THE INTERNATIONAL TAX ADVISOR by: Douglas J. Kingston, CPA/MBA • Mailing Address: 16443 N 59^th Place; Scottsdale, AZ 85254 • Telephone: +1 (602) 595-5885 (GMT-7) • E-Mail: doug@iTaxCPA.com • URL: http://www.iTaxCPA.com/
TAX TREATY ISSUES FOR CANADIAN INVESTORS IN U.S. REAL ESTATE
Background Rental Income and Expense Gain on Disposition Death Taxes How Does the Tax Treaty Affect You? It is important for Canadian investors in the U.S. to review their estate plans in order to take advantage of the Canada-U.S. tax treaty.	Background As described in previous articles, U.S. tax rules applicable to foreign investors in U.S. real estate are often less favorable than those applicable to U.S. citizens and residents. However, Canadian investors are entitled to special tax benefits under the Canada-U.S. tax treaty. In general, a tax treaty is a written agreement between two countries providing uniform bilateral tax rules intended to avoid double taxation of their cross-border citizens and/or residents. Tax treaty provisions override each signatory country’s own tax laws and may be invoked by the taxpayer if the treaty rule provides a lesser tax than domestic law of the taxing country. This article focuses on some of the more common U.S. and Canadian tax issues encountered by Canada resident individual investors in U.S. real estate (not U.S. citizens or “greencard” holders). Rental Income and Expense The Canada-U.S. tax treaty no longer provides overriding provisions applicable to real estate rental income, thus both country’s domestic tax laws apply unmodified. Under U.S. domestic tax law, rental income derived from U.S. real estate is subject to a 30% withholding tax imposed on gross rents unreduced by expenses or losses. However, U.S. law allows the foreign investor the option of filing U.S. tax returns and electing “net basis” taxation and graduated tax rates under the regular or alternative minimum tax rules (a net rental loss may not reduce other income). Once the election is made, it can only be changed with IRS consent and the election applies to all of the investor’s U.S. rental activities. Until 1983, the Canada-U.S. treaty provided a reduced tax rate of 15% instead of 30% and also provided a more flexible net-basis election. Under Canadian domestic tax law, U.S. rental income is included in a Canadian resident’s taxable income on a net basis (a net rental loss is allowed to reduce other taxable income, except to the extent the loss is attributable to depreciation or “capital cost allowances”). The investor must also take into account gains and losses resulting from currency fluctuations. Any U.S. taxes paid may be credited against Canadian tax attributable to the net U.S. income (amounts not credited may be deducted from taxable income). Gain on Disposition The current Canada-U.S. tax treaty generally does not provide U.S. tax exemption for gains derived from disposition of U.S. real estate. Thus, under U.S. domestic tax law, a Canadian investor’s net gain derived from disposition of U.S. real estate is subject to U.S. tax based on graduated tax rates under the regular or alternative minimum tax rules (subject to 15% and 25% maximum tax rates for capital gains). The treaty does however provide a limited exception from U.S. tax for investment or personal-use U.S. real estate owned by the taxpayer on September 26, 1980 provided the taxpayer was continually resident in Canada since on or before that date and until the date of sale. In this case, only gain accruing since January 1, 1985 is subject to U.S. tax.	Gain on Disposition (continued) Under its domestic tax law, Canada excludes 50% of capital gains but requires ordinary income recapture of capital cost allowances claimed in excess of the original cost less proceeds of disposition. The taxable amount is determined taking into account gains or losses resulting from currency fluctuations. A Canadian resident who emigrates and becomes a nonresident of Canada is deemed to have sold his or her U.S. real estate and is thus subject to Canadian tax under its so-called “departure tax” rules. A proposed amendment to the treaty (announced September 2000, but still not ratified) would provide such an individual the option of treating the property as deemed-sold for U.S. as well as Canadian tax purposes thus avoiding a double tax by enabling credit for Canadian against U.S. tax and a stepped-up U.S. tax basis in the property. Death Taxes Since its fourth amendment in 1995, the Canada-U.S. treaty has provided Canadian investors in U.S. real estate significant U.S. and Canadian “death tax” relief. Under U.S. domestic tax law, nonresidents who are not U.S. citizens are entitled to an estate tax exemption of only $US60,000 (whereas a U.S. citizen is entitled to an exemption of $US2 million increasing to $US3.5 million for 2009). However, the treaty provides an enhanced exemption for residents of Canada by allowing them a pro-rata portion of the exemption otherwise reserved for U.S. citizens. The pro-rata portion is based on the value of the deceased Canadian's U.S. estate over the value of the individual's worldwide estate (estate values are determined under U.S. rules). The treaty also provides a Canadian resident a "marital credit" against U.S. estate tax for transfers of U.S. property to a surviving spouse. Also, if the value of the worldwide estate of the deceased Canadian resident is less than $US1.2 million, the treaty also limits the U.S. estate tax by excluding from the taxable base assets other than U.S. real estate and business assets. Canada does not have an estate tax per se. Instead, a decedent’s final annual income tax return must include accrued capital gains as well as income earned up to the date of death. Under its domestic tax law, Canada does not allow a foreign tax credit for foreign taxes not considered income taxes (U.S. estate taxes are not). However under the treaty, Canada allows U.S. estate taxes as a credit against the deceased's Canadian tax attributable to his or her U.S. source income. How Does the Tax Treaty Affect You? Review Your U.S. Estate Tax Plan Canadian investors in U.S. real estate should be aware of the benefits available under the Canada-U.S. tax treaty, and plan their investments accordingly in order to reap the maximum tax savings.
Douglas J. Kingston is an Arizona certified public accountant (CPA) specializing in international tax planning and compliance for U.S., Canadian, European, Latin American and Asian business and individual clients and may be reached by: • Telephone: (602) 595-5885 • E-Mail: doug@iTaxCPA.com • URL: http://www.iTaxCPA.com/