This article examines the individual income tax implications in the U.S. and Canada for Canadians selling U.S. rental properties or personal use properties. For more information pertaining to Canadians purchasing U.S. rental properties, please refer to the accompanying article on our website.
Disclaimer – This article is about the U.S. and Canadian tax consequences of Canadian individuals selling 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 laws, 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 laws 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.
SELLING U.S. PROPERTY
When a Canadian sells U.S. real estate, the transaction will trigger U.S. income tax filings. This is the case if the property is owned for personal use, or as a rental property. For rental properties, this concept would be straight forward in that you were in business with Effectively Connected Income (ECI) all along. For personal use, IRS rules stipulate that the sale of real property in the U.S. by a foreigner constitutes ECI, regardless if it was used 100% for personal use or other purpose such as rental, or vacant land.
U.S. withholding tax
The disposition of a U.S. real property interest by a foreign person (the transferor) is subject to the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) income tax withholding. FIRPTA authorizes the United States to tax foreign persons on dispositions of U.S. real property interests.
A disposition means “disposition” for any purpose of the Internal Revenue Code. This includes but is not limited to a sale or exchange, liquidation, redemption, gift, transfers, etc. Persons purchasing U.S. real property interests (transferees) from foreign persons, certain purchasers’ agents, and settlement officers are required to withhold 15% (10% for dispositions before February 17, 2016) of the amount realized on the disposition (special rules for foreign corporations).
In most cases, the transferee/buyer is the withholding agent. The transferee/buyer must find out if the transferor is a foreign person. If the transferor is a foreign person, the transferee/buyer may be held liable for the tax.
The IRS provides exemptions from the 15% withholding tax in specific situations including the sale of the property for proceeds less than $300,000 USD where the property will be used for personal use purposes. A reduction in withholding tax to 10% pertains to sales of less than $1,000,000 and where the property will be used for personal use purposes.
Typically the buyer and agent will require that the seller prepare and submit Form 8288-B – Application for Withholding Certificate. This must be done on the day prior to, or the day of transaction closing. It is important to note that there may be a U.S. income tax obligation payable to the IRS as a result of the sale transaction, which is determined with analysis of the proceeds of disposition less adjusted cost base. If Form 8288-B is submitted and accepted by the IRS (usually takes 90 days to process), then the 15% tax can be recovered prior to filing a U.S. income tax return. Ultimately if you owe taxes, the IRS will charge past due interest beginning on the 21st day after the closing date of the transaction.
Form 8288 and Form 8288-A are also required. The tax withheld on the acquisition of a U.S. real property interest from a foreign person is reported and paid using Form 8288. Form 8288 also serves as the transmittal form for copies A and B of Form 8288-A, Statement of Withholding on Dispositions by Foreign Persons of U.S. Real Property Interests. Generally, you must file Form 8288 by the 20th day after the date of the transfer.
ITIN application for property sales
The U.S. property sale by a Canadian requires an ITIN. Owners of rental properties would have obtained this at the time of purchase, or when the property was converted from personal use to property rental. Owners of personal use who sell their property have U.S. tax filing obligations, and as such, are required to have an ITIN. The ITIN application can be submitted prior to filing a U.S. income tax return, as it meets one of the IRS’ prescribed exceptions. However, to complete the application, Form 8288, Form 8288-A and Form 8288-B must be submitted along with Form W-7 and the other supporting documents.
Schedule D – Capital Gains and Losses
This is relevant to rental property owners, and personal use properties. The sale of real property in U.S. is a reportable transaction, which includes a capital gain or loss. Capital transactions are reported on Schedule D which details and calculates the capital gain or loss on the sale. Proceeds of sale are compared to the adjusted cost base. The difference is the gain or loss. U.S. capital tax is based on several parameters including short-term (held for less than 1 year), and the adjusted gross income (AGI) of the taxpayer. Specific tax rates are then applied to the gain / loss typically ranging from 0% to 15%. U.S. capital losses are limited to $1,500 in year, but can be carried forward into future years.
IRC Section 1031 – Rollover of Property Rental sale into like business
This is relevant to rental property owners. The U.S. allows the gain on sale of a business (which includes rental properties) to be ‘rolled over’, and the tax on the gain deferred until a future point in time. There are numerous stipulations and requirements including;
- 45 day time limit from the date you sell the relinquished property to identify potential replacement properties. The identification must be in writing, signed by you and delivered to a person involved in the exchange like the seller of the replacement property or the qualified intermediary.
- The replacement property must be received and the exchange completed no later than 180 days after the sale of the exchanged property or the due date (with extensions) of the income tax return for the tax year in which the relinquished property was sold, whichever is earlier.
- Use of a qualified intermediary – Sellers cannot touch the money in between the sale of their old property and the purchase of their new property. By law the taxpayer must use an independent third party commonly known as an exchange partner and/or intermediary to handle the change.
There are many other considerations with section 1031. However, it might be an option to consider in advance of a rental property sale if the intent is to invest in a similar property. Note that Canadian tax laws do not include this type of tax deferral of a business located in the U.S.
Form 4797 – Sales of Business Property including real property and depreciable property
This is relevant to rental property owners. Form 4797 is required to be filed by property rental owners to recapture depreciation expensed on the rental property over the years. Recaptured depreciation is included as part of the adjusted cost base on Schedule D which in turn is reported on Form 1040NR – Line 14.
Schedule E – Supplemental Income and Loss
This is relevant to rental property owners. The sale transaction triggers the inclusion of unused and accumulated rental losses from the previous 20 years as detailed in Form 8582.
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 are tax deductible. 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.
- Sale of rental unit:
- Capital Gain / Losses – 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 in the U.S. 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 selling 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 CPA, CGA, Partner
Edelkoort | Smethurst | Schein CPAs LLP is located in Burlington Ontario servicing the Golden Horseshoe and Greater Toronto Area and beyond. The firm is fully licensed with CPA Ontario to provide assurance, tax and accounting services as well as registered as tax preparers with the Canada Revenue Agency (CRA) & Internal Revenue Service (IRS). Derek Edelkoort of Edelkoort | Smethurst | Schein CPAs LLP is an IRS Certified Acceptance Agent.
All blog posts published on this site are for informational purposes only and do not constitute professional advice. Readers should contact a professional to discuss their individual situation. Neither the author or the accounting firm shall accept any liability for any reliance placed on the information posted.