What are the tax implications of owning vacation property in the U.S.?

John is a family physician managing a busy practice in southern Alberta. He and his wife, Tiffany, travel to the United States (U.S.) with their three children whenever possible. They usually stay in the family cabin on Flathead Lake near Whitefish, Montana. John’s parents, who are now retired and in their mid-seventies, bought the property when John was very young, and it continues to be the traditional family gathering place for their children and grandchildren. His parents are in relatively good health, but John noticed during the visit to the cabin this past summer that they are slowing down a bit. Although it is not something the family discusses much, as the executor of his parents’ will, John sometimes worries about the tax implications of his parents’ estate, especially this property in Montana as it has appreciated significantly in value over the years. No one in the family is a U.S. citizen, but he has heard that there could be estate tax issues for Canadian residents owning property in the U.S. 

During their visit this summer, he also noticed several properties for sale and began thinking about purchasing a vacation property of his own in the area. Although it has been a great vacation spot and a good investment for his parents, he is unfamiliar with the tax implications and complexities of owning property and spending time in the U.S., and this makes him apprehensive about investing in a vacation property south of the border.

U.S. filing obligations and the substantial presence test

John and his family will not have U.S. tax filing obligations if they limit their time spent there and do not earn any income from the U.S. because they are not U.S. citizens and are considered “non-resident aliens” for U.S. tax purposes. Under U.S. domestic tax rules, you will be considered a resident for U.S. tax purposes if you meet the “substantial presence test”. This test is based on the number of days (including part days) spent in the U.S. over the last three consecutive years. It totals all the days spent in the U.S. during the most recent calendar year, 1/3 of the days in the preceding calendar year, and 1/6 of the days spent in the second preceding calendar year. If the sum of this calculation is equal to or more than 183 days, then you have met the U.S. substantial presence test and tax filing obligations exist.

Under U.S. domestic tax rules, there is a closer connection exemption to the substantial presence test that allows you to be treated as a non-resident alien if you were present in the U.S. for less than 183 days during the most recent calendar year and had a closer connection to Canada by, for example, maintaining a home here along with vehicles, personal belongings, bank accounts, drivers license, etc., during the entire year. For this exemption to apply, you must file a Closer Connection Exception Statement for Aliens (Form 8840) with the Internal Revenue Service (IRS) by the due date of the U.S. Non-resident Alien Income Tax Return (Form 1040NR), which is generally June 15 following the tax year.

If you exceed 182 days in the most recent calendar year, then you may still be able to claim residency in Canada under the Canada-U.S. Tax Treaty. You will need to file Form 1040NR to claim a treaty exemption but may still be required to file other information returns as a U.S. resident. These filings can be complicated, onerous, and expensive. It is important that you carefully track the days you spend in the U.S. each year.

Tax implications of selling vacation property in the United States

Non-resident aliens are still required to pay U.S. tax on the appreciation of real estate owned in the U.S. under the Foreign Investment in Real Property Tax Act (FIRPTA). Some states mirror this treatment and impose state tax withholdings, as well. If John’s parents were to sell their Montana property, for example, the lawyer or escrow agent facilitating the sale would be required to withhold and remit 15 percent of the gross sales proceeds to the IRS on closing (10 percent for homes sold for less than US$1 million), and 2.5% of the gross sales proceeds to Montana.

John’s parents would each need to file a Form 1040NR and a Montana state income tax return to report the actual capital gain on the sale of their property. They would receive a refund of any excess withholding taxes over and above the actual tax liability. In some cases, if the state does not require withholding, an individual may end up with a federal tax refund with taxes still owing to the state, however, they need to pay the state taxes right away, as in some cases, it can take many months to receive the federal refund owing from the IRS.

Applying for a clearance certificate to reduce withholding tax

In cases where the actual U.S. taxes owing will be less than the withholding taxes, it is possible to reduce or eliminate the FIRPTA withholding tax on property sales by applying for and receiving a clearance certificate from the IRS before the sale closing date. You do this by filing the Application for Withholding Certificate for Dispositions by Foreign Persons of U.S. Real Property Interests (Form 8288-B).

Regardless of whether you apply for the clearance certificate, as a non-resident alien, you will need to apply for and obtain a taxpayer identification number when you dispose of the property in the U.S. Each property owner needs to file their U.S. tax returns separately as non-resident couples are not permitted to file their U.S. tax returns jointly. To apply for a U.S. tax identification number, you should file a completed Application for IRS Individual Taxpayer Identification Number (Form W-7) with the Statement of Withholding on Dispositions by Foreign Persons of U.S. Real Property Interests (Form 8288-A) and send with the cheque for the required withholding taxes, so that the payment is properly tracked with the issued tax identification number. The IRS will then send confirmation of the payment and a stamped copy of Form 8288-A that you will later attach to your 1040NR tax return to support the withholding taxes paid. 

Claiming a foreign tax credit in Canada

John’s parents would need to include the capital gain on the sale of their Montana property on their Canadian personal tax returns in the year of the sale. The capital gain is determined in Canadian dollars by converting the cost of the property at the exchange rate on the date of purchase and the proceeds of disposition at the exchange rate on the date of the sale. This conversion to Canadian dollars may result in a foreign exchange gain or loss, in addition to the gain on the property appreciation.

On their Canadian tax returns, John’s parents should receive a foreign tax credit against their Canadian taxes for any U.S. tax paid on their 1040NR and state tax returns. It is important to keep complete records of the original purchase price and costs of improvements to the property during the period of ownership to accurately calculate the capital gain reported on both the U.S. and Canadian personal tax returns.

In addition, to support the foreign tax credit on their Canadian tax returns, it is important that they keep copies of any cheques paid to the IRS and in many cases, it is also necessary to request a tax transcript from the IRS. Unlike in Canada, the IRS does not routinely issue a tax transcript or notice of assessment unless it is requested.

U.S. Estate Tax

If John’s parents do not sell the property in their lifetime, but instead transfer it to their children in their wills¹ , a deemed disposition will be reported on the Canadian tax return of the last of his parents to pass away. It would be wise for the family to plan for this tax liability and how it will be funded. There is also the possibility of U.S. estate taxes based on the fair market value of the U.S. property at the time of death. For example, assuming John’s parents’ property is worth US$1.5 million at the time the estate tax arises, before considering any current estate tax exemptions, the estate tax on this property would be approximately US$545,800. The current estate tax exemption is US$12.06 million. The current unified credit is US$4,769,800 (2022), which is the amount that can be offset against the estate tax owing. However, a Canadian resident will only receive a pro-rated share of this unified credit, based on the value of the U.S. property as a percentage of their worldwide estate value. Importantly, a deceased Canadian resident’s executor must undertake a U.S. estate tax filing in order to avail the estate of this increased limit, as U.S. domestic rules only provide for a US$60,000 exemption to non-U.S. citizens or residents. If U.S. estate tax is payable, you would not be subject to double tax, as a foreign tax credit would be permitted against the Canadian tax. It may also be possible for the U.S. estate tax to be deferred until the second to die (if married).

If John’s parent’s total worldwide estate is worth US$5 million, for example, they would receive 30% of the unified credit which is US$1,430,940 (1.5/5 x 4,769,800). This would more than offset this estate tax liability given the current exemptions. 

The unified credit changes with government policy and the current increased exemptions are set to expire at the end of 2025. If nothing changes, in 2026, the estate tax exemption will revert to the 2017 level of $5 million indexed for inflation (estimated to be $6.6 million in 2026). It is also possible to undertake planning to reduce or mitigate your estate tax exposure.

In short, while owning property and vacationing in the United States does, unfortunately, add some complexity to tax filings and estate planning, being aware of the issues and working with an experienced professional to help navigate through these complexities can make U.S. property ownership less daunting, bring peace of mind and help facilitate the enjoyment of owning recreational property south of the border with family and friends.

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1.  Note that the Canada-US Tax Treaty only provides relief from U.S. estate taxes. Intergenerational transfers while alive may attract U.S. gift tax, which the Treaty does not offer relief from.