If you’re a Canadian who owns U.S. residential real estate, now may be a good time to ensure you are compliant with U.S. tax laws as the U.S. Internal Revenue Service may soon be cracking down on non-compliant foreign property owners as a result of a critical report issued last week by the Treasury Inspector General for Tax Administration (TIGTA).
TIGTA reports directly to the U.S. Treasury and is charged with providing independent oversight of IRS activities. Its report looked at property ownership by non-residents and concluded that “additional controls are needed to help ensure that non-resident alien individual property owners comply with tax laws.”
The report estimated that non-resident alien individuals’ investment in U.S. property increased from US$34.8 billion during the 12-month period ending March 2013 to US$43.5 billion during the 12-month period ending March 2016. The audit conducted by TIGTA was initiated to evaluate the IRS’s efforts in identifying and addressing non-resident alien individuals who should be paying tax on rental income of U.S. property.
If you are like many U.S. vacation property owners, chances are that you either rent or at least attempt to rent out your property when you are not occupying it. If so, the rental income that you earn may be taxed in both the U.S. and Canada.
In Canada, we pay tax at graduated federal/provincial tax rates on worldwide income, including net rental income from a U.S. property, after deducting applicable expenses. You can generally claim a foreign tax credit on your Canadian tax return for the U.S. income taxes that have been paid to reduce the tax that will be payable in Canada.
For U.S. tax purposes, a 30 per cent U.S. withholding tax applies to gross rental income that you earn from your U.S. property. The tenant of your property is required to withhold the tax and remit it to the U.S. tax authorities on your behalf.
You may, however, elect to have the rental income treated as “effectively connected to a U.S. trade or business.” By making this election, non-resident aliens (generally non-U.S. citizens) can reduce their rental income by offsetting rental income with the various expenses associated with the rental activity, such as property taxes, insurance, etc. The net rental income will be taxed at graduated U.S. federal tax rates. State income taxes may also apply.
TIGTA’s report looked at non-resident alien individuals, such as Canadians, who both own and derive rental income from U.S. residential real estate. The report found that, currently, the IRS does not ensure that these foreign taxpayers properly make the necessary election required before being allowed to pay tax on a net basis rather than on the gross rental income. As a result, TIGTA observed that taxpayers who don’t comply with the tax law end up receiving the same tax benefit as those who do.
By reviewing a random sample of non-resident aliens who rented their U.S. property in 2013, TIGTA found that just over two-thirds of them (68 per cent) reduced their gross rental income when reporting their rental activity without complying with the technical, legal requirement of applying for this tax benefit by submitting an election statement. As a result, the U.S. government is missing out on millions of dollars in withholding when the results of the audit are projected to the population.
The report also found that some non-resident aliens are not reporting any rental income from U.S. property they own. From the sample drawn from foreign property owners in five U.S. counties, TIGTA identified foreign property owners who appeared to have failed to report and pay tax on rental income they earned (13 per cent of foreign property owners sampled).
To solve this, TIGTA recommended that the IRS improve compliance checks for ensuring that election statements are made. In response, the IRS agreed to revising Form 1040NR, U.S. Nonresident Alien Income Tax Return for non-resident aliens to make the election. The IRS will also be revising its processing procedures to ensure that the election is recorded.
And, of most concern to non-compliant Canadian landlords, the IRS also agreed to develop a compliance initiative addressing foreign property owners who do not report rental income generated by real property they own in the U.S.
Note that even if you don’t rent out your property, when you sell it, you may face a tax bill in both Canada and the U.S. on any appreciated value. A capital gain arises if the proceeds from disposition, net of selling expenses, exceed the cost of the property, including any amounts paid for capital improvements.
Currently, the maximum U.S. federal long-term capital gains tax rate is 20 per cent. You would pay the long-term capital gains tax rate provided you owned the property for more than one year prior to sale. If you owned the property for one year or less, graduated U.S. federal income tax rates (with a top rate of 39.6 per cent) would apply to short-term capital gains. State taxes may also apply.
In the U.S., the purchaser is generally required to withhold 15 per cent of the gross proceeds when the seller is Canadian. (If the purchaser acquires property for use as a residence, no withholding is required when the proceeds of sale are under US$300,000 and a 10 per cent rate applies for proceeds up to US$1 million). You may apply to the IRS for a withholding certificate that would allow withholding taxes to be reduced or eliminated, such as when the ultimate income tax liability is expected to be less than the withholding amount. You may generally claim the withholding tax as a credit against any tax owing when you file a U.S. tax return.
For Canadian tax purposes, the disposition of your U.S. property must also be reported on your Canadian tax return, taking into account any foreign currency changes on calculation of the capital gain or loss. The gain is 50 per cent taxable at your marginal tax rate and you can claim a foreign tax credit for any net U.S. tax paid on the capital gain to reduce your Canadian liability so you don’t end up paying tax twice.
While you are allowed to claim the principal residence exemption (PRE) to reduce or eliminate any Canadian capital gains tax, if you own more than one appreciated residence you may be better off saving it for when you sell your Canadian home, otherwise you won’t get a foreign tax credit for any U.S. taxes paid, which are non-refundable.