S. federal income tax return requires an application for a U.S. Individual Taxpayer Identification Number. 

Where U.S. federal withholding taxes apply and no Individual Taxpayer Identification Number exists, withholding taxes are remitted to the Internal Revenue Service with only the seller’s name and address, making it more difficult to track the taxes withheld to the seller’s U.S. federal tax return claiming a refund of some or all the tax withheld. 

The Internal Revenue Service requires two to three months to process the Individual Taxpayer Identification Number application. Sellers can request a longer close to obtain this number however in most situations such delay isn’t practical and may jeopardize the sale.

Scenario 1 – Quick Sale of U.S. Real Property

A married Canadian couple lists their Hawaii home for $1.5 million and quickly receives an offer for asking price requesting a quick close. They have never lived or worked in the U.S. and don’t have U.S. Individual Taxpayer Identification Numbers. The escrow agent requires their U.S. Individual Taxpayer Identification Numbers to complete the sale and pay the $225,000 of U.S. federal withholding taxes.

What is the Solution?

  • Apply for a U.S. Individual Taxpayer Identification Number if there is enough time before closing.
  • Apply for the Individual Taxpayer Identification Numbers with the U.S. federal income tax return reporting the U.S. property’s sale.

Escrow agents can complete the sale of U.S. property without the seller’s U.S. Individual Taxpayer Identification Numbers. Once the Internal Revenue Service receives the tax withholding from the escrow agent, it sends a letter to the seller acknowledging receipt and provides a tax form with a unique identifying number. Even without U.S. Individual Taxpayer Identification Numbers, the seller can attach this letter with its unique identifying number plus a copy of the closing statement of adjustments as proof of the U.S. federal tax withholding amount. Doing so should ensure the seller receives proper credit for the withholding on their U.S. federal income tax return. Receiving credit for the U.S. tax withheld may take longer using this strategy than where a U.S. taxpayer identification number was submitted to the Internal Revenue Service with the documents referred to above.

Further information

If you want more information on any of the above issues or others, please contact any the following:

Warren Dueck, Partner T: 604-242-1401 or 587-390-1610
E: warren.dueck@AndersenTax.ca

Steven Flynn, Partner T: 604-242-1416
E: steven.flynn@AndersenTax.ca

Jonathan Garbutt, Principal T: 587-390-6569
E: jonathan.garbutt@AndersenTax.ca  

Krista Rabidoux, Principal T: 587-390-6568
E: krista.rabidoux@AndersenTax.ca

Eric Trumbull, Principal T: 604-242-1406
E: eric.trumbull@AndersenTax.ca

Emily Yu, Principal T: 604-242-1405
E: emily.yu@AndersenTax.ca

Catherine Shen-Weafer, Senior Manager T: 604-242-1407
E: catherine.shen-weafer@AndersenTax.ca

Darren Bastarache, Senior Manager T: 587-390-1616
E: darren.bastarache@AndersenTax.ca

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