With the Canadian dollar weakening and the price of US real estate rising, many Canadians who have previously purchased US real estate may now be tempted to sell. Those who purchased after the epic US real estate meltdown may walk away with a hefty profit. However, it is important for every Canadian who is considering selling US real estate to be aware of certain key US and Canadian tax issues in order to avoid getting mired with potentially disastrous consequences. The following are the five key tax issues for a Canadian resident planning to sell personally-owned US real estate, assuming the individual is not a US citizen or otherwise a US person (a determination which is surprisingly complex).
1. You need to get a US Individual Tax Identification Number (“ITIN”)
The IRS has trouble with names, so it identifies every taxpayer by a number. Individuals eligible to work in the United States are given a “social security number.” In theory, the primary function of this number is to track an individual’s contributions (meaning taxes paid) to the US social security program. In truth, the social security number has become the numeric identifier used by the IRS, financial institutions, educational institutions and (hopefully not) enterprising identity thieves.
However, because the social security number technically is for the purpose of tracking a worker’s contributions to the US “social security fund,” an individual ineligible to work in the US will not receive a social security number. In place of a social security number, the IRS requires that individuals obligated to pay a US tax, but ineligible to obtain a social security number, obtain a nine digit “ITIN,” which is formatted in the same 123-45-6789 format as a social security number, but contains specific numbers in the 1, 4 and 5 places, designed to prevent misuse as an actual social security number. The IRS will generally not issue an ITIN to a person unless they can demonstrate a need for the number (such as a US tax filing obligation). In order to obtain an ITIN, a foreign individual can either mail a completed Form W-7 to the IRS Austin service center or file such form with an “Acceptance Agent” or US consular office. Canadian taxpayers that have been earning rental or other income will hopefully have either a social security number or ITIN which they have been using to comply with previous years’ US tax obligations. However, if for whatever reason they do not have such a number, this is an excellent time to get one (and to give a good read to some of our catchup filing and compliance posts).
2. US tax filing due dates and obligations
Since persons who are not US citizens are generally beyond the jurisdictional reach of the IRS for purposes of determining and collecting US tax obligations, the US tax regime imposes a number of procedural “safeguards” on transactions involving non-US or ‘foreign’ persons to ensure the US treasury is not being “short-changed” with respect to tax on US sourced gains or income. As such, a purchaser of US real estate from a foreign seller must file an IRS Form 8288 within 20 days of the sale, together with any required withheld funds (see section 3 below for discussion of the withholding process). Additionally, the foreign seller will have to file a US income tax return (Form 1040NR for individuals) for the year of the sale to receive any refund it deserves. Generally speaking, a foreign individual is required to file and pay US taxes prior to June 15 (assuming an automatic extension is utilized) of the subsequent calendar year.
3. US Foreign Investment In Real Property Tax Act (“FIRPTA”) withholding process and waiver
US tax law imposes special requirements regarding the sale of US real property by foreign (including Canadian) sellers. When a foreign taxpayer sells an interest which is characterized both as (a) a capital asset and (b) a real property interest (a statutory term of art), a purchaser (or their agent) of the property is generally required to withhold from the sale proceeds delivered to the seller (and to pay over to the IRS) an amount equal to 10% of the gross sales proceeds (Canada has a similar process under section 116 of the Income Tax Act that requires a tax withholding and reporting to be done when “taxable Canadian property” is sold to non-residents of Canada). The withholding requirement itself can add some complexity to a transaction. The complexity is exacerbated when the withholding regime is layered together with escrow agreements, holdbacks, installment payments and other common features of commercial real estate transactions. With sufficient advance planning and written notice to the IRS, complete or partial exemptions from this withholding is often applicable. For Canadian taxpayers, reduced withholding is granted by the US/Canada income tax treaty in addition to other exemptions that may be available.
4. US capital gain and recapture income
As mentioned above, the FIRPTA regime requires a purchaser to withhold and remit 10% of the gross proceeds where the sale is by a foreign vendor unless a complete or partial exemption is granted. The purpose of the withholding is to ensure that the income tax obligations of the foreign seller are met. The withheld amount will be refunded (to the extent they exceed the seller’s tax liability) after the seller files the required US tax return.
With respect to real estate generally, the US/Canada income tax treaty generally grants the country in which the real estate is located the right to tax income arising from the sale or use of such property. The actual tax imposed on a seller of US real estate depends on the seller and the purpose for which they owned the real estate. For individual sellers, real property will either be a residence, an “ordinary” asset or a capital asset.
A gain from the sale of a residence may be partially exempt from tax if certain criteria are met. Gains from the sale of an “ordinary asset,” or from a capital asset held for less than a year, is taxed at the regular marginal rates applicable to the specific taxpayer (the current maximum federal rate for individuals is 39.6%). A Canadian individual reaches the top rate when the individual’s US income exceeds $406,750 for a single filer and $228,800 for married taxpayers filing separately. For individuals, gains from the sale of capital assets held for at least one year can qualify for more favorable capital gains rates ranging from 5% to 20%. Real estate will generally qualify for these “capital gains” rates if it is not held by a taxpayer for sale to customers (homes for sale by a developer) or as part of a trade or business (factories or warehouses). While individuals receive this favorable treatment for capital gains, an individual’s ability to offset ordinary income with capital losses is generally capped at $3,000.
Even when real estate qualifies for capital gains treatment, a portion of the sale proceeds may be treated as ordinary income. Taxpayers are generally required to “recapture” as ordinary income an amount corresponding to depreciation deductions previously taken on the real estate sold. If the amount of depreciation taken by the taxpayer against the property exceeds the actual gain realized on the sale, the recapture amount of ordinary income will actually exceed the actual gain from the sale of the property. It is crucial to obtain professional tax advice to optimize the after-tax outcome of a real estate transaction.
5. Canadian capital gain and recapture
A resident of Canada is subject to Canadian income tax on worldwide income, including income and capital gains earned outside Canada. In the year of the sale, the Canadian is required to report any capital gain or loss, as well as any recapture of previously claimed depreciation to the extent proceeds exceed the undepreciated capital cost. Although this is similar to the US income tax implications, there are a number of subtle differences. Firstly, there is no fixed period of time one needs to hold the property in order to qualify for the preferential capital gains rate (only half of any capital gain is taxable in Canada). However, the property needs to constitute “capital property,” so if the real estate is held for only a short duration, it becomes a question of fact whether a taxpayer is really selling real estate as a business or as an adventure or concern in the nature of trade (both results in full inclusion of the gain as income). Secondly, any capital gain or recapture income must be calculated in Canadian dollars, so both proceeds and cost amounts need to be converted into Canadian dollars at the exchange rate applicable on the transaction date. Therefore, someone who acquired property when the Canadian and US dollar were at par and sells the property when the Canadian dollar falls to 0.9 US dollar is subject to Canadian tax on the 10% foreign currency gain, even if there is no appreciation on a US dollar basis.
Since the gain or income in respect of the US real estate has already been subject to US taxation, the Canadian tax regime allows the taxpayer to claim a foreign tax credit for the US federal and state income taxes paid. The end result is usually that the taxpayer will pay overall tax at the higher of the two countries’ rates. Note that to qualify for the credit, the US tax must be paid. If the taxpayer neglects to file the required US returns and make the tax payments, the taxpayer cannot claim any foreign tax credit on the Canadian return. If the required US income tax is eventually paid after the Canadian return is statute-barred (an extended limitation period applies to claiming of foreign tax credits so that the taxpayer has six years after the notice of assessment date to amend), permanent double-taxation results.
Another potential trap a Canadian must be aware of is that a sale that is entitled to deferral treatment for US tax purposes (i.e. the so called “like-kind exchange” rules) would most likely still be considered taxable transactions for Canadian tax purposes. This mismatch in the timing of the gain could lead to permanent double-taxation since no US income tax is paid for the year in which the gain is recognized for Canadian purposes.
To illustrate, let us assume Kim and Dale are Canadian residents who bought into the US real estate dream and both purchased a condo unit for US$60,000 in Nevada in 2010 when the Canadian dollar was par with the US dollar. Both Kim and Dale purchased their respective condo units personally and have used it exclusively for their weekend getaways. After four years of sunshine and golf, both of them decided they wanted a change of scenery and each sold their condo for US$100,000. On the day of sale, the applicable exchange rate was 1 US Dollar equaled 1.1 Canadian Dollars.
In the year of sale, Kim’s only US income consists of the gain on the sale of his condo. On the other hand, Dale is involved with various other US ventures and earns significant US income so that he is taxed at the top US marginal rates. For Canadian tax purposes, let us assume that both Kim and Dale are subject to the top Canadian and Alberta marginal tax rates.
Dale is a firm believer in obtaining proper advice, so he obtained his ITIN and FIRPTA withholding waiver prior to the sale (we are assuming Dale’s eligibility for a withholding certificate exemption). Kim decided to “wing it” himself and did not obtain a withholding waiver prior to sale. The gain on the sale should generally be considered capital gain for both US and Canadian purposes and since both held the condo for more than two years, the long-term capital gain rates should apply for US tax purposes. The table below illustrates some of the resulting “tax math”.
Since Kim did not obtain a FIRPTA waiver, the purchaser had to withhold 10% on the gross proceeds, but Kim would eventually get part of the withholding back when he files his US personal tax return. From a global perspective, both Kim and Dale pay similar total Canadian and US income tax, i.e. total of CAD 9,750, due to the Canadian foreign tax credit regime which causes the taxpayer to pay overall tax at the higher of the two countries’ rates.
Other Ownership Structures
Different legal ownership structures may be used to hold US real estate with each having different Canadian and US tax results. This article focuses on the situation where a Canadian individual holds the US real estate personally. We will explore other structures and their implications in future posts – so do watch out for them!