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. 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.
WHEN IS A U.S. TAX RETURN REQUIRED?
The number of days you spend in the U.S. matters
Needless to say, you will want to spend time in the U.S. in order to enjoy the use of your U.S. vacation property. 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.
U.S. income tax return for personal use property
If you own the property exclusively for your own personal use, there is likely no need to file a U.S. income tax return until the property is sold, assuming you have properly managed the number of days you spend in the U.S.
U.S. tax return for rental property
If you are renting your property, you may not have to file a U.S. tax return, but it may be in your best interest to do so. As a U.S. nonresident, your tenants are required to collect 30% U.S. withholding tax on the gross amount of rents paid. You can file a U.S. tax return to get a portion of that withholding refunded, or make an election to have your rental property taxed on a net basis, eliminating the need for the 30% withholding tax. This special election allows you to claim deductions such as interest expense, property taxes, depreciation and maintenance expenses against your rental income.
There is also a benefit to filing a U.S. tax return to establish tax losses to offset against any ultimate U.S. gain on the disposal. Any taxes paid in the U.S. as a result of net rental income can be used to offset any Canadian income taxes paid on the U.S. rental income via a foreign tax credit.
States assess their own level of tax in addition to the federal tax. Some of the southern destination states do not impose an income tax (Nevada, Florida, Texas). Other states may or do impose an income tax and separate tax returns are required.
WHAT HAPPENS WHEN THE PROPERTY IS EVENTUALLY SOLD?
When the property is sold, you will be taxed on the net gain in the U.S. It is important to keep good records of the original purchase price as well as receipts for any improvements that you make to the property. You will need to file a U.S. federal tax return to report the gain.
Assuming you owned the property for personal use, the entire gain is eligible for special capital gains tax rates. If you rented the property and claimed depreciation, a portion of the gain would be subject to the ordinary tax rates.
Because you are a foreign seller, the purchaser of your property (regardless of whether they are U.S. or foreign) is required to withhold and remit to the Internal Revenue Service 10% of the sale price upon close. Alternatively, you can apply for a withholding certificate so that the purchaser holds back tax on a net basis.
WHAT IS THE EXPOSURE TO U.S. ESTATE TAX?
Owners of U.S. real estate are subject to U.S. estate tax even though they are not residents of the U.S. for tax purposes. U.S. estate tax is imposed on the gross value of U.S. situs assets on death. If your share of the property value and all other U.S. assets (this includes U.S. stocks held within and outside your RRSP) is under US$60,000, you do not have to file a U.S. estate tax return or pay U.S. estate taxes. In addition, the Canada-U.S. Treaty provides a partial exemption that is pro-rated based on your worldwide assets. For 2011-2012, if your worldwide estate (including life insurance death benefits) exceeds $5,000,000 you will want to quantify your U.S. estate tax exposure to understand the potential cost. The exemption is scheduled to decrease to $1,000,000 starting in 2013.
If the asset passes to your surviving spouse, an additional exemption amount is also available. You do get a foreign tax credit for U.S. estate taxes paid against any federal Canadian deemed disposition taxes on death. In many cases, however, the U.S. estate taxes are greater than the Canadian taxes that you will owe on your death. States can also impose an estate tax or inheritance tax.
WHAT IS THE BEST WAY TO OWN MY PROPERTY?
There is no one right answer to this question. You need to look at your own facts and circumstances and your short term and long term intentions for the property. Getting into the right structure at the outset is preferable.
KEY THINGS TO KEEP IN MIND
Since you are operating in a foreign jurisdiction, it is important to be aware of the rules. Here are some key concepts from this article to remember:
- Watch the number of days that you spend in the U.S. and file the appropriate forms on time
- File U.S. tax returns for your rental property to establish tax losses
- Consider applying for a withholding tax certificate when you sell the property to reduce the amount of proceeds held back
- Quantify the amount of your U.S. estate tax exposure
- Be proactive. Consult with a Canada/U.S. tax advisor prior to purchasing the property to ensure that you are properly structured so as to minimize U.S. estate tax
- Just because your friends purchased their property a certain way, does not mean you should too. Be sensitive to your own facts and circumstances
Gary Marcus, CA, CPA is a Partner at MNP who specializes in providing tax, consulting, accounting, and buy/sell advisory solutions to dental professional clients. You can reach him at 1.877.251.2922 or firstname.lastname@example.org
This article was originally featured in the Winter 2012 issue of Profitable Practice.