Many of Canadian taxpayers maintain a second home, a vacation property, or hold a U.S. real property interest for investment purposes. In 2020 and 2021, there is an upward trend of dispositions of U.S. real properties by Canadians.
This article is focused primarily on the Individual Canadian taxpayers disposing of U.S. property interest, and not on owning the U.S. property. Further, due to the complex nature of the U.S. Canada cross-border tax issues, the taxpayers must seek advice from a cross-border income tax professional. Please do not consider this post as tax advice of any sort.
There are many issues Canadian taxpayers should be aware of while selling their U.S. property.
FIRTPA Withholding on Sale of U.S. Real Property
The Foreign Investment in Real Property Tax Act (FIRTPA) imposes a requirement on the buyer to withhold taxes when a real property interest is disposed of by a foreign seller. A Canadian seller of U.S. property is considered a foreign seller, hence, the taxes must be withheld and remitted to IRS by the buyer.
FIRTPA Withholding Rates & Exceptions
FIRTPA withholding is generally 15% of the sales price. There are certain exceptions to withholding requirements.
- If the buyer of the property wants to use the same property for personal use for at least 50 percent of the time in the next two years:
- No withholding – Sales price of the property is equal to or less than US$ 300,000.
- 10% – Sales price is between US$ 300,000 and 1,000,000.
- If the seller is exempt from taxes
- The disposition results in a non-recognition of sale.
- The seller is allowed a reduced withholding rate due to submission and acceptance of form 8288-B., or a correctly completed statement.
Section 1445 requires the buyer/transferee to remit withholding taxes within 20 days of closing. The buyer uses form 8288-A to remit the withheld amounts. If the Canadian seller has ITIN, IRS will send stamped form 8288-A to the seller/transferor. If the ITIN is missing, a notice explaining the requirement of ITIN is sent to the seller.
How to apply for a reduced withholding rate?
The sellers can request a reduced withholding rate if they anticipate that their final tax liability will be less than the withheld amount. For this purpose, form 8288-B must be submitted and accepted by Internal Revenue Service (IRS).
Form 8288-B, Application for Withholding Certificate for Disposition by Foreign Persons of U.S. Real Property Interests, requires a U.S. Individual Income Tax Number (ITIN). The taxpayer must apply for ITIN using W7. IRS has strict supporting documents requirements for ITIN applications. Canadian taxpayers have often complained about the back and forth of the ITIN applications, or rejections due to incomplete or erroneous ITIN applications.
If your ITIN application is rejected or requires corrections, the withholding certificate issuance will be delayed. In order to save time, you can apply for U.S. ITIN using Certifying Acceptance Agent (CAA) Services in Canada.
The IRS takes significant time to process (around 90 days) Form 8288-B to issue the withholding certificates, therefore, proper planning ahead of the sale is important. Once the withholding certificate is issued, the excess funds are released from the escrow.
File the U.S. Income Tax Return to Report Gain or Loss
Canadian taxpayers must file a U.S. Income tax return for Non-residents using form 1040-NR by June 15th of the subsequent year. The capital gains or losses are reported on the 1040-NR. Taxes withheld under FIRTPA are credited against the final tax calculated on 1040-NR. Any excess is refunded to the taxpayer.
The U.S. Capital gains rules are different than the Canadian ones. The applicable rates depend on the duration the property was held by the seller. Generally, gains resulting from the properties held for less than a year are taxed at the marginal rates, however, there are favorable rates for more than a year holding period. Further, there is a cap of US$3,000 on capital losses that can be offset against ordinary income. Unlike Canada, there is no 50% deduction for capital gains in the U.S.
You should attach stamped form 8288-A as proof of FIRTPA withholding. If IRS did not send you the stamped (Copy B of) 8288-A due to missing ITIN, you need to attach evidence of withholding with your tax return.
Report the Capital Gains on your T1 in Canada
Canada taxes its residents on their Worldwide income. The Capital gain or loss from the sale of the U.S. property is reported on T1 in Canada. Capital gain/loss calculation is different than the one done in the U.S. due to different inclusion rates and depreciation rules amongst others. Whether the property sold generates a capital gain or business income is also a matter of surrounding facts. Further, the deferrals of income taxes in one country might not be deferral in other.
U.S. Canada Income Tax Treaty
The Canada U.S. Income tax treaty provides for the elimination of double taxation through foreign tax credits. Under the treaty, the U.S. has the first right to tax the income or gain on the disposal of U.S. real property. When the same income is subjected to Canadian income taxes, a foreign tax credit is allowed to offset the effect of the taxes already paid in the U.S., hence, avoiding double taxation.
Generally, the tax rates are higher in Canada than in the U.S., however, at the same time the inclusion rates vary. Therefore, it is important to get the income taxes done by a professional accountant specializing in cross-border tax issues.
In order to get foreign tax credits (or deductions), you must file U.S. federal and state income tax returns. You cannot claim a credit against the stamped Copy B of 8288-A if you didn’t file your tax return. Foreign tax credits and deductions are very frequently reviewed area by the CRA.
Beware of the State Income Tax Issues
Several states in the United States have their own withholding rules. Additionally, the Canada-US tax treaty works at the federal level. All states require out-of-state sellers to file income tax returns if they have a gain from the real estate. Some states require the filing of income tax returns even if there is a loss.
If you are a seller of U.S. real property and need help with the preparation of U.S. income tax returns for both federal and state, or require an ITIN without sending your original passport to the U.S., get in touch with us today.