With the Canadian dollar continuing to slide and the price of U.S. real estate on the rebound, many Canadians who have previously purchased a vacation property across the border may now be tempted to sell, particularly if the rental income has been as steady as they’d hoped. The good news is that those who got in following the epic meltdown will likely walk away with a hefty profit.
But, experts warn, Canadians considering selling U.S. real estate need to be aware of certain key U.S. and Canadian tax issues in order to avoid getting mired in potentially disastrous consequences. For example, if you’re a Canadian resident who receives rent from U.S. real estate, you’re normally subject to a U.S. withholding tax of 30% of the gross amount of any rent that you collect.
Why you have to file a U.S. tax return
Many Canadians mistakenly assume that because their expenses exceed their rental income, there’s no need to file a U.S. tax return or to have tax withheld at source. But that’s not the case.
If those rental expenses (such as mortgage interest, property taxes, management fees, etc.) are really high though, you can elect to pay tax on the U.S. rental income you receive on a net basis. In this case, you must file a U.S. tax return at the end of the year, reporting your net rental income.
By making this election with the Internal Revenue Service (IRS) and informing any tenants, the 30% withholding tax is no longer required. Once you make this election, it’s pretty much permanent, however. Knowing that they could be on the hook here, most Florida-based property managers will want proof that you’ve done this. Failing to make the election means you’ll lose the ability to claim deductions against the rental income, which means the gross, not net, rents will be hit with the 30% tax.
Watch out for rules on depreciation
In addition, unlike Canadian tax rules, depreciation is a mandatory deduction in the U.S. Taking depreciation, or capital cost allowance, and allows you to write off a portion of the cost of your rental property against your rental income. The drawback is that depreciation is ‘recaptured’ and added back on to your income in the year you sell your property. If you don’t file a return, you’re still deemed to have claimed depreciation and could be subject to recapture with no offsetting loss carry-forward.
What happens when it comes time to sell?
If you’re not a U.S. resident, you’re also required to file a U.S. return to report any capital gain/loss on the sale and to pay U.S. capital gains tax on any profit. The tax rate on capital gains varies depending on whether you’ve owned your home for more than one year or for a shorter time. Ten per cent of the sale price must be withheld when you sell U.S. real property – with a few exceptions.
For example, this withholding won’t apply if the property is sold for less than U.S. $300,000 and the purchaser intends to use it as a residence. Also, you can apply to the IRS to have the withholding tax reduced if the expected tax liability on the sale will be less than 10% of the sale price. In some instances, you may be able to avoid the 10% withholding if the purchaser stipulates that they intend to use the property for personal use at least 50% of the time.
No, you can’t just give it away
Instead of selling your property, you may be tempted to pass it on to the next generation to keep the property in the family. The trouble with turning it over to your spouse, children or grandchildren is that the transaction could be subject to U.S. gift tax based on the property’s fair market value at the time. You’d also still be responsible for Canadian capital gains tax on an increase in value from the date of purchase to the date of transfer. Due to the differences in the Canadian and U.S. tax systems, you’ll likely face double taxation by gifting a U.S. vacation property to family members.
Don’t forget about estate taxes
If you die owning on a U.S. vacation property, for Canadian tax purposes, you’ll be deemed to dispose of the property at fair market value, which could result in a taxable capital gain.
As well, under U.S. rules, you could be hit with U.S. estate tax that could reach rates of to 40% of the property’s fair market value. However, this is probably not a concern for most Canadians since the value of your worldwide estate has to be more than US $5.34 million before this tax kicks in.
The bottom line: When it comes to cross-border properties, be wary. And talk to someone other than that friendly real estate agent, including experts who know the tax laws of both countries.