It’s about that time of year when Canada’s snowbirds are enjoying warmer weather in southern parts of the United States and may be thinking about whether to buy a permanent vacation home there. They may want to rent it out for part of the year or sell the U.S. property they own. Other Canadians like skiing and skating they can do here in the winter and prefer to vacation south of the border during the spring and summer where the warm weather may start earlier and last longer.
In any case, it’s important to understand the tax implications of owning or selling a home in the United States.
First off, if you plan to buy and want a mortgage, be prepared for a complicated process.
Typically, the process involves:
- Completing a mortgage application,
- Accessing your Canadian and/or U.S. credit history and having it reviewed,
- Gathering income and asset documents,
- Ordering and obtaining documentation for an appraisal and title search, and
- Preparing closing documents.
It generally it takes as long as 45 days to get a home loan (it can last as long as 60 days if there are minor credit or income verification issues, and 75 days if there are difficulties with title transfers, missing documentation or insufficient appraisal values).
Typically, you’ll need to put down at least 20% of the value of the home. You’ll be asked to provide information and documentation about the source of the down payment. To avoid delays, it’s critical that once you’ve deposited your down payment into your banking account, it remains there.
The costs associated with obtaining a mortgage in the United States can be higher than in Canada, due largely to the third-party services needed to complete the process. There are standard application and transaction settlement fees for such services as property appraisal and title search. On average, expect to pay from 3% to 5% of the selling price in fees.
In addition, U.S. mortgage interest is compounded monthly, while in Canada it is compounded semi-annually. If you decide to become a permanent resident of the United States, interest payments may be tax deductible on the U.S. tax return you’ll be required to file.
And keep your eyes open for the foreign national premium. Many U.S. banks charge Canadians this premium, primarily due to a lack of information on the prospective mortgagee’s credit history. It can add 1% to 3% to your mortgage rate.
Many vacation property owners rent out vacation property when they aren’t occupying it. This rental income may be taxed in both countries. As a Canadian, you’ll have to comply with relatively complex U.S. income tax laws and reporting requirements. You may choose one of the following two options:
The United States tax rules that apply to ownership of U.S. real estate by foreign persons are different from the rules that apply to Americans. Canadian residents receiving rental income from U.S. real estate are usually subject to a U.S. withholding tax of 30% of the gross income. However, an alternative is to choose to pay tax on the rental income on a net basis. If you choose that option, you’ll have to file a tax return with the Internal Revenue Service (IRS) reporting your net rental income. That’s done by making this election with the IRS and providing appropriate information to the tenant. This election is permanent and can only be revoked in limited circumstances.
Don’t assume that because expenses exceed rental income you won’t have to file a tax return or have tax withheld. The IRS requires that a withholding agent (such as a real property manager who collects the rent on your behalf) be personally and primarily liable for any tax that must be withheld from the rental income. If you fail to file a timely tax return, the agent will be liable for the amount due as well as interest and penalties. In addition, you’ll no longer be able to claim deductions against the rental income causing the gross rents (instead of net rents) to be subject to the 30% tax.
In addition, unlike Canadian tax rules, depreciation is a mandatory deduction in the United States. If you don’t file a tax return, you’re still deemed to have claimed depreciation and could be subject to recapture. Failure to file a return also reduces your ability to carry forward passive activity losses. As a result, on a subsequent sale of the property, you’d have a taxable income inclusion in the form of recapture with no offsetting loss carry-forward.
In Canada, of course, you’ll pay graduated federal taxes on worldwide income, including revenue from your U.S. property after deducting applicable expenses. You can generally claim a foreign tax credit on your Canadian taxes for the U.S. taxes you pay.
Selling the Property
The general rule is that the agency closing the sale withholds 10% of the gross sales price and remits it to the IRS. This is simply a withholding that the IRS will apply against the tax payable on any capital gain. There are a couple of exceptions:
1. The withholding doesn’t apply if it is sold for less than US$300,000 (C$393,000) and the purchaser intends to use the property as a residence, and
2. You can apply to the IRS to have the withholding tax reduced if the expected tax on the transaction will be less than 10% of the sale price.
Any gain on the sale is taxable and you must file a tax return with the IRS. If the tax is less than the amount withheld, you’ll receive a refund for the difference. The U.S. tax you pay generates a foreign tax credit that can be used to reduce your Canadian tax liability. If you’ve owned the property continuously since before September 27, 1980, for personal use only, there’s a provision in the Canada-US tax treaty that can be used to reduce the gain. Consult with your tax advisor.
As a Canadian resident, you must report and pay tax on your worldwide income. This includes capital gains realized on the sale of U.S. real estate, which are taxed at 50%. You can reduce your gross sales price with deductions for broker commissions, closing costs and attorney’s fees. After those deductions, you’re left with the capital gain. The gain will be calculated in Canadian dollars so the actual capital gain or loss reported would include a foreign exchange component in addition to any change in the U.S dollar value of the property.
Again, you can claim a foreign tax credit for the U.S. income tax paid on the sale.
Any home you own, including in the U.S., can be designated as your principal residence for each year in which you, your spouse or common-law partner, or your children were residents in Canada and ordinarily lived in it for some time during the particular year. That allows you to claim the principal home exemption.
If you’re unable to designate your home as your principal residence for all the years you owned it, a portion of any gain on sale may be subject to tax as a capital gain. The portion is calculated using a formula that takes into account the number of years you owned the home and the number of years it was designated as your principal residence.
The principal residence exemption formula is:
Number of years the home is the principal residence, plus one, times the capital gain divided by the number of years the home is owned.
The extra year in the top of the equation (the “one-plus rule”) means that when you move, the old home and new home will be treated as a principal residence in the year of the move, even though only one of them can actually be designated as such for that year (for sales after October 3, 2016, the “one-plus” factor applies only when you reside in Canada during the year you buy the property).
So, say the following holds true:
- You own the home for 20 years,
- It has been your principal residence for 14 years,
- The capital gain on the sale is $100,000, and
- You lived in Canada when you bought the property.
The exemption amount = ([14 + 1) = 15 times $100,000] / 20 = $75,000, leaving a capital gain of $25,000, and a taxable capital gain (50%) of $12,500.
This article only covers some of the complex rules that come into play when you own real property outside Canada. Consult with your advisors so you comply with all the laws and requirements.