U.S. Tax Filing for Canadians: Renting or Selling U.S. Real Estate

It looks just like yesterday…. After the economic downturn of 2008 and due to the strength of the Canadian dollar, many Canadians took advantage of reduced real estate prices in the United States and purchased properties there. Just a dozen years later, and here we go again – the interest rates are rising, the recession is knocking on our door, the political situation in the world is unstable, the aftermath of Hurricane Ian in Florida is still being dealt with, the housing market is going through an adjustment, and many Canadians are now selling their U.S. real properties. For some, however, this economic downturn may present a good time to invest in the United States real estate market. After all, spending time in a warmer climate is always attractive.

Importance of Tax Residency Planning

Overview

Due to U.S. tax residency considerations and certain U.S. immigration law restrictions, Canadians would typically spend up to four months a year in the United States. Doing so generally allows Canadian snowbirds or temporary visitors to the United States to steer away from being treated as a U.S. tax residents. Some snowbirds spend as much as six months in the United States under a B1/B2 U.S. visa embedded in their Canadian passports without triggering U.S. tax residency. To avoid being treated as a U.S. tax resident under that scenario, however, would require filing Form 8840 to claim a closer connection to Canada (a fairly routine exercise for many experienced snowbirds) or to rely on the Canada-U.S. income tax treaty residency tie-breaker provisions (this is far from ideal, but can be used as an effective tax residency management tool, with some important additional considerations).

Practice Note - Safe Harbour Those Canadians who want to effectively manage their tax residency status and not be treated as a U.S. tax resident under the Substantial Presence Test (see below), should spend no more than 121 days in any given year in the United States - safe harbor.

Although from a purely income tax perspective a Canadian tax resident who is treated as a U.S. tax resident generally may not end up paying more tax (due to higher Canadian individual income tax rates), there could be some double taxation exposure and extensive U.S. tax filing and reporting obligations that would significantly complicate overall tax compliance for such a Canadian.

As a U.S. tax nonresident, a Canadian would generally only be subject to tax on U.S. source income. Potential double taxation would be prevented by claiming a foreign tax credit on a Canadian tax return for any income-based taxes paid in the United States (this, by the way, includes both federal and certain state income taxes). As a U.S. tax resident, on the other hand, a Canadian tax resident would be subject to U.S. tax on their worldwide income. As a result, such Canadians would get themselves in quite a tricky situation, which would be both complex and messy (partially, because an individual could be treated as a resident of more than one country).

Tax residency planning is a must for any Canadian who spends substantial time in the United States. Doing it ahead of time before one’s travel will make a difference between little or no U.S. tax exposure and potential double taxation (or, at the very least, much more complicated tax compliance). Important part of one’s tax planning is to ensure maintenance of adequate and contemporaneous supporting documentation.

To understand how best to plan your stay in the United States, one needs to have at least a general idea on how the United States determines if an individual should be treated as a U.S. tax resident vs. U.S. tax nonresident (or, putting it in proper technical terms, a nonresident alien individual).

Substantial Presence Test

Just to make sure we are addressing the right category of taxpayers, the United States treats U.S. citizens and U.S. permanent residents (Green card holders) as U.S. tax residents (proper technical term “U.S. Person”), no matter how much time they spend in the United States and irrespective of where they live and whether they have any U.S. source income.

A Canadian who is not a U.S. person will be treated as a U.S. tax resident if they meet the Substantial Presence Test. Under the Substantial Presence Test, a nonresident alien individual is treated as a U.S. tax resident if they spend in the aggregate more than 182 days in the United States over a three-year period, provided that at least 31 days are spent in the United States in the current tax year.

Practice Note One of common misunderstandings arises from misinterpreting the term “current tax year” for purposes of the Substantial Presence Test. This reference is to the tax year in question. For example, if an individual is filing their 2022 tax year return, the “current tax year” for purposes of applying the Substantial Presence Test would be the 2022 tax year. As a result, the number of days spent by the individual in 2022, 2021, and 2020 would need to be reviewed to determine the applicable U.S. tax residency status.

A formula is used to determine if the 182 day threshold is met: 100 percent of days spent in the United States in the current calendar year + ⅓ of days spent in the United States in the first preceding calendar year + ⅙ of days spent in the United States in the second preceding calendar year.

There are some exemptions from the Substantial Presence Test. For example, students who are studying in the United States under F1 visa are exempt from the Substantial Presence Test, even if they spend the entire year in the United States. Notably, they must file Form 8843 to claim the exemption, and depending on their particular circumstances, the exemption may no longer be available. In addition, such “exempt” individuals, while being exempt from U.S. income tax, may still be subject to tax on capital gains from a sale of certain capital assets and be subject to additional strenuous international information return reporting requirements. Any individual in that situation should consult their qualified U.S. tax advisor to ensure that they meet all applicable exemptions and comply with all applicable tax reporting obligations with respect to that particular exemption.

As noted, the exemption from the Substantial Presence Test may not exempt an “exempt” nonresident alien individual from certain tax obligations or U.S. international tax reporting. Failure to comply with one’s U.S. tax filing and reporting obligations may lead to substantial penalties, in many cases far greater than applicable U.S. tax liability. Many penalties apply irrespective of whether a taxpayer owes any tax, sustains losses, has a profitable business or operates a business that is dormant. This is yet another reason to ensure you understand your U.S. tax filing and reporting obligations prior to commencing your study in the United States or making a trip for any purpose.

If you need any help with determining your U.S. tax residency, including whether you qualify for applicable exemptions, and identifying applicable U.S. international tax and cross-border tax filing and reporting obligations, you can schedule an initial consultation and we will be happy to guide you through a maze of the applicable U.S. tax law, cross-border tax framework, and applicable Canada-U.S. income tax treaty provisions. You can choose the duration of the initial consultation that you believe would be sufficient to adequately address your questions or concerns.

Closer Connection Exception

As long as not more than 182 days is spent in the United States in a current tax year, a Canadian can be exempt from being considered a U.S. tax resident as long as they claim closer connection to Canada by filing Form 8840, Closer Connection Exception with the Internal Revenue Service (“IRS”) (please note that the link may not be updated and you should consult your qualified U.S. tax advisor for a proper IRS form to use under your particular facts and circumstances).

When evaluating whether you have closer connection to Canada, the IRS will evaluate the following factors (some of which may weigh more toward closer connection to the United States; some of which may be neutral):

• Where was your tax home during the tax year in question?

• Where was your principal residence located?

• Where was your family located?

• Where was your car located?

• Where was your car registered?

• Where were your personal belongings, furniture located?

• Where did you bank?

• Where did you conduct your business or had your employment exercised?

• Where was your driver’s license issued?

• Where were you registered to vote?

• What country (address) do you include in official documents and forms as the country (address) of your residence?

• Where do you keep your personal, financial, and legal documents and records?

• From what country did you derive the majority of your income?

• Did you have any U.S. source income?

• Where were your investments located?

• In what country did you qualify for a national health plan sponsored by the applicable country?

The determination of whether you meet the closer connection test is highly factual and additional factors may make a difference – for example, what was your U.S. visa status, what was your intent of traveling to the United States, how long were you planning on staying, and some other factors.

Depending on one’s U.S. tax obligations, Form 8840 may need to be attached to a U.S. tax return (Form 1040NR) or filed with the IRS on its own. The filing deadline for U.S. tax nonresidents is generally June 15. However, you should consult a qualified U.S. tax advisor to determine the U.S. tax filing deadline applicable under your particular facts and circumstances.

Practice Note If you meet the Substantial Presence Test, but have closer connection to Canada and do not intend on being treated as a U.S. tax resident, you can file Form 8840 with the IRS. Closer connection may be established to more than one foreign country. In addition, you do not have to file a U.S. tax return for purposes of claiming closer connection to Canada, unless you meet the U.S. tax return filing requirements. If you are not required to file a U.S. tax return (Form 1040NR), you would file just Form 8840 with the IRS.

U.S. Filing Deadlines and Forms

We created a reference chart on our website that provides a detailed list of IRS forms and applicable filing deadlines based on category of the taxpayer, individual or business, as well as based on the taxpayer’s tax residency status – resident or nonresident.

Canada-U.S. Income Tax Treaty Residency Tie-Breaker Provisions

What if you spent more than 182 days in the United States in a given calendar year? Can you still be exempt from being treated as a U.S. tax resident?

Indeed, you can. The Canada-U.S. income tax treaty provides further protection to Canadian tax residents by allowing them to use treaty tax residency tie-breaker provisions to determine if they can still be treated as U.S. tax nonresidents. The objective of treaty residency tie-breaker provisions is to ensure that no double taxation arises (or, if it did occur, it can be mitigated) in situations when an individual may be treated as a resident of both Canada and the United States.

Very generally, the Canada-U.S. income tax treaty looks to the following factors in determining if an individual should not be treated as a U.S. tax resident (each of these factors are reviewed in the order they are presented and, if a determination still cannot be made, the Competent Authorities of Canada and the United States would make a discretionary determination on the individual’s tax residency with a goal to avoid double taxation):

• Where is an individual’s permanent home available to them;

• To which country the individual’s personal and economic relations (center of vital interests) are closer;

• Where is an individual’s life’s sphere of interests;

• Where such an individual has a habitual abode;

• Individual’s citizenship.

Practice Note Although the treaty tax residency tie-breaker provisions can be and are effectively used, one must be careful in resorting to them from year to year and doing so without help of a qualified U.S. tax advisor. Contemporaneous tax residency planning is a great solution to effectively managing U.S. tax residency exposure as well as exposure to potential double taxation.

Renting or Selling U.S. Real Property

Since the U.S. real property stays vacant for several months during the year, many Canadians decide to rent out their properties or vacation homes to U.S. residents or nonresident alien individuals (fellow Canadians, for example). Others consider selling their U.S. real property.

In 2021 – early 2022, the U.S. housing market in Florida, for example, has been fairly hot. The prices have been going up and notwithstanding COVID-19 travel restrictions between Canada and the United States that were just lifted recently, more and more Canadians have been purchasing U.S. real property in U.S. sunny places. Even hurricanes do not appear to turn away prospective buyers. The higher activity in the Florida real estate market is also a result of pandemic and migration of workforce from higher individual income tax states (such as California and New York) to lower or no income tax states (Florida currently has no state individual income tax). More and more employers are embracing and accepting a new universe – the birth of the remote workforce. Indeed, why would anyone live in a cold climate when they can move to Florida and live and work out of there?

Without proper tax planning, renting U.S. real estate or selling it may result in adverse tax consequences. Keep reading to learn about the requirements for Canadians who sell their U.S. real estate, and for those who rent out their real property in the United States.

IRS Individual Taxpayer Identification Number (ITIN)

When renting out or selling your property in the United States, you may be subject to U.S. tax and/or U.S. tax filing requirements. To file a U.S. tax return, you must apply for a U.S. Individual Taxpayer Identification Number (ITIN) (unless you have a U.S. Social Security Number (SSN) or ITIN already) by filling out Form W-7, Application for Individual Taxpayer Identification Number (ITIN) and filing it with the Internal Revenue Service (IRS). Note that if you do have an ITIN, you may need to renew it.

One of the benefits of applying for ITIN in case of renting out your U.S. real property is to avoid 30 percent withholding by a U.S. withholding agent (typically, a management company that manages your property) on gross rental income.

If you would like to apply for ITIN, please make sure you qualify to apply for one before scheduling the service. You can review the information on our website – link here – and watch our YouTube channel videos to make the respective determination. Please do not book an appointment, unless you know that you are eligible to apply for ITIN.

If you are not sure if you qualify to apply for ITIN and would like to understand if you are eligible and review some options that may be available to you to apply for ITIN, you can schedule a 15-minute initial consultation and we will be happy to guide you on how you can qualify.

Canadians Selling U.S. Real Property – FIRPTA Withholding and U.S. tax filing requirements

Canadian residents who own and sell real estate property in the United States are generally subject to a 15 percent withholding tax of the gross selling price under the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA). The tax that is withheld can be offset against the U.S. income tax payable on any gain realized on the sale, and refunded if it exceeds the taxpayer’s ultimate tax liability. Naturally, to get a refund, you are required to file a U.S. tax return for the tax year in which the real property was disposed of. You may be able to eliminate or reduce the applicable FIRPTA withholding if, for example:

1.The property is sold for US $300,000 or less to a purchaser who intends to use the property as her/his principal residence. In that case, no FIRPTA withholding is due. However, a U.S. tax return is still required to be filed to report the disposition

2. The property is sold for US $1,000,000 or less to a purchaser who intends to use the property as her/his residence. In that case, a reduced 10 percent FIRPTA withholding applies. However, a U.S. tax return is still required to be filed to report the disposition.

3. Prior to the closing date, either the transferor (seller) or the transferee (buyer) applies for and obtains an IRS withholding certificate on the basis that FIRPTA withholding would exceed the maximum U.S. tax liability. The application for an IRS withholding certificate is typically made on Form 8288-B and FIRPTA withholding may be reduced or eliminated based on a number of applicable factors.

There is an elaborate process involved in the application for the IRS withholding certificate. Importantly, the application must be filed with the IRS on or before the closing date. You should plan accordingly.

Practice Note It is important to request proper and complete supporting documentation from the title/escrow company managing the closing of your U.S. real estate transaction. In the absence of such supporting documentation, the IRS may delay the issuance of your refund and you may have to request such documentation at a later stage. You should always have your closing documents (sale/purchase contract and closing settlement statement) handy, as well as request Forms 8288, 8288-A (make sure that they reflect the correct information, including the transfer/sale date), and proof of remitting FIRPTA withholding to the IRS (usually, a copy of the check or some other means of payment confirmation).

If the IRS withholding certificate is issued only after the transfer, this may allow the seller to apply for an early refund. Historically, prior to COVID, the IRS used to issue a withholding certificate within 90 days from the date of Form 8288-B submission (note that to expedite the IRS review, you should include all applicable documents in support of the reduced or zero FIRPTA withholding claim). Currently, it may take anywhere from 6 to 12 months to obtain an IRS withholding certificate. It is still faster than claiming a refund, but you will have to be patient and have reasonable expectations as to the timing of your funds release by the U.S. withholding agent.

Practice Note Generally, the benefit of applying for the IRS withholding certificate is really your cash flow. Depending on the amount of gain realized on the sale of your U.S. real property, applying for IRS withholding certificate may not be cost effective, unless the timeframe for getting your refund matters.

If you are not certain whether it makes sense in your situation to apply for the IRS withholding certificate, we can help. You can schedule a 15-minute initial consultation and we will help you estimate your U.S. tax liability based on your facts. You will then be in a better position to make a decision as to whether to wait for a refund or to apply for the IRS withholding certificate.

In order to claim the exemption from withholding, you must have a valid U.S. Taxpayer Identification Number (TIN) (ITIN or SSN).

Practice Note In practice, many Canadians apply for ITIN, but do not have it at the time of the closing. The U.S. withholding agent (title/escrow company managing the sale) would issue Form 8288-A without ITIN. In such cases, you may have to request a corrected Form 8288-A, once you obtained ITIN. Doing it before filing your U.S. tax return would not only increase your chances of a refund, where applicable, but also accelerate your refund from the IRS.

Canadians are required to report the sale of their U.S. real property on their U.S. tax return, Form 1040-NR. As a Canadian resident, you will also have to report the transaction in Canada, but should be able to claim a foreign tax credit for U.S. taxes paid (ultimate U.S. tax liability).

Generally, if there is a gain on the sale in both Canada and the United States, the United States has the first right to tax the profit and the U.S. income tax can be claimed as a credit against any Canadian and provincial tax on the sale. Foreign exchange gain or loss may also be realized.

Practice Note Escrow and title companies that close the transaction may not follow the IRS procedures for FIRPTA withholding. The sellers will be better off to discuss and pre-agree with the buyers and the title/escrow companies on the procedure to follow to avoid any last minute complications. This is especially true in case the seller wants to apply for the IRS withholding certificate. A better practice is to include relevant provisions in the applicable sale/purchase contract to protect the sellers.

State income tax may also apply on the sale, depending on the U.S. state where the real estate is located. Filing a state income tax return may also be required, again, depending on the applicable state requirement where the property is located. Finally, some states, such as California, have a process for claiming a reduced or zero withholding, similar to the IRS withholding certificate process.

Filing Deadlines and Penalties for Canadians Selling U.S. Real Property

The general filing deadline for Form 1040-NR is June 15th. However, if you earned any reportable wages in the United States, you must file your U.S. tax return by April 15th. The tax, if any is owed, must be also paid by the applicable filing due date. You can extend your filing deadline by six months by filing Form 4868. Form 4868 must be filed by the tax return filing due date. A failure to file penalty, along with interest may have to be paid if you have not filed your tax return by the due date.

The late-filing penalty is generally five (5) percent of the tax due for each month or part of a month that a return is late, but will not be more than 25 percent of the tax due, and is based on the tax that has not been paid by the filing due date. If your return is filed more than two (2) months (60 days) after the due date, the minimum penalty is US $205 or 100 percent of the unpaid tax, whichever is lesser.

The late payment of a tax penalty is usually ½ of 1 percent of the unpaid tax for each full/part month that the tax is not paid, but it will not be more than 25 percent of the tax due and unpaid. The penalty is imposed in addition to any interest charges.

Never miss a U.S. filing deadline again!

Do I Need to File U.S. Income Tax Return if I Rent out my U.S. Real Property or Vacation Home?

The short answer, Yes. Canadian individuals who rent out their U.S. real property for 15 days or more in a year may have to file a U.S. income tax return to report the rental activity and generated U.S. source income. Note that it doesn’t matter if you sustain losses or make a profit on your rental activity.

If you are a Canadian citizen and resident who owns a residential rental property in the United States, you are subject to U.S. income tax on rental income you receive from your U.S. real property, or potentially, the value of the property. Canadian taxpayers who do not follow this requirement may be subject to significant income tax liability and adverse consequences where proper procedures are not followed

U.S. Filing Requirements for Canadians With Rental Income

As a U.S. nonresident property owner, you are typically required to pay a 30 percent withholding tax on the gross amount of rent received. Although not required, the nonresident can engage with a U.S. withholding agent who collects the rent and remits the withholding tax to the IRS on their behalf. If proper withholding is made, the nonresident should generally have no further tax filing requirements.

To benefit from applicable deductions and to claim rental expenses, the nonresident owner can make a “net rental income election.” Making the net rental income election is usually more beneficial than having a 30 percent withholding on a gross rental income basis. You need to provide the U.S. withholding agent with a properly completed IRS 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, as well as to make the election on your timely filed U.S. tax return.

You only have to make the election once. The net rental income election will remain valid for as long as you own the property if you file your 1040-NR on time.

Filing Deadlines and Penalties for Canadians Claiming U.S. Rental Income

The general filing deadline for Form 1040-NR is June 15th. However, if you earned any reportable wages in the United States, you must file your U.S. tax return by April 15. The tax, if any is owed, must be also paid by the applicable filing due date. You can extend your filing deadline by six months by filing Form 4868. Form 4868 must be filed by the tax return filing due date. If you do not file your return by the due date, you may have to pay a failure-to-file penalty and interest. The penalty is based on the tax not paid by the due date.

Unlike Canadian tax rules, depreciation is a mandatory deduction in the United States. If you don’t file a return, you are still deemed to have claimed depreciation and could be subject to depreciation recapture.

Note: A Canadian resident is an individual who is considered as a Canadian resident for Income Tax purposes and is liable to pay his income tax in Canada. If you are a U.S. citizen, U.S. tax resident, or a Green card holder living in Canada, the comments in this note do not apply to you.

DISCLAIMER: Please note that the information contained in this article is general in nature, is current only as of the date of posting the respective information on the website, and does not (nor is intended to) provide legal or tax advice or an opinion on any matter or issue discussed. You should consult your qualified U.S. tax advisor for any advice on any matters or issues discussed in this article.