This article examines the individual income tax implications in the U.S. and Canada, for Canadians purchasing U.S. rental properties or personal use properties. For more information pertaining to Canadians selling U.S. rental properties, please refer to the accompanying article on our website. This article has been updated to include the 2018 Tax Cuts and Jobs Act (TCJA).
Disclaimer – This article is about the U.S. and Canadian tax consequences of Canadian individuals purchasing U.S. rental properties or personal use properties. Readers are cautioned that information in this article is for general purposes only and does not purport to provide specific advice. Individuals should consult with a tax professional. The author bears no responsibility for the use or dissemination of this information.
The Canadian and U.S. income tax rules and regulations are at the same time similar, and vastly different. It is very important for Canadians to understand U.S. tax laws and how they will impact your income tax filings in the U.S. and Canada.
The Internal Revenue Service (IRS) is the administrative arm of the U.S. income tax system and responsible for enforcing U.S. federal tax law, known as the Internal Revenue Code (IRC). Note – this is similar to the arrangement in Canada, whereby the Canada Revenue Agency (CRA) enforces the Canadian Income Tax Act (ITA). It does not end here. Each state within the U.S. has its own income tax regime, administered by that state, and which also must be taken into consideration in regards to income tax planning. The discussion below will focus on U.S. federal law initially, and then follow with an overview of state income tax considerations. Furthermore, this article is directed towards Canadians who are living in Canada, and as such are considered to be ‘non-resident aliens’ by the IRS.
Purchasing U.S. Property
U.S. – Personal Use Properties
Canadians purchasing U.S. personal use properties such as vacation homes, do not have any immediate U.S. or Canadian income tax implications. However, you should keep good records including the Purchase contract, as well as any investments that are made to improve the property (known as capital improvements) such as adding rooms and other permanent structures. Also, keep track of furniture purchases and appliances as these might be included in a future sale of the property. All of this will increase the ‘adjusted cost base’ of the property and impact the gain or loss on future sale of the property, which does indeed have tax implications in the U.S. and Canada. (More details on this to follow in sale of the property). Personal use properties do not have to be disclosed on Form 1135 to the CRA. Disclosure is only required for rental properties.
Substantial Presence Test
A further consideration pertaining to Canadian citizens who own or visit their vacation homes, stay in other rented or residences – you must be aware of the U.S. residency laws – otherwise known as the Canadian ‘snow-bird’ rules. Basically the U.S. tax laws will consider a Canadian citizen who is physically present in the U.S. for an extended period of time to be a U.S. resident for U.S. tax purposes, and taxable in the U.S. on their worldwide income. This is known as the ‘Substantial Presence Test’. (IRS publication 519 has more details). The threshold is 183 days in any given year, but is actually closer to 120 days if you are vacationing or staying in the U.S. on a regular annual basis. This is due to the formula used, which includes the most recent 3 years. Form 8833 Closer Connection Exception Statement for Aliens should be filed to if you expect to be in the U.S. between 120 and 183 days on an ongoing basis. Form 8833 needs to be filed no later than June 15th following the end of the tax year. Stays in excess of the 183 day threshold would result in a person being taxed as a U.S. resident. There are some exceptions to this rule, for example if you commute to the U.S. on a daily basis for employment. Best to discuss and review with a tax professional.
U.S. – Rental Properties
Canadian purchasing U.S. rental properties also do not have any immediate U.S. or Canadian income tax implications. However, once again, good record keeping is very important including the Purchase contract, as well as any investments that are made to improve the property (known as capital improvements) such as adding rooms and other permanent structures.
Canadian individuals owing U.S. property rentals are viewed by the IRS as non-resident aliens. The U.S. taxes foreign persons on income effectively connected with a U.S. trade or business, and certain U.S.-source income not effectively connected with a U.S. trade or business that being Fixed, Determinable, Annual or Periodic income (FDAP).
Canadians purchasing U.S. rental properties have a choice to make with the IRS in regards to reporting their rental income. The first concept to understand is that generating rental property income in the U.S. is considered to be taxable income and therefore reportable to the IRS. The choice to make is as follows;
- Remit 30% of gross revenues to the IRS for the calendar year (FDAP). No further U.S. federal income tax filings are required for the tax year. This choice is often referred to as the ‘gross rental basis’.
- Choose to report the rental property income as ‘effectively connected income’ (ECI) with a trade or business in the U.S., and in so doing, file annual U.S. individual income tax returns (Form 1040NR), and more importantly, take advantage of graduated U.S. individual income tax rates afforded to U.S. citizens. These rates are based on net income (gross revenue less allowable expenses and deductions), and begin at 10% and top out at 39.6%. This choice is often referred to as the ‘net rental basis’.
In almost all situations, the best choice is option 2. However this requires filing U.S. federal individual income tax returns with the IRS, and possibly state income tax as well, depending on the state.
Canadians purchasing U.S. rental properties and choosing to report ECI, have some immediate tax implications, including applying for an Individual Tax Identification Number (ITIN), and Form W8-ECI.
Effectively Connected Income
Under U.S. domestic tax law, a non-resident – whether an individual or corporation – is subject to U.S. federal tax if they have income that is “effectively connected with the conduct of a trade or business within the United States”. Effectively Connected Income (ECI) is generally U.S.-source business income attributable to a U.S.-based activity that rises to the level of a trade or business (TOB). The threshold for a U.S. TOB is fairly low, as any profit-seeking activity deemed to be considerable, continuous and regular can suffice. ECI includes situations where Canadian individuals own and operate property rentals in the U.S. Also, capital gains or losses earned on the disposition of U.S. real property, including shares of a U.S. real property holding company, are considered effectively connected to the U.S., even if you are not considered to be engaged in a U.S. trade or business (eg/ sale of personal use real property located in the U.S. by an individual to be discussed later).
The focus of the remainder of this article pertains to effectively connected income.
U.S. individual tax on effectively connected income (2018)
A significant change introduced in the 2018 Tax Cuts and Jobs Act (TCJA), was the elimination of the Personal Exemption of $4,050 for each individual filing a non-resident individual income tax return (1040NR). Prior to 2018, Canadian individuals owning and operating U.S. rental properties would be able to offset up to $4,050 of net rental income, with their Personal Exemption of $4,050. This often eliminated all taxes owed to the IRS, and most states. Beginning with the 2018 tax year, the $4,050 Personal Exemption is eliminated, meaning that some Canadians will owe tax to the IRS. Any taxed owed and paid to the U.S. can be claimed as a ‘Foreign Tax Credit’ by Canadians on their Canadian individual tax returns. This eliminates duplicate taxes paid on the same income being included in both U.S. and Canadian income tax filings. Foreign tax credits used to reduce taxes in Canada are closely monitored by the Canada Revenue Agency (CRA). The CRA will almost always audit these credits, and to support these tax credits, taxpayers will need to file a U.S. income tax return, and request an IRS Transcript. It is best to discuss and plan this with our firm’s cross-border tax specialists.
U.S. individual tax on effectively connected income (2017 and prior for comparative purposes only)
U.S. income tax filings
The following concepts should be considered for reporting U.S. rental property income and expenses;
- U.S. Income Tax (Form 1040NR, including Schedule E – Supplemental Income and Loss from real estate rental) is used to report the Florida property rental income to the IRS (Internal Revenue Service). Filing deadline Jun 15th of the following year. Extensions are available.
- Joint ownership – requires two separate US income tax returns. However, if more than one property is owned, both properties can be reported on the same return.
- Deductible Expenses – ordinary and necessary in the operation of rental business. Includes; advertising, cleaning, maintenance, commissions, insurance, tax return preparation fees, management fees, mortgage interest, repairs, supplies, property taxes, depreciation and utilities. Travel expenses to the property are deductible, as long as the primary reason for the trip is business.
- Capital assets and depreciation – home and major expenditures are not immediately expenses, but are depreciated over many years. Closing costs and travel to purchase the property are capitalized.
- The number of years to depreciate depends on the asset. The home itself is depreciated over 27.5 years. (There is an option to depreciate rental property over 40 years). You cannot “accumulate” depreciation – must use it, or lose it (different rules in Canada). Land is not depreciated.
- Section 179 Depreciation – this allows some purchased assets, such as appliances, to be fully depreciated in the year of acquisition. This might save taxes in some situations.
- If the property is “used as a home,” your rental expense deduction is limited. This means your deduction for rental expenses can’t be more than the rent you received. For more about this rule, see IRS Publication 527, Residential Rental Property (Including Rental of Vacation Homes).
- If the property is “used as a home” and you rent it out fewer than 15 days per year, you do not have to report the rental income.
- If you personally use your property and sometimes rent it to others or vice versa, special rules apply. You must divide your expenses between the rental use and the personal use. The number of days used for each purpose determines how to divide your costs.
- Rental losses are not refunded by the IRS, however the losses can be accumulated and carried forward for 20 years to offset future rental income, and gains of the sale of the property. Form 8582 is used to record and report ongoing rental losses.
As discussed previously, when filing 1040NR for U.S. property rental, IRS rules requires that you make an election that you are engaged in a trade or business and detail several pieces of information (refer to IRS Publication 519). This is important to do, so as to ensure that you are entitled to the U.S. individual graduated taxation rates and claim the allowable deductions.
Rental property owners are advised to keep detailed records, and summarize these for tax preparation purposes. Your professional accountant can reduce fees if the files are organized and summarized.
Caution about late filing and effectively connected income choice
A non-resident who fails to submit a timely filed income tax return loses the ability to claim deductions against the rental income, causing the gross rents to be subject to the 30 percent tax. Generally, the non-resident will need to retroactively file at least six years of delinquent income tax returns, or all prior year tax returns, if they have held the rental property for less than six years. However, the ability to elect to treat the rental income as effectively connected with a U.S. trade or business will be lost after 16 months from the original due date of the return, and the remaining back years may be subject to tax under the gross income method. Rental income from real property located in the United States and the gain from its sale will always be U.S. source income subject to tax in the United States regardless of the foreign investor’s status and regardless of whether the United States has an income treaty with the foreign investor’s home country.
Bottom-line – please ensure you discuss with your tax professional and understand your U.S. filing requirements.
U.S. taxpayer identification (ITIN)
An Individual Taxpayer Identification Number (ITIN) is a tax processing number issued by the Internal Revenue Service. The IRS issues ITINs to individuals who are required to have a U.S. taxpayer identification number but who do not have, and are not eligible to obtain, a Social Security number (SSN) from the Social Security Administration (SSA).
The IRS issues ITINs regardless of immigration status, because both resident and non-resident aliens may have a U.S. filing or reporting requirement under the Internal Revenue Code. They do not serve any purpose other than federal tax reporting. An ITIN does not authorize work in the U.S. or provide eligibility for Social Security benefits or the Earned Income Tax Credit.
The IRS requires ‘Non-resident Alien’ property owners who rent out their properties for more than 14 days per year to have an Individual Tax Identification Number “ITIN”. A separate ITIN is required for each part owner. Form W-7 is used to apply for the ITIN. Original, valid passports are required to be submitted to the IRS as support for Form W-7.
ITIN’s are normally required to be submitted to the IRS along with Form 1040NR (individual tax return) during tax filing season. However, the IRS does permit a few exceptions wherein the ITIN can be applied for separately, in advance of filing the 1040NR. One of the exceptions includes obtaining an exemption for 30% withholding tax on gross rents from a property management company or tenant. Specific templates and instructions are required to be followed by the IRS for this and other exceptions. Best to review with a tax professional.
ITIN’s are issued by the IRS by way of a letter mailed to the applicant’s address. You will receive a letter from the IRS assigning your tax identification number usually within seven weeks if you qualify for an ITIN and your application is complete. ITIN will expire if it is not used at least once in a three year period.
Certified Acceptance Agent
As mentioned previously, in order to apply for an ITIN, an original, valid passport must be submitted to the IRS along with Form W-7. The passports are returned by regular mail. For various reasons, primarily ongoing travel purposes, many people are not able to do without their passports for an extended period of time. The IRS recognizes this, and as an alternative, applicants such as property owners can use the services of a ‘Certified Acceptance Agent’ to validate the passport and submit the ITIN application. The firm of Edelkoort | Smethurst | Schein offer this service, which allows owners to retain possession of their passports. Passports are reviewed in our offices and returned immediately to the owner.
If you elect to file on a net rental basis, then you will need to complete Form W-8ECI to avoid the 30% U.S. withholding tax. Form W-8ECI is used if the rental income can be demonstrated to be effectively connected income (ECI) to a US Trade or Business, which allows for taxation at graduated rates ranging between 10-39.6% depending on the amount of taxable income. Foreign persons that own real property in the United States and rent it out may be considered to be engaged in a trade or business if the activities related to their investment are regular, continuous and substantial. Form W-8ECI needs to be submitted to your tenant or to a U.S. agent (not to the IRS). This allows the management agent to pay you your gross rental income. Without the withholding exemption your management agent should withhold 30% of your rental income on behalf of the IRS.
U.S. Individual filing deadlines for Non-Resident Aliens (Form 1040NR and schedules)
Canadian owners of U.S. rental properties file form 1040NR along with related schedules which includes Schedule E – Supplemental Income and Loss from rental properties, along with Form 4562 – Depreciation and Amortization. The filing deadline is June 15th, of the year following the end of the tax year.
Separate 1040NRs must be filed for each Canadian co-owner, and the filings must either have an ITIN, or have attached to them, the properly prepared Form W-7 ITIN application. The IRS cannot process Form 1040NR without an ITIN or W-7 application. Form 1040NR is manually submitted to the IRS for processing. The firm of Edelkoort | Smethurst | Schein submits all filings via courier, which enables our clients to verify tracking and receipt.
It is important that the initial 1040NR tax filings for a new property being accompanied by a cover letter which details the choice to elect to report as effectively connected income with a business or trade in the U.S.
U.S. INDIVIDUAL TAX INTEREST AND PENALTIES
The IRS will charge interest on taxes not paid by their due date, even if an extension of time to file is granted. They also will charge you interest on penalties imposed for failure to file, negligence, fraud, substantial valuation misstatements, substantial understatements of tax, and reportable transaction understatements. Interest is charged on the penalty from the due date of the return (including extensions).
If you do not file your return by the due date (including extensions), the IRS penalty is usually 5% of the amount due for each month or part of a month your return is late, unless you have a reasonable explanation. If you do, include it with your return. The penalty can be as much as 25% of the tax due. The penalty is 15% per month, up to a maximum of 75%, if the failure to file is fraudulent. If your return is more than 60 days late, the minimum penalty will be $135 or the amount of any tax you owe, whichever is smaller.
Late payment of tax
If you pay your taxes late, the penalty is usually 1/12th of 1% of the unpaid amount for each month or part of a month the tax is not paid. The penalty can be as much as 25% of the unpaid amount. It applies to any unpaid tax on the return. This penalty is in addition to interest charges on late payments.
U.S. state income tax
A state has the right to impose any reasonable form of tax and to tax income of property transactions (rental income and property sales) occurring in their state. Each state has separate rules and regulations which must be understood. The ITIN assigned by the IRS is used as the same tax ID for the state income tax returns. States are interested only in the income occurring in that state, and usually there are no tax implications for transactions in other states. Best to discuss with a tax professional.
CANADIAN INCOME TAX
Canadian (permanent) residents are taxed on their worldwide income, and this would include the rental properties. Canada Revenue Agency (CRA) has specific regulations pertaining to property rentals that must be followed. Some of the most important of these are summarized below.
- Rental Income / Expenses are reported on a separate Schedule (T776 – Statement of Real Estate Rentals).
- Deductible expenses follow similar rules conceptually, but there are differences.
- Buildings can be depreciated using Capital Cost Allowance (CCA) rules specific to the type of asset. Typically CCA for buildings acquired after 1987 the CCA rate is 4%. CCA rate for buildings acquired before 1988, the CCA rate is 5%. There is “half year rule” in the year of acquisition (transfer of use). CCA not claimed in a year, can be carried forward.
- Each rental building must be place in a separate CCA class if the cost of the building is greater than $50,000.
- CCA is deductible, but CCA cannot create a rental loss for the taxation period.
- Land cannot be depreciated.
- Borrowing expense (interest) is deductible for tax purposes, but not principal. If there is a mortgage underlying the property, it is important to obtain a schedule from the lender indicating the interest vs. principal components of the payments made for the taxation period.
- Operating expenses such as; maintenance, utilities, and other reasonable business expenses. There are specific regulations pertaining to expenses which are allowable and not allowable. For instance, Home office expenses are not allowable deductions, nor any personal expenses.
- Personal occupation of a rental unit – claiming a percent of personal and business use – there are specific CRA guidelines.
- Renovation expenses – some can be deducted as operating expenses, but other expenditures which increase the “economic life” of the building are capital in nature and would follow CCA rules for tax deduction. It is important to understand the difference.
- When a property is co-owned, each co-owner owns a part of it and must individually report rental income according to the proportion owned.
- Sales of rental unit:
- Capital Gain / Loss – there are specific guidelines on “Proceeds of Disposition” and “Cost Base” that support this calculation
- Terminal Loss
- Recapture of CCA
- Form 1135 – Disclosure of Foreign Property
Rental Property owned by individuals
Canadians who own U.S. rental properties are essentially engaging in a trade or business in the U.S. and as such, the rental property is effectively connected income. A common consideration is whether or not to operate the property rental as an individual, or set up some other structure such as owing the property within a Canadian corporation. The decision has implications for both U.S. income tax, and U.S. Estate Tax. U.S. Property rentals owned by a Canadian corporation would be taxed as a foreign corporation and file Form 1120F. The U.S. property is deemed to be a permanent establishment, and taxes would be calculated as outlined previously.
U.S. Estate Tax
The U.S. also has an Estate Tax, and this tax is applicable to foreign persons including individuals. If the U.S. property is owned by an individual, depending on the situation, there might be U.S. Estate tax obligations upon death of the owner. There are numerous tax treaty exemptions to reduce or completely eliminate the tax for the deceased individual, but the possibility exists nonetheless. If on the other hand the U.S. property is owned by the Canadian corporation, the U.S. Estate tax would not be applicable due to tax treaty provisions which allows a non-resident alien individual to transfer U.S. real property on a tax-free basis to a foreign entity (Canadian corporation), which will be treated as a domestic entity for income tax purposes and as a foreign (non-taxable) entity for U.S. estate tax purposes.
The costs and benefits of a Canadian corporation owning U.S. property would need to be examined by a tax professional.
We hope you have found this article useful. As you can appreciate if you have read this article, the income tax implications in the U.S. and Canada pertaining to purchasing properties in the U.S. are complex. Please contact our firm to discuss how Edelkoort | Smethurst | Schein CPAs LLP can assist you with your U.S. and Canadian individual tax planning and filings. We look forward to hearing from you. Thanks for taking the time to read this article, and best wishes.
This article was written by Derek Edelkoort, Partner, CPA, CGA