First and foremost, a Canadian should not create an LLC to acquire FL real estate, or any US real estate for that matter. This is the biggest mistake Canadians make as they fall prey to local advisors who have promoted the LLCs as the best vehicle to do business in the US or own real estate. This is true if you are a US resident but not in Canada as LLCs are treated differently in Canada vs the US and the potential for double taxation is real.
There could be a potential for US estate tax exposure of up to 40% of the value of the US real estate on death of the Canadian while owning US real estate. However, after the changes to the US tax law effective in 2018, if the Canadian’s worldwide net worth (including the US real property) is no more than USD11.2M (this is the 2018 threshold or exclusions from estate tax which is adjusted yearly for inflation and is extended to Canadians under the Canada-US Treaty), then the US estate tax should not be an issue although a US estate tax return must still be filed to clear the title. The threshold is doubled if the Canadian is married and transfers the US property to the non-US spouse on death. This is just a rule of thumb to follow. These thresholds are only good until the end of 2025 after which the exclusions would revert back to current law (unless there are changes), which is USD5.6M in 2018 (subject to inflationary adjustments) prior to the Trump Tax Reform. This is doubled for transfers of property to a non US spouse. Gifting US property during one’s lifetime creates double taxation in the US and Canada.
If the intent is to occupy the Florida real estate as a vacation home and spend much of the warmer months in Florida to avoid the harsh winters in Canada, the Canadian has to be careful about staying in the US for 183 days or more in any calendar year to avoid becoming a US resident for tax purposes. Although the Canada-US Treaty will protect the Canadian from being taxed as a US resident if the threshold is reached, the US will require a long list of information returns to report ownership in certain Canadian entities and investments, which is a compliance nightmare and may be very costly. The 183 day rule should not be confused with the immigration rule that Canadians may visit the US for up to six months within a 12 month period. Remaining in the US from July 1 to December 31 (184 days) in every calendar year may be permissible from an immigration perspective but this would cause the Canadian to be subject to US reporting requirements as a deemed US resident.
Even if the 183-day test can be avoided, the Canadian “snowbird” can still be a deemed US resident if the “substantial presence test” is met in the US which is based on a formula involving a 3 consecutive year rolling average of US presence. The US will count 100% of the current year (only if the Canadian was present in the US for at least 31 days), 1/3 of the year prior and 1/6 of the 2nd year prior to the current year and if the number of days add up to at least 183 days, then the Canadian is a deemed resident of the US only for tax purposes. For example, if the Canadian was in the US for 130 days in 2017, 125 days in 2016 and 120 days in 2015, the Canadian is all of a sudden a US resident under the “substantial presence test”. He would have 192 days in the US which is the sum of 100% of 2017 (i.e. 130 days), plus 1/3 of 125 days in 2016 (i.e. 42 days) plus 1/6 of 120 days in 2015 (i.e. 20 days). Again, the rule of thumb is to limit the stay in the US to less than 121 days in any calendar year. If the 183 day is met but the Canadian is not in the US in the current year (2017 in this example) for at least 183 days, then the Canadian can rely on the “closer connection exception” in the US which essentially provides that for as long as the Canadian can prove stronger ties to Canada vs the US, the Canadian will not be treated as a US resident. In order to benefit from the “closer connection exception”, the Canadians needs to file US Form 8840, Closer Connection Statement for Aliens, which is due June 15 following the end of the calendar year.
If the Florida real estate is to be rented out, the Canadian will have US filing requirements, even if the property is generating losses. A common misconception among Canadians is that no US tax return is required if there are losses. This is incorrect in that the IRS either requires a 30% withholding tax against rents (without the benefit of deductions) paid to the Canadian, or a filing of a US nonresident tax return that is due June 15 following the end of the calendar year in order to claim expenses and any resulting losses. Without a US nonresident tax return, the gross rents are subject to a 30% tax that is required to be withheld by the tenant or the payor of the rent. More importantly, when the US real property is sold, generally, 15% of taxes have to be withheld from gross proceeds regardless of whether the property is a vacation home or rental property. The 15% is a temporary tax and all or some can be recovered when a US nonresident tax return is filed the following year. The Canadian can elect to reduce the withholding tax by applying for a “clearance certificate” with the IRS, to limit the withholding tax to the maximum rate of tax applicable to the gain, if any. The application has to be made before closing of the sale.
Are you considering a relocation which involves the US? If so, you should be aware of the changes to the rules for the moving expense deduction and the treatment of moving expenses which are reimbursed by your employer. Public Law 115-97 (“HR.1”), formally known as “an Act to provide for the reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018”, formerly known as Tax Cuts and Jobs Act, has suspended the moving expense deduction, which was previously available to individuals for taxable years 2018 through 2025.
Whether you are an American expatriate abroad or if you’re considering a move to or from the US, the recent changes should be considered carefully before deciding whether to accept an offer of employment. Conversely, if you are an employer you will need to recalculate the cost of offering relocation benefits as part of an employment offer or transfer package.
Under the tax rules applicable to 2017 and before, qualifying a moving expense could be deducted against an employee’s income provided all three tests were met.
- The moving expense must be incurred within one year of the date on which you first report to work at the new location;
- The new workplace must be at least 50 miles farther from your old home than your old job location was from your old home. If you had no previous workplace, your new job location must be at least 50 miles from your old home; and
- After relocating, the taxpayer must be employed full-time at the new job for at least 39 weeks during the first 12 months immediately following the arrival in the new location. There are exceptions to the time test, such as members of the armed forces moving due to a military order, seasonal workers, temporary absences from work including vacation and holidays, illness, and strike.
An employer had the option to reimburse an employee for qualified moving costs, which passed the expenses to the employer for who would then be permitted to deduct the expenses for corporate tax purposes. The relocation benefit was not taxable to the employee, provided the expenses were paid or reimbursed in respect of a qualifying moving expense, and a deductible expense for the employer.
As of January 1, 2018, moving expenses are no longer deductible for individuals. Furthermore, any moving expense paid to or on behalf of the employee will be considered a taxable benefit. An example of a family of four, with adjusted gross income of $175,000, relocating from the US to an international location at the request of the employer:
|Before HR.1||After HR.1|
|Employee tax (24%) – paid by employer *||–||3,789|
|Taxable wages – employee||–||15,789|
|Moving expense deduction||–|
*This is at the option of the employeer and therefore the tax resulting from the taxable benefit may not be covered by te employer.
Relocation is an expensive venture. Now that the cost of moving is no longer a deductible expense under HR.1, the decision to take a position that requires relocating may involve more thought. Look at the dollars and cents or ask a professional. Planning before you accept the job could save you a lot of money.
RENTAL INCOME REPORTING
As a Canadian resident investing in Canadian real estate, you will have to report your worldwide income to the Canada Revenue Agency (“CRA”). This includes rental income from Canadian real estate. The CRA allows deductions for related expenses, such as insurance, mortgage interest, property taxes and repairs. A deduction for tax depreciation (capital cost allowance or CCA) on the property, excluding land, is also available. While claiming CCA cannot create a rental loss, which is deductible against other sources of income, it may reduce the net rental income to zero.
If you are a non-resident read this post.
PRINCIPAL RESIDENCE ELECTION
The deemed disposition recognized at the time the change in use occurs is automatic. However, an election may be filed, under subsection 45(2) of the Income Tax Act, with the tax return in the year that the change occurs. By making the election, the change in use from a “personal use” property to an “income producing” property is deemed to occur with no immediate deemed disposition, meaning there is no taxable event recognized at that time. This election may preserve your right to designate the property as a principal residence for up to 4 years. If the election is made, CCA is not permitted to be claimed in any year. Claiming CCA will make the election invalid.
Planning should be undertaken to determine which option makes sense as there are a lot of factors which must be considered.
RENTING A PRINCIPAL RESIDENCE
The rental property may be a home previously used as your primary residence. There are tax consequences when you change the use of the property from a personal use property to an income producing property. At the time, when you begin renting the property or the property is available for rent, a deemed disposition of the property is considered to occur. This means that you are required to report the disposition of your principal residence at fair market value. If you have not previously designated a property as a principal residence for the period over which the property was owned, you may be eligible for the principal residence exemption to recognize the deemed disposition on a tax-free basis.
RENTING A PORTION OF YOUR HOME
Many Canadians chose to use their principal residence as an investment property to generate rental income. However, there are tax consequences when you change the use of your home from a personal use property to an income producing property. At the time, when you begin renting the property or the property is available for rent, a deemed disposition of the property is considered to occur. This means that you are required to report the disposition of your principal residence at fair market value. If you have not previously designated a property as a principal residence for the period over which the property was owned, you may be eligible for the principal residence exemption to recognize the deemed disposition on a tax-free basis.
Investing in real estate for the purposes of “flipping” is quite popular. If you are planning to flip properties, the tax treatment may be considered as ordinary income as opposed to capital gains. If you are in the business of buying and selling properties, the profit is taxed as business income. As a result, the capital gains treatment is not available. You will be subject to income tax at the marginal rates, on 100% of the profit.
The determination of the nature of the transaction as income or capital, is very fact based, however, it may be very easy for the CRA and the tax courts to consider “house flipping” to be business income. The courts generally look at the following factors when making the determination:
- taxpayer’s motive;
- nature of the property sold;
- the length of ownership;
- frequency of similar transactions;
- time and effort spent regarding the property and circumstances surrounding the sale of the property
Depending on the level and type of rental revenue, you may have to register and start collecting and remitting the GST/HST.
Accommodations rented for a consecutive period of more than one month are excluded from GST/HST. However, GST/HST would be collected and remitted for commercial rentals and residential rentals where the occupancy period is less than one consecutive month (e.g. Bed & Breakfast, Airbnb, shared accomodations, etc.).
It is important to understand the many aspects of investing in Canadian real estate to ensure you are reporting the income properly as well as paying both income and sales taxes as applicable.
Click here for a downloadable PDF version of this post.
It appears almost 13% of all foreign property owners in various counties of California, Florida, Nevada and Texas aren’t reporting rental income on their US properties. Chances are they aren’t paying the associated taxes on that money either. That is what a recently released yearlong investigation by the Treasury Inspector General for Tax Administration (TIGTA) determined.
The report stated that nonresident aliens (NRAs) living in 5 counties of those 4 states failed to report and pay any taxes on rental income in 2013. If that statistic is assumed for the estimated 5,600 NRA rental properties in those regions, the unpaid taxes could exceed $60mil. The TIGTA feels this is unreasonable. “The IRS should explore the feasibility of obtaining property tax lists through its information sharing partnerships with the states.” The report goes on to add “The IRS recognizes the potential for noncompliance in this area but has not been proactive in addressing the issue.”.
The TIGTA’s audit of the IRS ended in October of 2016 and the subsequent report outlined recommendations for the IRS to develop a compliance initiative which focuses on this underreported revenue. The IRS agreed and set a deadline of Oct. 15, 2018 for implementation.
TIGTA’s review discovered 68% of NRAs had not been complying with proper elections, which means approximately 12,000 individuals violated the rules. The report pointed out that the IRS could assist NRAs, making them aware of proper elections that will benefit them by reducing their tax liability. Since withholding tax on gross rental income for US properties owned by NRAs is 30%, electing to treat this revenue as linked to US trade or business may be wise. Applying associated expenses against the proceeds could also help with the balances due.
The review goes on to suggest the IRS revise the form 1040NR (the Nonresident Alien Income Tax return) to guide NRAs to the proper elections under Section 871(d). “While Schedule E is required to be used by nonresident aliens to report their rental income and expenses, the form instructions do not include any mention of the election requirements… The significant percentage of nonresident alien individuals not attaching election statements to their Form 1040NR may be due to the limitation of the Schedule E instructions.”
The third recommendation laid out by TIGTA suggested the IRS verify withholding credits claimed on Form 1040NR to information in the database created for Foreign Investment in Real Property Tax Act. Researching the NRA’s master file account to verify rental and depreciation calculations was also brought forth. The IRS, however, declined to act on this stating “Absent enhancements to the IRS’s systems that will capture data and automatically verify cost basis, it is not feasible at this time to include a manual verification of cost basis for a potential audit when validating FIRPTA withholding”.
Recent information shows that from April 2015 to March 2016, NRAs accumulated an additional $43.5 billion of US property. This reflects an $8.7 billion growth over the 2013 levels. Seems to me like the IRS should get busy on this issue and capture some of that cash.
Post #6 – How Can HCBT Help
In the previous posts, we outlined:
- tax compliance and reporting issues that S1 & S2 had not dealt with;
- how HCBT could help correct prior year problems / reduce penalty exposure through a VDP submission;
- assist with CofC submissions and the reporting of the property sale;
What we cannot do is eliminate the incremental stress and professional costs of dealing with tax authorities in a time crunch before a pending sale.
What can be learned from this?
There are important triggering life events when every taxpayer should seek appropriate and timely professional advice. In the cross border context, all moves between countries requires professional advice. The tax and financial consequences in both the departure and arrival country must be identified in advance. It is imprudent to assume there are no changes from your current domestic situation or that issues can be reviewed after the move. Often, compliance or planning issues can only be dealt with properly, before the move. Although rare, it is conceivable that a tax / financial issue created by a transfer between countries could be sufficiently important, to rethink the move decision.
In a Canadian domestic context, any change in use of any real estate from personal to rental / business use, creates tax consequences, whether or not properties are sold. Failure to consider these issues in advance could be costly.
HCBT has realized that sharing peoples past tax situations can be a very valuable learning tool to our clients and community. We will continue to publish sanitized client situations in future posts. In the meantime, if you need or know someone who needs our assistance on cross border or other Canadian / US tax issues please contact us.
Post # 5 / Damage Control
In the last post HCBT had recommended S1 & S2 access the Voluntary Disclosure Program [VDP] to possibly reduce the penalty component of their $20,000 tax problem. However, timing was an issue.
CRA public information states that most Certificate of Compliance [CofC] requests will be processed in 30 days. The 30-day target presumes no unresolved prior year issues. After receiving the offer, consulting with the lawyer / HCBT less than 30 days remained before closing date. The CofCs must be presented to the purchaser’s lawyer on closing to avoid withholding from the sale proceeds.
The VDP submission to correct the 2013 to 2015 deficiencies must be completed and submitted before the CofC request. S1 & S2 had to scramble at the last minute to assemble old financial information from 2013 to 2016 so the proper reporting on departure and rental reporting can be completed/submitted. Even with professional help and utilization of the VDP there was a real risk the CofC review would not be completed on time to prevent withholding of sale proceeds. If so, the process could be extended for several months, delaying the tax refund.
S1 & S2 also needed to understand why the sale of their family home was not tax free, which is what most of the Canadian tax paying public thinks. The theory is that 1 family unit [2 spouses plus children under 18] can own 1 family home / principal residence without paying tax on any gains realized on that home. The tax mechanics to accomplish this are based on a formula
Exempt Gain = Total Gain Realized x Principal Residence Years / Total years of ownership
Principal residence years are the years the taxpayer used the property as a family home plus 1 bonus year to allow for mid-year transactions. In most cases the years of usage and the years of ownership are the same, so 100% of the gain is exempt. However, in Expat or rental conversion situations a problem results. Any year after ceasing to be a resident of Canada does not count in the top half of the fraction. S1 & S2 had a change of use to a rental property just after departure. Rental years do not count in the top half of the fraction. The mechanics of the formula are such that the sheltered gain percentage gets smaller with each passing year after departure from Canada.
US Implications: The use of the family home as a rental property and subsequent sale will also have US tax consequences, which are not discussed as part of this series of posts.
If you want to know how HCBT can help, see post # 6.
Post # 4 / Financial Damage Control
In the last post we outlined the tax compliance and reporting issues that S1 & S2 had not dealt with in tax years 2013-2015 inclusive. This created over $20,000 in tax, penalties and interest. Here are the main points of our discussions.
S1 & S2 were primarily concerned with getting the Certificate of Compliance [CofC] so that no funds are withheld from the sale proceeds – they want to submit the CofC request and hope the issues in 2013 to 2015 are not questioned. They were unsure why this process was so onerous when the sale of their family home should be tax free.
HCBT Response: The documentation required to obtain a CofC is quite extensive. The submission form specifically asks the following:
- how the property was used while the owner was non-resident [ e.g., personal use, business use, rental, etc];
- about Canadian tax reports filed for business and rental activities of the property;
- a proforma calculation of the capital gain and/or income earned and the tax owing on the disposition of the property;
CRA essentially conducts a desk audit of S1 & S2 Canadian tax compliance to ensure all required returns / reports have been filed, any tax has been collected, before funds leave Canada. CRA will use S1 & S2’s social insurance number to check all activities that might have a Canadian tax balance owing. With this information it will be obvious to CRA that there are compliance problems in the year of departure and subsequent. If no CofCs are obtained substantial funds will be withheld from the sale and placed on deposit with CRA. S1 & S2 will have to file Canadian personal tax returns to recover the excess withholding. After receiving the returns CRA will do essentially the same desk audit before processing the refund.
HCBT Alternative Approach: CRA has a voluntary disclosure program [VDP] that allows taxpayers to correct prior year tax deficiencies. If certain conditions are met, only the tax and interest must be paid but not penalties. Given that penalties are a significant portion of the $20,000 financial exposure using this program could be of serious benefit to S1 & S2. To be accepted the taxpayer has to voluntarily initiate the corrections before CRA is investigating the taxpayer. Secondly, complete disclosure of all issues is required. The taxpayer cannot selectively disclose tax problems.
If S1 and S2 are going to access the benefits of the VDP they must submit most if not all of the corrective information on the 2013 to 2015 issues before the is CofC submission request is made.
If you want to know how this story ended, see post # 5.
Post # 3 / What Went Wrong – Specifics / Financial Risk Created
In the last post S1 & S2 were dealing with the shock of over $20,000 in tax, penalties and interest plus the possible delay of the sale of the family home. These following compliance deficiencies were identified.
Tax Year of Departure 2013
- S1 did not file prescribed “List of Properties by Emigrant of Canada” to disclose 50% interest in family home plus $75,000 RV personal use property. Penalty for failure to file $2,500;
- S2 did not file prescribed “List of Properties by Emigrant of Canada” to disclose 50% interest in family home plus 1,000 shares of previous employer. Penalty for failure to file $2,500;
- S2 did not file prescribed “Deemed Disposition of Property by Emigrant of Canada” or a tax return to report $55,000 accrued gain on 1,000 shares of previous employer. S2 will owe CRA approximately $4,500 for unpaid tax, late filing penalty, and interest because no return was filed in 2013;
- S1’s return will be adjusted to disallow the spouse credit because S2 revised income exceeds allowable limit. S1 will owe CRA approximately $2,300 for unpaid tax and interest.
Tax Year 2014
Because they were renting their family home on a breakeven basis S1 & S2 did not think they had to report this activity to the US or Canadian tax authorities. For Canadian purposes the gross rental income is subject to non-resident withholding tax of 25%. This should have been remitted to CRA in the month following the rent receipt, unless elective procedures followed and a special rent return is submitted by June 30, 2015. The elective return reports rental income net of expenses and tax is charged at normal Canadian marginal tax rates on the net profit only. Often the tax owing at marginal rates on a net basis, is relatively nominal compared to the 25 % withholding
- No elective procedures or special rental return has been filed. CRA can charge $5,400 [$1,800 per month for 12 months @ 25%] plus interest for late payment;
- S1 & S2 held the property jointly. Both should have elected and filed special rental return on their respective share;
Tax Year 2015
- No elective procedures or special rental return has been filed by June 30, 2016. CRA can charge $5,400 plus interest for late payment;
This looks really bad, if you want to know how Hanson Cross Border Tax helped S1 & S2 minimize the financial damage, see post # 4 next week.