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

John is a business owner in Canada. He owns a construction company in Southern Alberta which he manages alongside his wife, Heather. The couple fly to the United States (U.S.) for an annual family vacation with their two children and when they’re there, they rent a cabin on Flathead Lake near Whitefish, Montana.

As John and Heather age, they’re starting to consider owning a vacation property in the U.S. The couple are aware that they will have to pass on the construction business to their children in a few years. A vacation property outside Canada may be a good investment opportunity that they could sell or pass down to the children and spend more time there in retirement

John and his family are not U.S. citizens, but they have heard of the tax issues that may arise when a Canadian resident acquires property in the U.S. These complexities have left John panicky about the decision he is about to make. The family would love to make this investment but what should they do or know before they begin the process?

Tax considerations when buying property in the U.S.

John and his family will not have U.S. tax filing obligations if they limit their time spent in the U.S. and do not earn any income from the U.S., because they are not citizens and are considered “non-resident aliens” for U.S. tax purposes. You will be considered a resident for U.S. domestic 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.

It is important that you carefully track the days you spend in the U.S. each year. You should consult with your tax advisor as there may still be an information return to file to report which country you are more closely tied to, despite being under 183 days in the current year.

What to know when selling property in the U.S.

The U.S. requires non-resident aliens to pay tax on the appreciation of real estate owned in the country under the Foreign Investment in Real Property Tax Act (FIRPTA). If John and Heather decide to sell their property, 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. Some states mirror this treatment and impose state tax withholdings, as well. Montana withholds 2.5% of the gross sales proceeds.

John and Heather would receive a refund of any excess FIRPTA withholding tax over and above the actual U.S. tax. In some cases, if the state does not require withholding, the seller may end up with a federal tax refund with taxes still owing to the state, however, they would 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. 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.

Regardless of whether you apply for the clearance certificate, as a non-resident alien, you will need to apply for and obtain a U.S. 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.

Claiming a foreign tax credit in Canada

John and Heather would need to include the capital gain on the sale of their 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 and Heather should receive a foreign tax credit against their Canadian taxes for any U.S. tax and state tax paid. 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.

What happens to your U.S. property when you pass away?

If John and Heather do not sell the property in their lifetime, but instead transfer it to their two children in their wills, a deemed disposition will be reported on the Canadian tax return of the last of them to pass away creating a tax liability on any accrued gain. 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 on the value of the U.S. property. For example, assuming John and Heather’s 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$545,000. The current estate tax exemption is US$12.92 million (for 2023). This exemption is multiplied by 40 percent to calculate a unified credit of US$5,113,800, which is the amount that can be offset against the estate tax owing. However, a non-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. 

If their total worldwide estate is worth US$5 million, for example, they would receive 30% of the unified credit which is US$1,534,140 (1.5/5 x 5,113,800). This would more than offset this estate tax liability given the current exemptions. 

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 2^nd to die (if married).

It may also be possible to undertake planning to reduce or mitigate your estate tax exposure.

Talk to a professional

Owning property in the U.S. can come with complexities around tax filings and estate planning. Working with a professional can help you have a seamless experience with the complexities surrounding your U.S. vacation property.