Recently my wife and I attended my niece's wedding in southern California.
It was February and the location was intended as part escape from winter cold and part functional locale for the happy couple.
We were near a beautiful beach and spent most of our spare time there, walking its shores and enjoying the relatively mild temperatures, ranging from 20 to 29 Celsius.
I thought I was an ice-hardened Canadian, but the cool ocean breezes kept me for the most part fully clothed and out of the water.
It was those visiting from the winter states who were bravest in the midst of the blowing mists, many of them stripping down to spandex and wrestling the waves like gleeful children in a big wet sandbox.
Each year, many Canadian snowbirds escape the long and cold winter by flocking to popular warm climate destinations in the U.S. such as Florida, Arizona and California. While some snowbirds choose to rent their vacation or retirement home in the south, others choose to purchase their own U.S. real estate property.
Purchasing your own property has its advantages; however you may be surprised by the numerous tax requirements and other considerations that can substantially increase the complexity of owning real estate in the U.S.
This series of articles will discuss the U.S. tax implications for Canadian owners renting or selling their U.S. real estate and will highlight key estate planning considerations.
The information provided is based on direct U.S. real estate ownership by Canadian individuals who are not U.S. citizens, green-card holders or residents and who are not engaged in a U.S. trade or business. This article was not written to address all the considerations for ownership in more complex ownership structures.
Tax on rental income from U.S. property
A Canadian resident earning rental income from U.S. real estate must comply with relatively complex U.S. income tax laws and reporting requirements. A Canadian may choose one of the following two options:
Option 1 - Pay 30 per cent withholding tax on gross rents.
You can choose to have the gross rental income you earn taxed at a flat 30 per cent U.S. withholding tax and not have to file a U.S. income tax return. This option is simple and you avoid the cost of preparing a U.S. income tax return. However, if you choose this option, you cannot deduct any rental expenses in determining your U.S. tax obligation. Since this option generally results in a higher overall cost than Option 2 it may not be the most appropriate option economically.
Also, while you do not have to file a U.S. income tax return, you will still need to file a Canadian return. For Canadian tax purposes, regardless of whether you choose Option 1 or 2, you are subject to Canadian tax on the net rental income.
You will need to report the gross rental income and related ordinary expenses on your Canadian income tax return. You can claim a foreign tax credit for the U.S. tax you paid to reduce or eliminate double taxation. It is possible that the foreign tax credit will not allow you to recoup the full 30 per cent U.S. withholding tax paid.
Option 2 - pay tax on a net rental basis.
Alternatively, you can elect to file a U.S. non-resident income tax return (Form 1040 NR) and pay tax on a net rental basis without being subject to the withholding tax. This election to file annually is a permanent election and can only be revoked in limited circumstances.
Similar to the Canadian rules, you can deduct expenses such as property taxes, mortgage interest, insurance, management fees and utilities to determine your net rental income. U.S. tax laws also impose a mandatory deduction for depreciation.
There are special rules regarding the ability to claim rental losses. Those losses that cannot be claimed in the current year can be carried forward and potentially used to offset rental income in future years and capital gains if the property is sold.
The benefit under this option is that your net rental income amount is subject to U.S. tax at your marginal tax rate, which will likely be substantially lower than the amount of withholding tax you would otherwise have to pay.
As in Option 1, you must report the net rental income on your Canadian tax return. You will be able to claim a foreign tax credit which will likely be sufficient to recoup all of the U.S. tax paid thus eliminating double tax. This option may result in a lower overall cost than Option 1 even if you must pay tax return preparation fees.
If you elect to file on a net rental basis you are required to complete 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. You should submit this form to your tenant or to a U.S. agent, not to the Internal Revenue Service (IRS). You are also required to file a U.S. non-resident tax return that includes completing and attaching Schedule E - Supplemental Income and Loss. The U.S. return must be filed even if the net rental calculation results in a rental loss.
The information in this article is not intended to provide legal or tax advice. Readers should obtain professional advice from a qualified cross-border tax advisor before acting on any of the information in this article.
Mark Ryan is an advisor with RBC Wealth Management, Dominion Securities, (member CIPF) and can be reached at [email protected] or 250-960-4927.
