Introduction
Investing in real estate across international borders can be a lucrative opportunity, especially for Canadians looking to own property in the United States. However, along with the potential rewards, there come several tax implications that need careful consideration.
In this article, we will explore the U.S-Canada cross-border tax implications of owning real estate in the U.S. for Canadians. From understanding rental income treatment and filing requirements to deductions, tax returns, and potential penalties, we’ll cover all you need to know to navigate this complex tax landscape.
US TAX IMPLICATIONS OF U.S. RENTAL INCOME:
Treatment of Rental Income in the U.S.
One of the primary concerns for Canadians owning U.S. real estate is how rental income is treated in the U.S. tax system. As a Canadian resident, if you own or have an interest in real estate properties in the US, such as condominiums, apartments, or residential homes that you rent out for all or part of the year, you will be liable to pay US income tax on the rental property.
FDAP Income
FDAP Income stands for Fixed, Determinable, Annual, Periodical Income and encompasses a wide range of income sources that are fixed in amount and paid from time to time in regular or irregular intervals. This includes income such as rents, dividends, interest, wages, and other forms of remuneration.
Withholding Tax on FDAP Income
A non-resident alien (NRA) is liable for a flat tax rate of 30% on all U.S. source FDAP income that is not effectively connected with the NRA’s US trade or business. The tax is withheld by the payor and remitted to the IRS. Consequently, FDAP tax is commonly referred to as FDAP due to this withholding mechanism.
Effectively Connected Income (ECI)
Income sourced in the U.S. and effectively connected with a US trade or business is subject to taxation on a net basis using graduated income tax rates and no tax withholdings, unlike FDAP income, ensuring a fair and equitable approach.
May the US Rental Income be FDAP?
Rentals of US real estate on a “net lease” basis, in which the tenant assumes the responsibility for the majority, if not all, of the ownership costs like taxes, insurance, and repairs, are not considered to be generated by a US trade or business. Consequently, they are classified as FDAP.
Rental income sourced in the U.S. is subject to a 30% federal income tax, without any allowance for expense deductions. The tenant or property management company in the U.S. must withhold 30% of the rent throughout the year and submit this amount to the Internal Revenue Service.
From a US tax perspective, Canadians are considered as non-resident aliens (NRAs). When they occasionally, rather than regularly, rent out US real property. In such cases, there is a certain level of risk that these rentals may be classified as Fixed, Determinable, Annual, or Periodical (FDAP) income.
Federal Election To Treat the US Rental Income as ECI
The U.S. Internal Revenue Code 871 includes a provision for a special election that allows taxpayers to be taxed on their net real property income, rather than on a gross basis. It’s important to note that this election only applies to real property income and does not encompass other sources of income, such as FDAP.
By taking advantage of this planning opportunity, taxpayers can mitigate the risk of the potential FDAP treatment of their real estate income, ensuring a more favorable tax outcome.
Why and how the election is filed?
If this election is made, the tenant or property management company will no longer be obligated to withhold and remit 30% of the rent for US taxes. This election can be made through the U.S. Federal 1040NR return or by filing the form W-8ECI – Certificate of Foreign Person’s Claim That Income is Effectively Connected With the Conduct of a Trade or Business in the United States. It is important to provide this form to the property management company or tenant to ensure that you receive your full rent payment without any tax withholding.
Validity of the Election
To make a valid election, ensure that the following information is included: a clear statement declaring the election, the relevant section of the code, the property address, your percentage of ownership, a description of any significant property improvements, and any relevant details regarding previous elections or revocations of the net income election.
This election remains in effect indefinitely and applies to all future tax years. While it may not be necessary to make the election annually, it is important to file Form 1040 NR each year to report income, expenses, and any tax withheld. Revocation of the election is only possible under limited circumstances and requires approval from the IRS.
Some states do not acknowledge the federal election for net income taxation, which may necessitate the payment of withholding tax to the state.
Relief for Canadians
Canadians can file this election to treat the US rental income as income that is effectively connected with the conduct of a US trade or business. This election would permit the Canadians to deduct the expenses incurred in connection with the rental property during the rental period, so that you would only pay US tax on the net rental income at the regular graduated rates applicable in US.
Deductions from US Rental Income
Fortunately, the U.S. tax system allows for deductions that can help reduce the tax burden on rental income. Some common deductions allowed in computation of net income from U.S. real estate rentals are as follows:
- Real estate (property) taxes
- Insurance
- Condominium fees or Homeowner’s association (HOA) fees
- Utilities
- Depreciation on straight line basis (mandatory for U.S. tax purposes. Any portion not claimed annually can be disallowed by the IRS)
- State income taxes
- Legal and other professional fees
- Repair and maintenance costs
- Mortgage Interest and/or other interest
Depreciation on US real estate is mandatory on annual basis for U.S. tax purposes. Any portion not claimed annually can be disallowed by the IRS in future or upon sale of that property.
If a Canadian owner uses a real estate property as a residence and also rents it out, they can fully deduct real estate taxes and interest. However, other deductions will be limited based on the proportion of days the property is rented. However, If a residence is rented for less than 15 days in a calendar year, there is no tax due on the rental income.
Filing Requirements
US Federal 1040NR Income Tax Return(s)
As a Canadian owner of U.S. real estate, you are required to file a U.S. federal 1040NR non-resident income tax return to report any rental income or loss on annual basis.
There is a common misconception among some Canadians that they are exempt from filing this return if they experience a net rental loss from their U.S. property. However, this is not accurate. In accordance with U.S. tax regulations, any rental loss from the U.S. is temporarily suspended and carried forward until there is future net rental income or the property is sold. Failure to file the return would result in the loss of the rental loss, which cannot be utilized to offset future income or gains from the sale of the property.
If Canadian husband and wife jointly owns a U.S. real property, they are required to file their 1040NR returns separately to report 50% of rental income and expenses.
US IRS Individual Taxpayer Identification Number (ITIN#)
Non-resident aliens filing US 1040NR returns must first obtain an ITIN# from the IRS. The ITIN# has an expiration date and requires periodic renewal to remain valid.
Canadians can request the US ITIN# by submitting the W7 application form and certified true copy of Canadian Passport that they can request from nearest passport Canada office.
State Income Tax Return(s)
In addition to US federal 1040NR income tax return(s), U.S. state income tax return is also required to be filed annually for the state in which U.S. real estate property is located. States income and other tax rules can vary widely. Therefore, it’s essential to understand the specific tax requirements of the state in which your U.S. property is located.
For example, state of Hawaii also requires Canadians to obtain the Hawaii general excise tax (GET) and file annual excise tax returns for rental income from Hawaii state real estate property.
Canadians who are timeshare owners may also be subject to transient accommodation tax (TAT)
Due Date for US 1040NR Return
The deadline for filing the 1040NR return is typically June 15th of the year after the calendar year. If there are no taxes owed, it is possible to submit the form after the due date.
However, please note that the net income election will generally only be valid for the specific year if the return is filed no later than 16 months after the original due date.
Late Filing Penalties and Consequences
Deadline for filing the 1040NR return is typically June 15th of the year after the calendar year. If there are no taxes owed, it is possible to submit the form after the due date.
However, please note that the net income election will generally only be valid for the specific year if the return is filed no later than 16 months after the original due date.
US Estate Tax
Canadians who pass away while owning property in the US, known as US situs property, may be liable for U.S. estate taxes upon their death. This applies if the total value of all US situs properties, including US real property and US stocks/bonds, exceeds USD$60,000 at the time of death. In such cases, it is necessary for these Canadians to file the form 706-NA – United States Estate (and Generation Skipping Transfer) Tax Return Estate of Non-Resident Not a Citizen of the United States and pay the US estate tax due if any.
The U.S.-Canada Tax Convention (1980) offers certain treaty benefits to help offset the US estate tax with the Unified Credit. To claim these benefits, it is necessary to file the forms 706-NA and 8833 – Treaty Based Return Position Disclosure.
CANADIAN TAX IMPLICATIONS OF U.S. RENTAL INCOME
Treatment of Rental Income in Canada
In Canada, any income earned, including rental income from U.S. properties, must be reported on your Canadian tax return. However, the Canada-U.S. Tax Treaty helps prevent double taxation by providing a foreign tax credit for taxes paid to the U.S. on rental income. This credit helps offset the Canadian tax liability, ensuring you aren’t taxed twice on the same income.
For Canadian tax purposes, rental losses from U.S. residential property can be deducted in the year they are incurred, provided they are reasonable in relation to property management, maintenance, and location of that property. The Canada Revenue Agency (CRA) may closely examine substantial rental losses to evaluate their reasonableness.
Depreciation or Capital Cost Allowance (CCA) on U.S. real estate property is not mandatory but discretionary for Canadian tax purposes. Given the relatively higher tax rates in Canada compared to the U.S., it is generally more advantageous to refrain from claiming any depreciation/CCA in Canada. This approach helps maintain a higher cost basis and ultimately resulting in a reduction of the tax on capital gains realized when the property is sold.
Filing Requirements
Canadian T1 Income Tax Return
As a Canadian owner of U.S. real estate, you are required to file the T1 income tax return and report the rental income and expenses from U.S. real estate property on form T776 – Statement of Real Estate Rentals. Bank of Canada’s US-Canada average exchange rate for tax year will be used to translate all amounts in USD to CAD.
If there is any net US federal and/or state income tax owing, a foreign tax credit can be claimed on the T1 return using the forms T2209 – Federal Foreign Tax Credits and T2036 Provincial or Territorial Foreign Tax Credit.
Form T1135 – Foreign Income Verification Statement
Canadians who own foreign properties, including U.S. real estate, with a total cost of more than CAD $100,000 must report these holdings on Form T1135, the Foreign Income Verification Statement. This form aims to provide the Canadian government with information about foreign assets owned by Canadian residents. It’s crucial to accurately complete and file this form to avoid penalties.
It is recommended that Canadians owning real estate property in the United States should consult with a tax professional who is familiar with the tax laws in both Canada and the US including the US-Canada Tax Treaty to ensure that all filing requirements are met and to take advantage of any available tax planning opportunities.
Raj Pandher is a qualified CPA (cross border tax accountant), an associate member of Society of Trust and Estate Practitioners (STEP) Canada and a Certified Executor Advisor (CEA) who assists the U.S. citizens living in Canada with their U.S. income tax return filing including foreign information return reporting.
