Vacation property taxing affair; Gifting asset to next generation not optimal
With much of Canada suffering from freezing cold temperatures in the past few days, and winter fast approaching, the thoughts of vacationing somewhere warm may be tempting you to snap up that Florida or Arizona property you have been tempted to buy for so many years.
But before you dive into the U.S. real estate market, keep in mind that just because your vacation property may be located beyond Canada's borders, it doesn't mean that it's outside the reach of the tax authorities. If you're Canadian, there are a few situations that could trigger a tax bill in conjunction with your U.S. property.
If you're like many vacation property owners, you may be inclined to rent out your property when you are not occupying it. If you do so, you should consider filing a U.S. tax election to have the rental income treated as income from a U.S. business and thus avoid a 30% U.S. withholding tax that would otherwise be taken off your gross rental income before you receive your cash. By electing, you can instead report only your net rental income, after applicable expenses, on an annual U.S. income tax return and have the income taxed at graduated U.S. tax rates. Although net rental income from your U.S. property is also taxable in Canada, the good news is you won't pay tax twice since you can generally claim a foreign tax credit on your Canadian tax return for the U.S. income taxes paid.
If you sell your U.S. vacation property, there may be tax on the capital gain in both Canada and the U.S. The U.S. federal tax rate on capital gains is significantly lower for property that has been owned for more than one year than for property held for a shorter duration. In the United States, the purchaser is generally required to withhold 10% of the gross proceeds when the seller is Canadian. To avoid this withholding, consider applying for a certificate allowing the withholding tax to be reduced or eliminated in certain circumstances. A U.S. taxpayer identification number will also be required. In Canada, 50% of any capital gain is included in your taxable income and you can claim a foreign tax credit for the U.S. capital gains tax paid when calculating the net Canadian tax owing.
Instead of selling your property, you may be tempted to gift it to the next generation to keep the property in the family. This is often not advisable since the gift could be subject to U.S. gift tax based on the property's fair market value at the time of gift as well as be subject to Canadian capital gains tax on an increase in value from the date of purchase to the date of gift. Since the U.S. gift tax is not creditable on your Canadian tax return, you could end up paying double tax.
Dying with it
Finally, if you die owning a U.S. vacation property, for Canadian tax purposes, you are deemed to dispose of the property at fair market value, which could result in a taxable capital gain. Under the U.S. rules, instead of a deemed disposition and tax on the accrued gain (if any), U.S. estate tax may be levied at rates up to 40% of the property's fair market value. The good news, however, is that unless you are extremely wealthy such that your total worldwide estate (i.e. the value of both your U.S. and non-U.S. assets) is greater than US$5.34 million at the time of your death, you won't have to pay any U.S. estate tax.
If you have a large enough estate such that U.S. estate tax is a concern, be sure to check with a cross border tax lawyer or accountant before buying your property as it can sometimes be difficult to do any necessary planning after you've already closed your deal.