With the decline in the real estate market in the United States following the 2008 financial crisis, many Canadian residents have taken advantage of investing in U.S. real estate for income generation and/or personal vacation homes. This was especially advantageous for Canadians between 2010 and 2013, when the Canadian dollar was close in value to the U.S. dollar.
Many Canadian resident taxpayers fail to realize that the acquisition of U.S. property may result in income tax and other information reporting requirements in both Canada and the U.S. Further, if the property generates rental income, that income may be determined and treated differently in Canada and the U.S.
DETERMINATION OF RENTAL INCOME
Canadian capital cost allowance vs. U.S. depreciation
Since the purchase of capital property (in this case, the land and building of a rental unit) may not be "written off" in the year it is purchased, the cost must be capitalized and depreciated over time. The method and rate of depreciation differ between the two countries such that significantly different results may be reached both on an annual basis and when the property is sold.
In Canada, a rental loss is often fully deductible, whereas in many cases a rental loss realized in the U.S. will not be deductible against other sources of income. The inability to claim these rental losses in the U.S. when incurred is partially mitigated by having these suspended losses applied against any gain realized on the sale of the property.
Additionally, tax depreciation in Canada is discretionary and may not be used to create or increase a rental loss, whereas depreciation is mandatory in the U.S and, if not claimed, it will be deemed to have been claimed. This treatment results in a reduction of the cost of the property for U.S. tax purposes without a corresponding deduction for the depreciation claimed. When the property is sold, the gain recognized will be higher due to the depreciation claims without a corresponding increase in the suspended losses to apply against it.
Limitation on certain expenses
While most deductible rental expenses are claimable on both Canadian and U.S. tax returns, certain expenditures are subject to different rules in the U.S.
Repairs and maintenance
The Internal Revenue Service (IRS) issued guidance, known as the tangible property regulations (effective January 1, 2014), to clarify whether certain materials, supplies and repairs and maintenance were deductible or whether capitalization was necessary. Under these regulations, items that would be eligible to be expensed in Canada might be required to be capitalized in the U.S. unless the taxpayer is eligible for certain exceptions, two of the most common being those for small expenditures and small taxpayers.
There are additional exceptions and other determinations for capitalization that should be discussed with your Collins Barrow advisor.
Mortgage interest and property taxes
If your [D1] U.S. rental property is also a vacation home (defined as a property that is used personally for the greater of 14 days or 10 per cent of the total days it was rented to others in the tax year), the expenses incurred should be allocated proportionately by dividing the number of days the property was rented by the number of days the property was used (rented and personally).
In contrast, mortgage interest and property taxes are calculated by dividing the number of rental days by the number of days in the year, often resulting in a deductible portion that is less than in Canada.
If you paid a U.S. person at least USD $600 in connection with your U.S. rental property, you may be required to file Form 1099-MISC with the Internal Revenue Service. The form must be filed for each person to whom you have paid at least $600 for services (including parts and materials) in connection with the property. The payments must have been made by payment other than credit card to an unincorporated entity.
For example, suppose you hire a landscaper to mow the lawn of your U.S. rental property, and you pay this self-employed individual in cash more than $600 during the year. You will be required to file Form 1099-MISC to report the amounts paid to the landscaper and you will need to obtain the landscaper's U.S. Social Security Number for reporting purposes.
The due date for filing this form with the IRS for the 2015 tax year is February 29, 2016, or March 31, 2016 if filing electronically. The due date for the filing of these forms in connection with the 2016 taxation year will be January 31, 2017.
In Canada, ownership of revenue-generating property in the U.S. is subject to reporting on form T1135 if your share of the cost of the property (when added to the cost of all other reportable foreign property) is CAD $100,000 or more.
Selling your U.S. real property
With the recent decline in the Canadian dollar against the U.S. dollar, many Canadians are selling or thinking of selling their U.S. properties (rental or otherwise). The U.S. dollar proceeds, when converted to Canadian funds, may be higher due to changes in the foreign exchange rate, even though they may be selling for less in U.S. dollars.
For example, suppose you purchased U.S. property for $400,000 in 2012 when the average exchange rate was 1.00. Your cost for both Canadian and U.S. purposes is, therefore, $400,000. If the property is sold for USD $350,000 on, say, December 31, 2015, when the exchange rate was 1.384, the Canadian equivalent of the proceeds is $484,400. In the U.S. you realize an economic loss of $50,000 and pay no tax. In Canada, however, you actually have a capital gain of $84,400 with no foreign tax credits to offset the Canadian tax that may be payable.
Further implications for nonresident aliens
If you acquire a property in the U.S. as a nonresident alien and the property is used to generate rental income, you will likely be required to file a U.S. Nonresident Alien Income Tax Return (US1040NR), and possibly a state income tax return, to report these rental activities.
Generally, rental income earned in the U.S. will be subject to a 30 per cent withholding based on the gross rents collected unless an election to have the income treated as "effectively connected" with a U.S. trade or business is made. This election should be made with the first income tax return filed, and will permit any income arising to be taxed on a net basis (net of expenses) at graduated rates.
In order to file, you will need to obtain a U.S. Individual Taxpayer Identification Number (ITIN). This application often is made with the first federal income tax return filed.
Tax withholdings on disposition
There are also withholding requirements for non-U.S. persons on the disposition of real property under the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA). Unless certain exceptions are met, the Act requires the purchaser to withhold 15 per cent of the proceeds and remit them to the IRS (prior to February 16, 2016, the withholding tax rate was 10 per cent). The withholding may be claimed on your U.S. tax return when you report the disposition.
An application to reduce or eliminate the amount of tax withheld may be made by filing Form 8288-B within certain time constraints. Additionally, many states (e.g. Hawaii) have similar withholding requirements on the disposition of real property. Many of these states have provisions reducing the amount to be withheld, similar to those under FIRPTA.
For more information on FIRPTA, please refer to the Collins Barrow U.S. Tax Alert "U.S. Real Estate Issues," and contact your Collins Barrow advisor.
Long-term stays in the United States
In June 2013, the Senate passed the JOLT (Jobs Originated through Launching Travel) Act of 2013, which essentially permits Canadian retirees to stay in the U.S. for up to 240 days without a travel visa. Previously, the limitation was 182 days.
What does this have to do with taxes?
If you spend more than 182 days in the U.S. in any one year, the U.S. will likely consider you a resident for tax purposes and therefore subject to U.S. income tax on your worldwide income unless relief is granted under the Canada–U.S. Tax Treaty. State filing requirements may also exist.
This consideration may also result in other U.S. filing obligations, including the requirement to file FinCEN Form 114 "Foreign Bank Account Reporting" (FBAR), which carries a penalty of $10,000 for each account not reported in a timely manner. Generally, no treaty relief is available should these obligations arise.
Additionally, if you are outside your province of residence for an extended period, entitlement to certain provincial health coverages may be affected.
The U.S. determination of residency is not limited to 183 days in the current year. An additional "substantial presence" test may apply should you spend a significant amount of time in the U.S. each year. If you are considered a resident under this test, you may be required to file Form 8840, Closer Connection Exception Statement. Please refer to the Collins Barrow U.S. Tax Alert "Snowbirds and the Closer Connection Exception" for more information on the substantial presence test and Form 8840.
These are just a few of the complexities Canadians face when owning U.S. real property.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.