Canada: Tax Traps Of Owning U.S. Real Estate

Many Canadian Snowbirds who have become fed up with Canada’s long, hard winters (and there are bound to be many more this year, especially from the Eastern provinces) have purchased winter homes in Southern U.S. states. This has been an especially popular move over the past few years, with U.S. real estate at exceptionally affordable levels and interest rates at rock bottom. If you fall into this fortunate group, there are some cross-border tax traps to beware of, particularly if you rent out your U.S. property, and also when you decide to sell.

Rental income

If you own a second home in the U.S., chances are that you may be renting it out during the off-season to help offset costs (especially if the home is sitting empty for that part of the year).

However, if you do this, be aware that U.S. withholding tax of 30% normally applies to the gross rent you receive. Unfortunately, unlike withholding tax on interest and dividends from U.S. investments, this withholding tax is not reduced by any provisions of the Canada-U.S. Tax Treaty.

You can avoid this withholding tax by voluntarily filing a U.S. tax return and electing to pay the tax on the net rental income. You might take advantage of the Net Rental Income Election by deducting expenses on your rental property, such as maintenance, insurance, property taxes, and so on. Yes, in the U.S. you can even deduct mortgage interest payments on your home or vacation property.

This election can apply for future years and to all of your rental real estate in the U.S. On your U.S. tax return (1040NR), you would show the income and expenses, as well as the amount of tax withheld.

This may also allow you to receive a refund of any excess of the withholding tax over your actual tax payable). To make the Net Income Election, you must file Form 1040NR, including a statement declaring that you are making the election. It should include the address of the property and your percentage ownership.

The 1040NR is due by June 15 of the year following the calendar year in question (subject to any extensions). Once the election is made, you should provide Form 4224 to your tenant, and you should be exempt from the 30% withholding.

Sale proceeds

If you decide to sell your Snowbird getaway, a withholding tax of 10% of the gross sale price is normally payable under the Foreign Investment in Real Property Tax Act (FIRPTA) at the time of sale.

In addition, you will still be required to file a U.S. tax return for the year of sale, because the U.S. has the right to tax non-residents on the sale of real property in the U.S. The tax withheld under FIRPTA may be offset against the U.S. income tax payable on any gain realized on the sale (or refunded if it exceeds the income tax liability) that you will have to report in your U.S. tax return. Note, however, that the tax under FlRPTA may be reduced or eliminated in certain circumstances.

Withholding tax can be reduced

There is no withholding requirement where (a) the purchase price for the property is under US$300,000, and (b) the property is acquired by the purchaser as a home, with actual plans to reside in it for at least 50% of the time that the house is occupied in the first two 12-month periods after purchase.

The withholding tax can be reduced if you obtain a withholding certificate from the IRS on the basis that the expected U.S. tax liability on the gain will be less than 10% of the sale price. The certificate will indicate the reduced amount of tax that should be withheld.

Taxpayer identity number essential

On a sale of your real estate, you will need to provide an Individual Taxpayer Identity Number (ITIN) to the transfer agent, even if there is no withholding tax due.

The sale cannot close without both the vendor and purchaser providing an ITIN. In addition, the IRS will not issue a receipt for the withholding tax paid unless both the vendor and purchaser provide an ITIN. An ITIN can be obtained by filing Form W-7 with the IRA. This can take six weeks or longer, so make sure you have this in hand well before your planned sale.

Filing a U.S. tax return

As mentioned above, if you sell your real estate, you will have to file a U.S. tax return to report the gain (with a credit that may be claimed for tax withheld under FIRPTA). If you have owned the property since before September 27, 1980, you can take advantage of the Canada-U.S. Tax Treaty to reduce the gain.

In this case, you will have to pay tax only on the gain that accrued since January 1, 1985 (this does not apply to business properties that are part of a permanent establishment in the U.S.). To claim this Treaty benefit, you have to make the claim on your U.S. tax return and include specific information about the sale.

Any U.S. tax paid on the sale of the property will generate a foreign tax credit, which you can use to reduce your Canadian tax on the sale (courtesy of the Treaty). Note: This tax credit may be limited if you use your principal residence exemption to reduce your Canadian gain.