Buying real estate in the United States can be attractive for Canadians looking for a vacation property, rental investment, retirement home or a way to diversify outside Canada.
But owning property across the border can create tax obligations in both Canada and the United States.
The key is to think about the tax structure before the property is purchased, rather than waiting until it is eventually sold.
How You Own the Property Matters
One of the first decisions is how the U.S. property will be owned.
Depending on the circumstances, Canadians may consider:
- Personal ownership
- Joint ownership
- A trust
- A partnership
- A corporation
- A limited liability company, or LLC
There is no single ownership structure that is best for every Canadian buyer.
A structure that works well under U.S. tax rules may create problems in Canada.
LLCs are a good example. They are very common in the United States, but Canada and the U.S. can treat the same LLC differently for tax purposes. This can create additional reporting requirements and make foreign tax credits more complicated.
The ownership decision should take into account:
- How the property will be used
- Whether it will be rented
- How the purchase will be financed
- The owner’s Canadian tax situation
- What may happen when the property is eventually sold
Changing the ownership structure after closing can also create additional tax, legal and financing costs.
U.S. Rental Income
Canadians who rent out U.S. property generally have U.S. tax obligations on the rental income.
Canadian owners can often make a U.S. tax election that allows them to pay tax on their net rental income after eligible expenses, rather than having tax applied to the gross rent collected.
This is commonly referred to as the Section 871(d) election.
Depending on the circumstances, eligible expenses may include:
- Property taxes
- Mortgage interest
- Insurance
- Property management fees
- Repairs and maintenance
- Certain operating expenses
- Depreciation
Without the appropriate election, U.S. rental income received by a nonresident owner can potentially be subject to tax based on the gross rental income rather than the actual profit.
Because each situation is different, rental property owners should review the structure with a tax professional familiar with both Canadian and U.S. tax rules.
You May Also Have to Report the Income in Canada
If you remain a Canadian tax resident, owning U.S. property does not eliminate your Canadian tax obligations.
Canadian residents generally have to report their U.S. rental income in Canada as well.
You may be able to claim a foreign tax credit for qualifying U.S. income tax already paid. This is intended to reduce the possibility of paying full tax twice on the same income.
However, the Canadian and U.S. tax calculations do not always match.
Differences can arise because of:
- Exchange rates
- Depreciation
- Deductions
- Ownership structures
- Timing differences between the two tax systems
As a result, foreign tax credits do not always create a perfect dollar-for-dollar offset.
This is why cross-border tax advice is important rather than relying only on an accountant who works exclusively in Canada or exclusively in the United States.
Do You Need to File a T1135?
Canadian residents may have to file Form T1135, Foreign Income Verification Statement, if the total cost of their specified foreign property exceeds CAD $100,000 at any time during the year.
The threshold is generally based on the cost of the foreign property, not its current market value.
Whether a U.S. property has to be reported can also depend on how it is used.
For example, a Florida condominium used primarily as a personal vacation property may be treated differently from a condominium that is primarily operated as a rental property.
A property used mainly for personal enjoyment may not need to be reported as specified foreign property, while an income-producing rental property may.
Canadian owners who rent out U.S. property should ask their Canadian accountant whether T1135 reporting applies to their situation.
Selling U.S. Property: Understanding FIRPTA
One of the biggest surprises for Canadian property owners can occur when they sell their U.S. property.
Under the Foreign Investment in Real Property Tax Act, commonly known as FIRPTA, withholding can apply when a foreign person sells U.S. real estate.
For many sales, the buyer is generally required to withhold 15% of the amount paid for the property, subject to certain exceptions.
The most important point is that FIRPTA withholding is not necessarily your actual tax bill.
FIRPTA is essentially a withholding system designed to make sure the United States can collect any tax that may ultimately be owed by the foreign seller.
For example, a Canadian could sell a property for $800,000 while having a much smaller taxable gain. FIRPTA withholding may still be based on the sale amount rather than simply the seller’s profit.
The seller’s actual U.S. tax liability is determined when the appropriate U.S. tax return is filed.
If too much was withheld, the excess may generally be recovered through the tax filing process.
Capital Gains and Depreciation
For a rental property, the tax calculation when the property is sold can involve more than simply subtracting the original purchase price from the selling price.
If you claimed depreciation while renting the property, that depreciation can increase the amount of taxable gain when the property is sold.
Part of the tax owing may also relate specifically to depreciation that was previously claimed.
This is one reason the actual U.S. tax bill can be very different from the FIRPTA amount withheld at closing.
FIRPTA Exceptions and Reduced Withholding
There are situations where FIRPTA withholding may be reduced or eliminated.
Certain transactions where the buyer intends to use the property as a residence can qualify for special treatment.
Depending on the purchase price and whether the specific requirements are met, withholding may potentially be:
- 0% where the amount realized is $300,000 or less
- 10% where the amount realized is more than $300,000 but not more than $1 million
- Generally 15% for transactions above $1 million
Specific occupancy and other requirements apply.
A foreign seller may also be able to request an IRS withholding certificate when the normal FIRPTA withholding would be much higher than the seller’s expected U.S. tax liability.
If approved, the amount withheld may be reduced.
Because this process can take time and requires documentation, FIRPTA should be discussed well before closing whenever possible.
Waiting until the closing date to discover that a large portion of the sale proceeds must be withheld can create an unexpected cash-flow problem.
Do Canadians Pay Capital Gains Tax Twice?
Canadian residents generally report the gain from selling U.S. property in both countries.
The United States can tax the gain because the real estate is located in the United States.
Canada may also tax the gain because Canadian residents are generally taxed on their worldwide income.
However, this does not usually mean that you simply pay the full capital-gains tax twice.
Canadian residents may generally be able to claim a foreign tax credit for qualifying U.S. tax already paid on the same income.
The purpose of the foreign tax credit is to reduce double taxation.
However, Canada and the United States may calculate the gain differently.
Differences can result from:
- Currency exchange rates
- Depreciation
- Selling expenses
- Differences in tax rules
- Differences in adjusted cost basis
As a result, you may still owe additional tax in Canada after claiming the U.S. tax as a foreign tax credit.
What About a 1031 Exchange?
A Section 1031 exchange can allow certain U.S. investment or business real estate to be exchanged for another qualifying property while deferring certain U.S. taxes.
It generally does not apply to property held primarily for personal use.
For Canadians, a 1031 exchange can be more complicated.
The United States may allow the tax to be deferred, while Canada may not provide identical treatment.
In other words, the U.S. may allow you to postpone recognizing the gain while Canada may still require you to report it.
Canadians considering a 1031 exchange should therefore obtain Canadian and U.S. tax advice before selling the original property.
Plan Before You Purchase
Cross-border real estate taxation is manageable, but mistakes can become expensive when planning happens after the purchase.
Before buying U.S. property, Canadians should consider:
- How the property will be owned
- Whether it will be rented
- Canadian reporting requirements
- U.S. income-tax obligations
- Future capital-gains exposure
- The effect of depreciation when the property is sold
- FIRPTA withholding
- Whether financing affects the ownership structure
- Whether an LLC, corporation or trust could create additional Canadian tax issues
The mortgage, tax and legal structure should ideally be considered together before closing.
A little planning at the beginning can help prevent much more complicated problems later.
This article is for general informational purposes only and is not tax or legal advice. Canadians purchasing, owning or selling U.S. real estate should obtain advice from qualified Canadian and U.S. professionals familiar with cross-border taxation.