Purchasing a property in Florida or Arizona can be an enticing option for anyone looking to escape the bitter bite of another Canadian winter. But as Canadians face greater scrutiny at the border while dealing with rising insurance rates, as well as higher condo and HOA fees, the U.S. may be losing its appeal for some snowbirds.
Selling a U.S. property as a Canadian tax resident can be a complicated process. It requires navigating two tax systems with different rules, currencies and timelines. Before you make a move, here’s what you need to know to get through the sale smoothly and keep more money in your pocket.
How the U.S. taxes your sale
If you’re selling a property in the U.S. for more than you paid for it, you may already be expecting to pay capital gains tax on the difference. But what many Canadians might not know is that there may be a shared tax obligation between the Internal Revenue Service (IRS) and the Canada Revenue Agency (CRA).
While certain exceptions exist, the Foreign Investment in Real Property Tax Act (FIRPTA) in the U.S. requires the buyer to withhold 15% of the gross sale price – not the profit – and remit it to the IRS at closing as an instalment. For instance, if you sell a home for US$1 million, the 15% withholding tax will be US$150,000. This isn’t the final or total tax you may owe; it’s a temporary holdback to make sure the IRS gets paid. Your actual tax bill is calculated later, when you file both your Canadian your U.S. tax returns, to report the capital gain realized.
Think of this withholding tax as a security deposit for the IRS, a portion of which could get returned to you at a later date. In many cases, the amount withheld is higher than your actual tax liability, which means your money could be tied up with the IRS for months.
Reducing the withholding tax
The key to reducing the withholding tax is to apply for the right paperwork before you close. According to Dante Rossi, Director of Tax Planning at BMO Private Wealth, Canadians can apply for an IRS Withholding Certificate before closing, which may reduce the withholding tax amount to reflect your expected tax owed (on the capital gain), not the entire sale price.
The catch? The Certificate can take up to three months to process – longer if there are errors or omissions of facts in the application. And at the end of the day, your final tax bill may not be any different with the Certificate than without one, explains Rossi, in which case the financial impact of withholding really comes down to the time value of money.
Jean Richard, Senior Manager and Cross Border and International Tax Consultant at BMO, notes that the gain on the sale of U.S. real property by a non-U.S. person is required to be reported on a U.S. individual non-resident income tax return.
For instance, if you bought a property for US$400,000 and sold it years later for US$1 million then you’d have a US$600,000 capital gain. If that gain was subject to the maximum 20% (federal) tax on capital gains, then your U.S. tax bill could reach US$120,000. That’s $30,000 less than the withholding tax amount outlined earlier on the gross proceeds and, depending on the time of year, you may be waiting months to get that back.
Recovery of the withheld funds depends on when you close. Sales that come late in the year allow you to file your U.S. return early the following year and get your money back faster. But if you sell in January, the money will sit a lot longer, explains Richard.
The work to get reimbursed a portion of the withholding tax starts after the sale. Canadians have to file a U.S. non-resident tax return to report the actual gain, calculate the actual tax owed and claim a refund if too much was withheld.
Many sellers skip this step and lose money they’re entitled to. That’s a mistake, explains Richard. “Many think the withholding is a final tax, but it’s not.”
The Canadian side of the sale
Once you’ve dealt with the IRS, there’s still the Canadian side to consider. As a Canadian resident, you’re subject to tax on your worldwide income, which means you must also report the sale on your Canadian tax return, explains Rossi.
When you report the sale to the CRA, you’ll have to do so in Canadian dollars based on the foreign exchange rates when you purchased the property and at the time of the sale transaction, so currency fluctuations can become part of your taxable gain. Returning to the earlier example, if you purchased the property for US$400,000 in 2007, when the Canadian and U.S. dollars were at par, your cost would have been about CAD$400,000. But if you sold it today for US$1 million, current exchange rates would translate that amount to roughly $1.4 million in Canadian dollar terms. From the CRA’s point of view, your capital gain is closer to $1 million, compared to US$600,000 in the eyes of the IRS.
While U.S. federal tax rates top out at 20% for long-term gains, in Canada, half of your capital gain gets added to your taxable income and taxed at your marginal rate. Depending on the province you live in and your tax bracket, your effective tax rate on the gain could exceed 25%.
Fortunately, the foreign tax credit system prevents double taxation. Under this system, the eligible U.S. taxes on the gain can be claimed as a foreign tax credit in Canada for the U.S. tax paid. If the Canadian taxes on the gain are higher than what you’ve paid in the U.S., you’ll essentially owe the difference to the CRA. “In the end, your total payable is the highest amount of both countries, but not both,” Richard says.
Selling at a loss
Unfortunately, if you happen to be selling property at a loss, that loss does not provide any tax relief in Canada. That’s because you can’t claim a capital loss on your principal residence or personal use vacation home the way you can with an investment property (meaning you can’t use it to offset other gains or reduce your tax bill).
The challenge, Richard says, is that the U.S. withholding requirement still applies: 15% of the sale price must go to the IRS at closing, even on a loss. Without the IRS Withholding Certificate, on an $800,000 sale, that means $120,000 will be tied up, even though no tax is owing in either country.
“In the case of a sale at a loss, your Withholding Certificate will likely be approved, but they’ll need to see documentation,” Richard says. The challenge, of course, is timing. Obtaining a Withholding Certificate takes roughly three months, which can be “a deal killer” for sellers trying to close quickly, he explains.
What you can do now
The best way to minimize your tax bill starts long before you list the property. Richard recommends keeping detailed records of your original purchase price along with any capital improvements you make over time. Renovations, additions and major upgrades can increase your adjusted cost base, which reduces your taxable gain when you eventually sell.
When the property sale day comes, don’t be afraid to ask for help. Rossi recommends Canadians work with cross-border tax advisors who understand both systems and can navigate Withholding Certificates, foreign tax credits and dual-filing requirements. The cost of compliance, which includes filing all of the documents with the IRS, and tax reporting on both sides of the border can be a significant amount and quite complex, which is why it is important to obtain tax advice prior to selling a U.S. property, Rossi says.
And while there’s no way to eliminate your tax obligation, proper planning can reduce what you owe. “It’s a little like debt,” Richard says. “But what you can do is mitigate the amount that will be at stake when you sell.”
