It’s been another long Canadian winter for Mr. and Mrs. Smith. Not a year goes by where they wished they would have abstained from purchasing a winter property in the U.S. Sunbelt. Trading the snow shovel for SPF 100 Coppertone and enjoying an annual four-month winter hiatus never felt so good. A healthy dose of Vitamin D and the creation of many fond family memories continuously solidify the rationale as to why the Smiths purchased this winter home south of the Canada/U.S. border. That said, the Smiths are aging, and the annual treks back and forth are not without a physical toll. Lately, the Smiths have been pondering how they can pass this home on to their children. Should they gift it, sell it, or have it inherited at their passing?
The Smiths are careful not to exceed the “Substantial Presence Test” given their annual migration to their winter abode. As Canadian citizens/residents with no residency or tax ties to the U.S., the Smiths need to be very cautious in transitioning the U.S. vacation home to their heirs.
Summary and Takeaways
If you are a Canadian resident but own real estate in the U.S., there are several tax implications that deserve careful consideration. Otherwise, it’s possible that you could wind up paying substantial taxes to both governments.
- You can sell the property, gift it, or have it inherited upon your death.
- Gifting is generally the most costly strategy because of a lack of U.S. gift tax exemptions and Canadian foreign tax credits.
- There is also the potential for steep U.S. gift taxes coupled with Canadian capital gains taxes.
- Instead of gifting the property, you could sell it to your children, or pass it along to them through inheritance.
- Leaving the property as inheritance may offer lucrative tax exemptions. But that still requires detailed tax filing – which you may deem overly invasive.
- Canada allows a foreign tax credit for estate taxes paid to the IRS, so that path avoids double taxation on capital gains. But that only applies to federal, not provincial taxes.
- As you can see, the issues related to cross-border property taxes are complex, and require keen awareness of the nuances of current rules and regulations.
Option 1: Should they gift it?
As non-U.S. citizens/residents gifting tangible U.S. situs assets, the Smiths would not be entitled to the lifetime gift tax exemption (currently set at $12.06M USD for the 2022 tax year). If they were to gift the home to their children, beyond the annual gift tax exclusion of $16,000 USD, a gift tax at a rate of between 18% – 40% would be imposed based on the fair market value (FMV) of the home. The U.S. would have the first right to tax the gift since the immovable property is domiciled in U.S. territory. Canada would deem the transfer of title as a deemed disposition subject to capital gains taxes. Furthermore, Canada would disallow a foreign tax credit for the net gift tax liability paid to the IRS.
U.S. Federal Estate & Gift Taxes
(Unified Transfer Tax Rate Schedule)
For Tax Year 2022
|If Taxable Gift||Tentative Tax Is|
|Is Over||But Not Over||Tax is||Plus %||Of Excess Over|
Example: The Smiths jointly – which they can support based on their purchase agreement – own a winter home in Florida valued at $800K USD. They originally purchased the property for $500K USD. They decide to gift the home to their two children who are also Canadian residents only. From a U.S. gift tax perspective, after the application of the $16,000 USD annual gift tax exclusion that they can apply to each child and the value of the allocated FMV of the home, the Smiths would owe a total of $221,840 USD in gift tax.
On the Canadian side, the appreciation in the value of the home +/- the gain or loss in foreign currency exchange between purchase and gift date would be considered capital gains. Half of that gain would be tax-free with the remaining 50% taxed at the Smiths’ Canadian marginal tax rates with no foreign tax credit offsets.
Furthermore, as previously noted, the net U.S. gift tax would NOT be eligible to be taken as a foreign tax credit on Mr. and Mrs. Smith’s Canadian tax returns. From a Canadian perspective, the U.S. gift tax is not an income tax eligible for foreign tax credit relief.
As you can see, gifting is not a good option.
Note: These non-U.S. citizen/resident gifting rules only apply to U.S. situs real and tangible personal property. Intangibles, such as personally held stock of U.S. corporations, are not subject to the U.S. gift tax regime.
Net Gift Tax Valuation
For Tax Year 2022
|Dad (50%)||Mom (50%)|
|Child 1 Gift Exclusion||(16,000)||(16,000)|
|Child 2 Gift Exclusion||(16,000)||(16,000)|
|U.S. Taxable Gift||$368,000||$368,000|
|Gift Tax to Pay||$110,920||$110,920|
|Rate per Table||34%||34%|
|Total Tax on Gift||$221,840|
|Effective Rate on Gift||28%|
Option #2: Should they leave it as an inheritance?
Unlike the full reduction in gift tax exemption, the IRS allows non-U.S. citizens/residents the ability to take a partial estate tax exemption. There is a pro-rata calculation performed to quantify the value of U.S. situs vs. worldwide assets. For non-residents, the U.S. only imposes an estate tax on assets situated in the U.S. that exceed $60K USD at death.
However, under the Canada-U.S. Tax Treaty, certain thresholds apply that are unique to Canadians. Based on current U.S. estate exclusion amounts, these thresholds exempt most Canadians who do not have worldwide estates that exceed $12,060,000 USD individually or $24,120,000 USD if a married couple. Therefore, if the Smiths have a worldwide estate of $10M USD, they are well beneath the U.S. worldwide estate tax exemption that would expose them to any U.S. nonresident estate tax exposure at either of their deaths.
That being said, because their worldwide estate is well beneath the current exclusion amounts, if the FMV value of a Canadian decedent’s U.S. personally held property is greater than $60K USD, a U.S. estate tax return would STILL HAVE TO BE FILED even though the estate tax result would be NIL. The executor would also have to include the value and the reporting of the decedent’s worldwide estate, including all assets in Canada. Some might find this quite intrusive, knowing that there would be no estate tax. However, the filing and compliance requirements are necessary in these cases.
Example: In the previous example, if the Smiths had a U.S. home valued at $800K USD and the total value of their worldwide assets was $10M USD, given the information presented above, the Smiths would face no exposure to U.S. estate tax.
Furthermore, given that the property is held jointly, if Mr. Smith were to predecease Mrs. Smith, such that the full value of the property were to form part of her U.S. gross estate and make her worldwide estate larger, the utilization of the Marital Credit under the Tax Treaty could be used to double up on the credit available under Mr. Smith’s estate tax return.
Despite the above, and with the U.S. estate tax exemption “sunsetting” at the end of 2025 to return to a likely $6M USD amount – unless future legislation changes – it is always important for Canadians who hold U.S. property personally to be aware of current and future U.S. estate tax exemptions and plan accordingly.
From a Canadian death tax perspective, half of the appreciation of the home +/- the gain or loss in foreign currency exchange rates between purchase date and death would be taxed at the Smiths’ Canadian marginal tax rates. Canada would allow a foreign tax credit for any estate taxes paid to the IRS. However, the foreign tax credit would only be eligible for federal and not for provincial tax purposes.
As you can see, this option is better than gifting, due the ability to leverage the pro-rata U.S. estate exemption calculation and potential allowance of foreign tax credits for Canadian federal tax purposes.
Option #3: Should they sell it?
Per the Canada/U.S. Tax Treaty, the country in which the real property resides has the first right to tax any potential sale. The Smiths would need to obtain a current valuation and sell the property to their children at fair market rates to avoid selling at a discount and incur potential U.S. gift tax liability. If the property were held longer than one year, the U.S. would tax the appreciation at long-term capital gains tax rates (15% or 20%) with the potential for an additional 3.8% Medicare surtax. The Foreign Investment in Real Property Tax Act of 1980 (FIRPTA), depending on the value of the property and the use of property by the purchaser, requires either a 10% or as high as 15% withholding tax on the sales proceeds. If the net income tax on the sale would be lower than the Federal withholding tax requirements under FIRPTA, the Smiths could file a specific IRS Form – IRS Form 8288B – to request a reduction or elimination of such tax. However, the administrative hassles and the requirements to obtain a U.S. Individual Taxpayer Identification Number (ITIN) — if they do not already have one – can present some significant challenges prior to or shortly after the closing of the property. The Smiths would have a requirement to file a U.S. Form 1040NR by June 15 of the year following the year of the sale of the property to reconcile the gain or loss on the property. Any Federal withholding taxes imposed could be recovered at that time. It should be noted that processing times for the return of partial FIRPTA withholdings via 1040NR filings are longer than normal with the IRS backlog continuing.
As previously stated, Canada taxes the appreciation of the property +/- the gain or loss in foreign currency exchange and taxes 50% of that gain at the current Canadian marginal tax rates of the individual. The good news is that Canada will allow a foreign tax credit for taxes paid to the IRS in such a transaction. This allows the nonresident Canadian taxpayer to avoid double taxation on the capital gain sale.
That being said, you might want to read our blog CRA and IRS Administrative Issues that Cross-border Tax Filers Should Be Aware of for further insights into challenges that you might ultimately face through this process.
In Summary: In this specific scenario, gifting of real and tangible property should be avoided due to U.S. gift tax liability and the unavailability of foreign tax credit utilization resulting in double taxation. Whether one decides to sell the property to their kids or let it pass via an inheritance requires careful and detailed analysis alongside competent cross-border financial planning and tax counsel. The information in this article comes from high-level expertise, and qualified US/Canada financial advisors are rare. Each scenario is truly unique and the cross-border fiduciaries at Cardinal Point are happy to engage in dialogue to help you quantify your specific circumstances.