The long, long arm of the tax man

National Post

2007-08-04


Your vacation property may be located beyond Canada's borders, but that doesn't mean that it is outside the reach of the tax man.

As a resident of Canada, you are taxed on your worldwide income. When you dispose your property you could have a capital gains tax liability on its appreciation from the date you bought it until the sale. If you own the property at death, you are deemed to dispose of it at fair market value. Any of these scenarios might pose a significant tax problem.

First, let's deal with worldwide income. If you are like many vacation-property owners, chances are that you rent or at least try to rent your property when you are not occupying it. If so, any rental income after deducting the appropriate expenses is taxable in Canada.

The unique problem with foreign rental income is that the country in which the property is located may also tax rental income, potentially resulting in double taxation. The good news is that you can generally claim a credit for any foreign tax paid on your Canadian return. You may end up paying the higher tax rate, but that is still better than paying tax twice.

Some countries, such as the United States, may impose a withholding tax on the gross rental income (pre-expenses), which must be deducted by the rental agent or tenant before paying you the rent.

As surprising as that may sound, Canada has a similar rule, generally requiring a Canadian tenant to withhold 25% of gross rental income paid to a non-resident. There was a 2003 tax case involving a tenant who failed to report such tax withholdings to the CRA. The CRA successfully argued before the court that the tenant was "deemed to know the law... Ignorance of the law is no excuse."

The U.S. withholding tax, set at 30%, can be avoided if you file a special tax form to have the rental income "effec-tively connected" to the U.S. This is done by sending the Internal Revenue Service a letter attached to Form 1040NR -- U.S. Nonresident Alien Income Tax Return. On this return, you will report your rental income after expenses and will be taxed at graduated U.S. tax rates. Details can be found in the IRS Publication 519, Tax Guide for Aliens (www.irs.gov/ pub/irs-pdf/p519.pdf).

When disposing of foreign property, if you sell it for a profit the capital gain is taxable in Canada. However, the same gain may be taxable in the country in which it arose. Again, a foreign tax credit is generally available and you'll end up paying the higher tax rate. If your vacation home is in the U.S., you may find that the purchaser is obligated to withhold 10% of the proceeds, which you would then claim as a credit against any capital gains tax owing when you file a U.S. return.

Finally, if you die owning your vacation property, Canada's tax rules consider you to have sold it for proceeds equal to fair market value, which can give rise to Canadian capital gains tax. The country in which the property is located may also impose a capital gains tax or, as is the case in the U.S., may impose an estate tax based not merely on the apprecia-tion of the property but on the property's full fair market value. While a foreign tax credit may be available, the U.S. estate tax can often be considerably more than any Canadian taxes paid on the gain.