Owning property in the U.S. is desirable to many Canadians, whether it be as a vacation/retirement retreat or an investment. While it does add an element of complexity to your financial situation, it certainly is manageable as long as you take a few things into consideration.
Have a discussion around ownership
There are many different ways you could structure your U.S. real estate ownership. The simplest, of course, is owning it directly either as an individual or jointly with your spouse. However, a lot depends on your plan for the property (personal use vs. commercial), your personal net worth (as it relates to estate tax exposure), and whether you expect there to be any liability risks associated with owning the property. You may wish to explore other holding options including ownership within a trust, corporation, limited partnership, or some planned combination. Obtaining professional cross-border advice is crucial here.
Know what your operating costs are
Before you pull the trigger on your purchase, you should take the time to know what your operating costs will be for your new property. Things to consider are property taxes, home insurance, utilities, and maintenance services for both your Canadian and U.S. properties (remember, you will be away from each home for a large portion of the year). You may also need to hire a house sitter or ask a family member or friend to keep watch over your Canadian property while you are stateside, as it is common for insurers to require that vacant homes are not left unattended for too long. Lastly, don’t discount the cost of travelling between your two properties.
When adding up these expenses, make sure to leave some wiggle room to allow for currency fluctuations. If you budget for operating costs with 80-cent Canadian dollars, is your plan still feasible with 65-cent Canadian dollars?
To balance some of the concerns over currency fluctuations, you may find it worthwhile to line up your personal savings with your travel plans. If you spend one third of the year in the States, perhaps one third of your portfolio should be invested in USD denominated securities. Then, you can link that investment account to your USD bank account, thus protecting yourself from short-term currency fluctuations.
Plan for health insurance
If you plan to be in the United States for a significant portion of the year, you should also plan for the possibility of a medical emergency while there. It’s important to have adequate health coverage wherever you go. Don’t just assume that your provincial health plan or your credit card will cover you. Instead, take the time to make sure you know what coverage you have and then top it up as required. Pre-existing conditions are especially concerning as most travel health plans will not cover them.
The amount of time you can spend stateside is limited
If you had thought that you could sell your home in Canada and move to the States permanently, think again. There are specific rules that Canadians need to abide by, and failure to do so could result in your being considered a U.S. tax resident, meaning that you would be subject to U.S. taxation on your worldwide income, along with a host of other IRS-induced disclosure requirements.
The U.S. domestic tax residency rules are based on what is called the Substantial Presence Test. This test considers the days that you were present in the U.S. during the past three calendar years, with a higher weighting given to the most recent year, and progressively less weight being given to the second and third most recent years. Specifically, you need to add up all the days in the most recent year, plus one third of the days in the year before that, and one sixth of the days in the year before that. If the combined total is less than 183, then you have not met the conditions of the test and you will not be considered a U.S. tax resident. If, however, you have met the test (meaning that your combined total is 183 or more), then you are considered to have been “substantially present” in the States and will be classified as a U.S. tax resident under U.S. domestic tax law. If that is the case, you still have an out if you file an IRS form called the “Closer Connection Exception Statement for Aliens,” otherwise known as Form 8840. (Yes, to the U.S., anyone not from there is referred to as an “Alien.”)
I should also point out that Form 8840 must be filed by June 15 of the following calendar year (e.g., 8840 forms for the 2017 tax year are due to be filed no later than June 15, 2018). If you forgot to file your 8840 form, speak to a cross-border tax advisor – you have a final fallback position that you can take under the Canada-U.S. income tax treaty.
Form 8840 will keep most snowbirds out of trouble as long as they have not spent more than 180 days in the U.S. in any 12-month period. The twist here is that, for immigration purposes, you are not looking at a calendar year – you need to be aware of a continually rolling period of 365 days. Be careful. If you get on the wrong side of the immigration rules, you could find yourself being barred re-entry into the U.S. for three years – which would really put a damper on your plans for that shiny new U.S. home.
To summarize, be prepared to count days. Keep a log of your trips, and note that partial days count as full days. If, on average, you spend more than 122 days per year in the U.S. for any reason, then file Form 8840 and do not exceed 180 days in any rolling 12-month period. Period!
What are the tax implications?
As is the case with a Canadian property, the tax implications for your U.S. home will largely depend on your intended use for the property.
If you are planning to own the property for personal use only, there are no ongoing annual tax filing requirements on either side of the border.
If you are planning to use the property to generate rental income, you will have to report this rental income annually. Because the income is sourced from within the U.S., you will need to file an annual federal income tax return to the IRS (1040NR – the NR stands for non-resident) and also the applicable state tax return. You will also need a U.S. tax identification number (a.k.a. an ‘ITIN’) number, or, if you qualify for one, a U.S. Social Security Number. ITIN numbers are far more common for Canadian snowbirds as the latter requires a work visa.
In Canada, you will have to report the same rental income again on your annual filings. Any tax that you pay south of the border can be claimed as a foreign tax credit to lower your Canadian taxes. Assuming the property was purchased for more than $100,000 CAD, you will also need to report the property as a foreign income producing asset on Form T1135 each year.
One significant difference is that, in Canada, you are able to choose whether or not to claim depreciation on your rental property to lower your net rental income (for the tax savvy people out there, I am referring to claiming CCA), whereas in the U.S. depreciation is mandatory. The rate at which the depreciation must be claimed on your U.S. return is 1/27.5.
What are the tax implications when the property is sold?
When you ultimately decide to sell the property, you should be aware that it is very likely you will not receive the full proceeds of the sale on closing. Rather, in accordance with the Foreign Investment in Real Property Tax Act (FIRPTA), the U.S. will withhold up to 15% of the gross sale proceeds. Under normal circumstances you can apply to reduce the 15% withholding by proving that the tax will only apply on net proceeds (proceeds after closing costs and your purchase price), but, your paperwork needs to be impeccable and filed in a very timely manner (prior to closing). Alternatively, when you file your U.S. tax return, you will get a refund if your actual tax payable is less than what was withheld. On the other hand, if your actual tax is greater than the withholding, you will have to pay the difference.
The actual tax is based on the gain over and above your cost to purchase the property. On your U.S. tax filings, all figures will be reported in USD, and on the Canadian tax filings all figures will be reported in CAD. This sounds simple enough, but it is easy to be caught off guard by the significance of currency fluctuations over time. For example, consider a property that someone may have bought for $500,000 USD in 2011 when the USD and CAD were at par. Now, let’s assume that you sold that same property in early 2017 for $450,000 USD when the Canadian dollar was worth $0.65 USD. In the U.S. you have a loss, but on the Canadian return you have a gain of $192,000 ($450,000/0.65 = $692,308 – $500,000).
Choose your state wisely
All states are not created equal. Here’s a tip: if you are only just embarking on your quest to find the right U.S. property, it would be advisable to compare the tax regimes of the various states you are considering. You might be surprised to find that some states have no income taxes (so no capital gains taxes to worry about when you sell your property – at least at the state level), while other states have no sales tax. And some states will impose a higher property tax levy on non-residents. Also of note is that Hawaii imposes its own state withholding (5%) on the sale of a property by a foreigner (similar to FIRPTA). Depending on your circumstances, these state-level differences may swing you one way or another.
The estate debate
The always-trendy and ever-changing discussion of U.S. Estate Tax. From a Canadian’s perspective, as of the date of this writing, you could fall subject to U.S. estate tax if you die while holding U.S. situs assets and your worldwide estate is greater than $5.49 million USD ($10.98 million USD for a couple). U.S. situs assets would most commonly be U.S. real estate, shares held in U.S. companies, and assets held with a U.S. brokerage firm. U.S. estate tax is then levied against your U.S. assets based on progressive tax brackets that start at 18% and max out at a top rate of 40%.
There are ownership structures that can be put in place to avoid U.S. estate tax that might make sense for certain individuals. For the general public, the problem with spending too much time and money trying to devise a structure that protects you from U.S. estate tax is that you can only plan based on the current rules. In the past 10 years alone we have seen several changes to the U.S. estate tax regime, and President Trump would like to do away with the estate tax altogether. From a more practical perspective, you can mitigate your exposure using much simpler methods. For instance, you could carry extra life insurance, or take out a non-recourse mortgage. You could perhaps even plan to sell your U.S. property during your lifetime, and while you of course don’t know when you will die, you could likely look at an actuarial table and get a guideline that could be more reasonable than trying to predict the policy changes of future U.S. governments.
My intention is not to discourage you from buying a U.S. property, but to help you think of things that you may not have otherwise considered. I have many clients who have properties in the United States and they love the lifestyle. So if you think this might be right for you, it’s worthwhile to have a conversation with your planner to figure out the most tax-efficient way to proceed.
Aaron Hector, Doherty & Bryant, Calgary
This article was published in T.E. Wealth’s Strategies newsletter, September 2017 edition. Read the full edition here.