Seller beware: tax issues for Canadian residents selling U.S. real estate
For a few years following the 2008 financial crisis, we saw many investors and snowbirds purchasing U.S. properties to take advantage of real estate bargains and a weak U.S. dollar. Over a decade has passed, the Canadian dollar has weakened, and with limited ability—or desire—to travel to the U.S. due to COVID-19 we are noticing a significant increase in U.S. real estate sales by Canadian residents. The situation provides an incentive to review some of the common U.S. tax issues when a Canadian resident sells U.S. real estate.
U.S. tax withholding
At the time of sale of U.S. real estate by a non-resident of the U.S., the buyer is required to withhold 15 per cent of the gross proceeds (selling price) under the Foreign Investment in Real Property Tax Act. This withholding is a temporary tax that is remitted to the IRS and is credited to the seller when their U.S. tax return is filed.
The withholding can be reduced to ten per cent if the selling price is between $300,000 and $1 million, and can be eliminated completely if the selling price is under $300,000. In both cases, the buyer must confirm that the property will be used primarily as their residence. This strategy merely reduces the tax withholding requirements; it does not eliminate the need to file a U.S. tax return to report the sale.
If tax withholding is required, the withholding agent (often the title agent) must provide the seller with Form 8288-A, a U.S. tax slip that is required for the U.S. tax return. The form provides the IRS with proof that the seller was subjected to tax withholding, along with the amount of withholding, so that the seller can be properly credited for the withholding on their U.S. tax return. The form is due either 20 days after the closing date or 20 days after the IRS has notified the parties of its determination regarding the withholding certificate (discussed below).
In addition to the $300,000 exemption, a seller may request a reduction or a full elimination of the tax withholding by applying for a withholding certificate (Form 8288-B) from the IRS if they anticipate their actual tax will be less than the required withholding tax. The due date for the withholding certificate application is the closing date of the transaction. Since it is almost guaranteed that the seller will not have the withholding certificate from the IRS by the closing date, the withholding agent often will hold the maximum withholding funds (15 per cent) in escrow until the IRS provides relief of the required withholding in whole or in part. The withholding agent then will distribute a portion of the funds held in escrow to the seller and a portion to the IRS according to the outcome of the withholding certificate.
The decision to obtain the withholding certificate depends on several factors, including the amount of withholding tax that would apply absent the certificate and the timing of the sale. For example, for a sale at the end of the year, one likely would not bother with a certificate application since it can take the IRS a few months, or longer, to respond. By that point, it would likely be better simply to allow the maximum withholdings at closing and file the U.S. tax return as soon as possible to recover the excess withholding amount.
Individual Taxpayer Identification Number
Non-residents of the U.S. must obtain an Individual Taxpayer Identification Number (ITIN) during the withholding process (if they do not already have one). The ITIN application is not a complex process but there is often confusion around the timing of the application and the necessary documents that must be attached.
If the transaction is not subject to U.S. tax withholding, the seller may apply for an ITIN only at the time of filing the tax returns. If the transaction is subject to withholding, the ITIN application is submitted with copies of Forms 8288 and 8288-A, or with Form 8288-B, if applicable. Failure to get an ITIN at the time of withholding, or when applying for a withholding certificate, can lead to unnecessary complications trying to match the tax withholdings to the seller when the IRS processes the tax return.
The IRS guidance and the ITIN application form itself can lead taxpayers to believe that a Certifying Acceptance Agent (CAA) is required in the ITIN application process. In fact, a CAA is not required in the ITIN process, but engaging a CAA may help avoid ITIN application rejections. The role of the CAA is to help taxpayers ensure that the application form is properly completed and that all required documents are attached. A CAA can also help in certifying the taxpayer’s identification.
A list of CAAs in Canada can be found here: https://www.irs.gov/individuals/international-taxpayers/acceptance-agents-canada
Income tax returns
The disposition of real property in the U.S. triggers a requirement to file a U.S. tax return, Form 1040NR, to report the capital gain from the sale. The due date to file this return is June 15 of the year following the sale.
For Canadian residents, the same capital gain (adjusted for foreign exchange and differences in Canada/U.S. tax rules) is also reported on the Canadian tax return. To avoid double taxation, Canada allows a foreign tax credit for taxes paid to the United States. However, there are times when the foreign exchange and tax reporting rules alter the outcome of the actual economic situation, and taxes are unexpectedly payable in Canada.
For example, suppose you purchased U.S. property for $400,000 in 2012 when the average exchange rate was 1.00. Your cost for both Canadian and U.S. purposes was, therefore, $400,000. If the property was sold for $350,000 USD in, say, December 2019 when the exchange rate was 1.3172, the Canadian equivalent of the proceeds was $461,020. In the U.S., you realize an economic loss of $50,000 and pay no tax. In Canada, however, you actually have a capital gain of $61,020 with no foreign tax credits to offset the Canadian tax that may be payable. Of course, the opposite can occur where the foreign exchange works in the taxpayer’s favour.
While a full discussion of U.S. estate tax is beyond the scope of this article, it is worth noting that if a Canadian resident dies owning U.S. situs assets (i.e. U.S. real property) worth more than $60,000 USD, a non-resident estate tax return (Form 706-NA) must be filed within nine months of the date of death. Despite the requirement to file a tax return, in most cases U.S. estate taxes will not be owing because of exemptions allowed in the Canada/U.S. Tax Treaty. Additionally, the IRS will issue a Transfer Certificate once Form 706-NA is processed. The Transfer Certificate releases any federal estate tax liens on a decedent’s property. Many U.S. financial institutions require this confirmation from the IRS before they will release property to beneficiaries.
These are just some of the complexities Canadians face when owning U.S. real property. Speak to your Baker Tilly advisor for more information and to ensure your tax exposure is as limited as possible.
Meet the Author
Kevin Tippett
Information is current to October 6, 2020. The information contained in this release is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation.