Vacation properties in the u.s.
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What many Canadian investors may not realize is that real property
ownership in the U.S. may come with some tax headaches,
especially if the property is rented out
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On a recent vacation to the U.S., you may have been tempted to explore properties for sale in the area. You may also have been thinking — wouldn’t it be great to have our own place? We plan on coming back every year. And it’s such a great location that we can rent it out too!
You wouldn’t be alone — Canadians have been buying their own place in the sun for years. The recent decline in property values in the U.S. and a stronger Canadian currency have made this a more common occurrence in the past year or two.
What many Canadian investors may not realize is that real property ownership in the U.S. may come with some tax headaches, especially if the property is rented out.
This article will explore what those tax responsibilities are — when the property is rented out and when it is sold. If a Canadian dies while owning U.S. real property, U.S. estate tax becomes an issue. For a discussion of U.S. estate tax issues for Canadians, see “U.S. Estate Tax Update” in this edition of the Tax Factor. Both of these articles assume that the Canadian investor is a resident of Canada for income tax purposes, and is not a U.S. citizen or green card holder.
U.S. rental income
If you decide to rent your U.S. vacation property, your gross rental income will be subject to U.S. tax. And as a Canadian resident, you will also be subject to Canadian tax on the net rental income.
Let’s look at the U.S. tax first — the rents received are subject to a 30% withholding tax which tenants are required to deduct and remit to the IRS, even if the tenants are Canadians or other non-residents of the U.S. This is a flat rate of tax charged on the gross rents. However, if you have expenses associated with renting out your U.S. real property (such as interest, property taxes, utilities, condominium fees, rental agent and cleaning fees), you can elect to be taxed on the net rental income at graduated tax rates, rather than a 30% flat rate on the gross rent. In many cases, the tax on the net rent will be much less than the tax on the gross rent.
Making this election will require you to file a U.S. tax return for each year the property is rented, and such returns must be filed on a timely basis. Taxes withheld and remitted on the gross rent will be applied to your net U.S. tax liability, and if the net tax is less than the taxes withheld, you will be able to get a refund of the excess. If you fail to meet the deadlines and requirements for filing, you could lose the right to make a net income election and, therefore, be exposed to tax at 30% on your gross rental income.
When you file your U.S. tax return, you will need to get a U.S. Individual Taxpayer Identification Number (ITIN) if you don’t already have one or if you don’t have a U.S. Social Security Number. See your BDO advisor for details.
Depending on the state where your property is located, you may also need to report the rental income earned to the state. For example, Florida does not levy state income tax, and neither does Texas, but Arizona and California both do. Filing state income tax returns can increase the complexity of your tax return obligations, but if income taxes are owing to the state, the tax will be either creditable or deductible in Canada.
In calculating the net rental income for either Canadian or U.S. tax purposes, if you also use the property for yourself or let friends or relatives stay without paying the going rate for rent, the expenses that you can deduct in determining net taxable rental income must be apportioned appropriately between rental expenses and personal expenses.
Because you are also a Canadian resident, the gross rent received from renting your U.S. vacation property must be reported, and certain qualifying expenses can be deducted in Canada. If there is a net profit in Canada, and Canadian tax owing on the U.S. rental income, you can apply the U.S. federal and state taxes on the rental property as a tax credit to reduce Canadian taxes. If there is U.S. tax but no Canadian tax (due to differences in the two countries’ tax systems), the U.S. tax can be deducted as an expense, rather than taken as a tax credit. While the expenses that can be deducted are similar in both countries, there are differences, particularly when it comes to claiming depreciation. Your BDO advisor can assist you with these tax returns.
If the U.S. rental property costs $100,000 or more in Canadian currency, or if the cost of the U.S. rental property plus the cost of other non-Canadian investment assets, such as marketable securities, is $100,000 or more (in Canadian currency), you will be required to comply with Canada’s foreign reporting requirements (Form T1135). Contact your BDO advisor for more information.
Selling the property
When it comes time to sell the property, here are some things to think about:
- The sale of the property will need to be reported for both Canadian and U.S. income tax purposes even if there is not a gain on the property, and even if the property was held for personal use and was not rented out;
- When determining if there is a gain for U.S. tax purposes, the calculation needs to be done in U.S. currency and under U.S. tax principles;
- When determining if there is a gain for Canadian tax purposes, the calculation needs to be done in Canadian currency and under Canadian tax principles. The profit or loss for Canadian tax purposes will differ due to differences in the currency exchange rate between the date of purchase and the date of sale. So even if the property shows no gain, or even a loss, when measured in U.S. currency, there may be a foreign exchange gain to report in Canada;
- If there is a loss in Canada but not in the U.S., and the property is considered personal use property in Canada, the loss is not deductible and the U.S. tax may not be creditable;
- Before selling a U.S. property, get advice as to whether there will be U.S. withholding tax on the sale as U.S. law requires withholding at a current rate of 10% of the gross sales price where a non-resident of the U.S. sells real property. There is, however, an exemption from withholding if the property is sold for $300,000 U.S. or less and the property will be used by the purchaser as a residence. In order to meet the “use as a residence test”, the purchaser must have definite plans to reside at the property in accordance with IRS rules;
- If the property is subject to U.S. withholding tax, steps can be taken to reduce the withholding at the time of sale from 10% of the gross sales price to an estimate of the actual U.S. tax liability — however, these steps must be taken on a timely basis prior to the sale;
- If the property has not been rented, you must obtain a U.S. ITIN if you don’t already have one or if you don’t have a U.S. Social Security Number. This needs to be obtained prior to or at the time of sale so that the tax withheld can be reported to the proper account;
- If the property is owned jointly between spouses, separate tax reporting must be done for each co-owner in each country. Even though the U.S. allows spouses to file joint tax returns, non-residents must file separate tax returns;
- State income tax may apply on the sale depending on the state where your property is located; you may also need to report the sale of the property to the state and submit state withholding tax at the time of sale (for example, in California);
- If there is a gain on the sale in both countries, the U.S. has the first right to tax the profit, which means that any U.S. federal and state or local tax, where applicable, is paid first, and this tax can be claimed as a credit against any Canadian and provincial tax on the sale. The Canadian tax credit will generally be limited to the lower of the combined U.S. taxes and the Canadian tax on U.S. source income.
Your BDO advisor can assist with your questions about buying real property in the U.S.
Next section: U.S. Estate Tax Update
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