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Canadians Living in California, California Tax Filing with a Canadian Spouse

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canadians living in californiaOur previous article discussed the concept of California domicile and the application of California community-property rules to Canadians domiciled in the state. This article is the second installment in our series explaining about Canadians Living in California and how California community property laws can impact Canadians.

At Cardinal Point, we regularly deal with cross-border couples who maintain cross-border lifestyles due to career commitments or other obligations. It’s important to understand how California’s community property laws apply when one spouse is domiciled in California and the other in Canada.

Imagine a married couple in which the wife lives in Toronto (and is domiciled in Ontario) and the husband lives in Los Angeles (and is domiciled in California). Both spouses are dual American and Canadian citizens and they file a joint U.S. Form 1040 tax return. The husband, Drew, is a professional hockey player who plays for a California-based NHL team. Drew’s wife, Amber, is a top fashion model based out of Toronto. The couple owns homes in both Toronto and Los Angeles. Since Amber is mainly working in Toronto, New York, London and Paris, she only spends two weeks a year in Los Angeles with her husband. Moreover, Amber does not earn any California-sourced income.

One might assume that Amber does not need to file a California tax return and pay California tax, given that she doesn’t earn any California income and isn’t domiciled in California.

But as we stated in our previous article, California follows its own rules for determining tax residency. Unlike federal tax treatment, an immigrant to California is normally a California resident from the date of arrival. No 183 physical presence test or green card is required to determine California residency status. Moreover, since California is not a party to the Canada-U.S. tax treaty, the treaty is not applicable for purposes of determining California residency (similarly, California does not allow a foreign tax credit or the federal foreign earned income exclusion).

Going back to Drew and Amber, because they are filing jointly on their federal return, California requires the same joint filing status on their California return, and they would pay California tax on their worldwide income.
There is, however, a little-known legal exception that will allow our imaginary couple to file separately instead of jointly for California tax purposes. To file separately in California, two criteria must be met: (1) Amber must not be a resident of California and (2) she must not have any California-sourced income, including California wages and income from California real-estate property.

With Amber filing separately under the exception, she would still need to file a California 540NR non-resident return to pay tax on 50% of her husband’s California income. That’s because Drew is domiciled in California. Moreover, she would need to disclose her non-California-sourced income on the California return to determine her California tax rate.
Because of the complexities facing cross-border couples, they are well advised to seek out tax advisers who specialize in navigating the cross-border tax landscape.

Marc Gedeon is a CPA (U.S), CPA (Canada) and Tax Attorney at Cardinal Point, a cross-border wealth management organization with offices in the United States and Canada.  Marc specializes in  providing Canada-U.S. cross-border financial, tax, transition, and estate planning services.  This piece is for informational purposes only and should not be considered legal or tax advice. Online readers should not act upon this information without seeking professional counsel.

Canadians Beware of California Community Property Rules

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Canadians find many things in California to be foreign, like the sun, surf and In-N-Out Burgers.

But when it comes to Canadians who have family in California, or who spend considerable time in the Golden State, California’s community-property laws make Canadians realize just how foreign the state can be.

WelcometoCaliforniaAs we’ve discovered over the years, California tax laws and the concept of community property are foreign to Canadians and their Canadian tax preparers. While many Canadians are aware that California taxes its residents on worldwide income, few truly understand the complex interplay of California’s tax and community-property laws on California tax filings.

We’ve seen many Canadians and their Canadian tax advisers incorrectly prepare California tax returns by not taking into account Canadian-sourced income on a California non-resident return, or by failing to apply California community property laws.

Since California’s community property laws are fairly complicated, this article will be the first in a series of articles explaining how the state’s laws apply to Canadians who are living or working there.
To start, California is one of only nine U.S. states that is a community-property state. Texas, Arizona and Nevada are among the others.

In a nutshell, California defines community property as any asset acquired by, or income earned by, a married person. As a result, California considers property and income derived during a marriage to be owned 50/50 between the spouses. Any property or income not considered community property is treated as separate property.

California community-property rules have a profound effect on the federal and California tax returns for Canadians who are domiciled in the state. This is especially true when spouses have different domiciles—where, for example, one spouse is domiciled in California while the other is domiciled in Canada.

Because community-property laws only apply to taxpayers domiciled in California, this first article will discuss the concept of California domicile.

Domicile is a legal term of art. As such, there is no bright-line test that defines when a person is domiciled in California. This is different from how the IRS uses an objective test to determine residency for federal tax purposes.

Instead, for California tax purposes, domicile is defined as the place where an individual has their true, fixed, permanent home and principal establishment, and to which they intend to return after being absent. Another way to look at: You are a resident of the place where you live, and you are domiciled in the place to which you intend to return. Therefore, the question of domicile boils down to a taxpayer’s intention as demonstrated by the taxpayer’s actions.

Most people would think that where you reside is where you are domiciled. In most cases, this is absolutely true. For Canadians facing cross-border issues, however, “residence” and “domicile” do not necessarily mean the same thing. While a person can have several places of residence, such as Toronto and Los Angeles, they can only have one domicile.

When assisting Canadians with their California domicile determination, we apply the following factors to determine a taxpayer’s intention for maintaining a California domicile:
Is the taxpayer on a temporary work assignment in California?

  • Where is the taxpayer employed?
  • Where is the taxpayer’s immediate family located?
  • Where does the taxpayer vote?
  • Where does the taxpayer own property?
  • How long did the taxpayer live in California?
  • Where does the taxpayer have their business and social ties?

California maintains a rebuttable presumption (an assumption that something is true unless someone proves otherwise) that someone living in the state for at least nine months out of the year is presumed to be domiciled in the state. On the other hand, if someone is in California for less than six months in a calendar year, California presumes the person is a not domiciled in the state. In cases where a Canadian is spending considerable time in California, such as working for Google on a TN visa, the community property rules would not apply if the Canadian still maintains a domicile in Canada.

Generally, a Canadian in California working on a temporary visa is probably domiciled in Canada. As such, income earned in California is not community property. Conversely, a Canadian who obtains a green card and moves to California is very likely to be subject to community property rules.

A little-known exception to applying community property rules for federal tax purposes applies when a Canadian is filing a dual-status federal return. In this case, the community property rules do not apply during the period of residency in a dual-status year. Therefore, for federal tax purposes, income earned is treated as separate property. Unfortunately, California does not conform to this exception for California tax purposes.

One situation we often run into illustrates the impact of California community property laws well. In this situation, a Canadian spouse is working in Canada and the other spouse is working in California.

For example, George is a Canadian television personality who exclusively works in Canada on a popular hockey program. George owns a home in Toronto where he lives while working in Canada. He’s married to an American, and they own a house together in Venice Beach, Calif. George files a Form 1040NR under the Canada-U.S. tax treaty, and his wife files a Form 1040 with a married-filing-separately status. George’s wife only works in California. On a regular basis, George makes trips to Los Angeles to be with his wife, and he spends the offseason in Los Angeles.

Although George lives and works in Toronto, he still maintains a home for his family in California. And his regular trips to Los Angeles demonstrate that California is where he intends to return when able to do so. Therefore, George and his wife are considered to be domiciled in California, and are subject to worldwide taxation as California residents.

Consequently, George’s Canadian income is considered community-property income, and his wife would have to pay federal and California tax on her 50% share of George’s out-of state earnings.

Marc Gedeon is a CPA (U.S), CPA (Canada) and Tax Attorney at Cardinal Point, a cross-border wealth management organization with offices in the United States and Canada.  Marc specializes in  providing Canada-U.S. cross-border financial, tax, transition, and estate planning services.  This piece is for informational purposes only and should not be considered legal or tax advice. Online readers should not act upon this information without seeking professional counsel.

Canadian Tax Filers: Report Your Foreign Property Annually—Or Else

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A lot has been made of the IRS’ onerous foreign-account and property-reporting requirements, and understandably so. But largely overshadowed by that discussion is a similar requirement that the CRA has inflicted on Canadian tax filers.

As part of its efforts to address tax noncompliance involving foreign property, CRA, in 2013, introduced a revised Form T1135 Foreign Income Verification Statement. Form T1135 now requires significantly more detailed information regarding foreign property owned by Canadian residents.

What’s more, the form must be filed by the taxpayer’s income tax return due date (generally April 30), and no extension is available. Taxpayers who fail to comply with the filing requirements face stiff penalties—up to $2,500 for late filing. Form T1135 is similar to the U.S. Form 8938, Statement of Specified Foreign Financial Assets. To assist our clients, we’ve put together the following Q&A summary about the T1135:

Q: Who is required to file Form T1135?
A: Any Canadian resident who, at any time during the year, owned specified foreign property with a total cost in excess of $100,000 is required to file Form T1135 for that taxation year. Individuals who immigrate to Canada are not required to file Form T1135 in the taxation year in which they first become Canadian tax residents (unless they were previously Canadian tax residents). However, Form T1135 must be filed for all subsequent taxation years, including a taxpayer’s year of departure from Canada. In addition to Canadian individual residents, Form T1135 must also be filed by corporations and trusts resident in Canada.

Q: What is specified foreign property?
A: The definition of specified foreign property is quite broad. It includes most non-Canadian assets, such as funds held outside of Canada, shares in non-Canadian corporations, indebtedness owed by a nonresident, an interest in a nonresident trust that was acquired for consideration, as well as real property situated outside of Canada. Specified foreign property excludes personal-use property, such as a vacation home.

Specified foreign property also includes most non-Canadian investments (i.e. U.S.-traded securities) held in Canadian non-registered brokerage accounts. Thus, in certain cases, taxpayers whose assets are all physically located in Canada may still be required to file Form T1135.

Q: What is new about the revised Form T1135?
A: It requires filers to disclose significantly more information regarding foreign assets. For each foreign asset, the revised form requires the following information to be disclosed on a per-asset basis:

  • Name of the foreign entity holding the funds, name of the foreign corporation or foreign trust, or description of the foreign property;
  • Country where the foreign asset is located;
  • Maximum cost of the foreign asset during the year;
  • Cost of the foreign asset at year-end;
  • Amount of income (or loss) related to the foreign asset; and
  • Amount of any capital gain (or loss) realized on the disposition of the foreign asset.

Q: Does the revised Form T1135 provides any reporting exemptions?
A: Yes, an exemption is available for reporting specified foreign property for taxpayers who have received Canadian tax slips related to such foreign property (e.g., a T3 or T5 slip). In these instances, no additional disclosure related to such foreign assets is required. However, while this relief may exclude specific reporting for foreign assets held in a Canadian brokerage account for which income has been reported on a T3 or T5 slip, it would not exclude foreign securities held in the same Canadian brokerage account for which there was no income to be reported on a T3 or T5 slip.

In addition, each stock or bond held in a foreign investment portfolio is required to be reported separately on Form T1135. This will require taxpayers to compile a significant amount of additional information.

Q: How is Form T1135 filed?
A: Taxpayers should begin collecting the necessary information to complete the T1135 early in the new year, rather than waiting until April 30, when the form is due. Form T1135 currently cannot be filed electronically. Taxpayers who electronically file their income tax returns should forward a signed copy of Form T1135 to the CRA by the due date.

Marc Gedeon is a CPA (U.S), CPA (Canada) and Tax Attorney at Cardinal Point, a cross-border wealth management organization with offices in the United States and Canada.  Marc specializes in  providing Canada-U.S. cross-border financial, tax, transition, and estate planning services.  This piece is for informational purposes only and should not be considered legal or tax advice. Online readers should not act upon this information without seeking professional counsel.

Estate Planning: Uncle Sam’s Nasty Surprise for Non-U.S. Citizen Spouses

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Are you a U.S. citizen married to a non-U.S. citizen? Or, are you and your spouse both green card and/or U.S. visa holders living in the United States?

If so, then you’ll want to be aware of U.S. estate-tax rules that, without proper planning, can result in an outsized tax bill.

married-taxesRecently, we started working with an American client who has a significant estate and lives and works in the United States. His wife is a Canadian citizen and U.S. green card holder, but not a U.S. citizen. The couple does not have kids.

In a recent tax-planning session, our American client was shocked to learn that any gifts between he and his wife may be subject to tax rates as high as 40%. The same high tax rate may apply to any inheritance left by a deceased spouse to the surviving spouse. Our client’s surprise was understandable, because the rules are very different for couples who are both U.S. citizens.

Most Americans leave the bulk of their estate to their surviving spouse, because most of it can be transferred without tax consequences. In particular, under the “unlimited marital deduction,” if a person leaves his or her estate to a spouse, there is no estate tax on the transferred property, regardless of the size of the estate.

Simply put, the IRS is willing to wait until the second spouse dies before levying an estate tax. Similarly, married couples are free to make unlimited inter-spousal gifts without incurring gift taxes.

By the way, because of the U.S. Supreme Court’s recent DOMA decision, same-sex couples can now join heterosexual couples in transferring as much of their estate as they like to their spouse, free of gift or estate taxes. The catch is that both spouses must be U.S. citizens.

The IRS sees things differently when it comes to transfers in which one spouse is not a U.S. citizen. The “unlimited marital deduction” treatment does not apply to a foreign spouse because the IRS is afraid the non-citizen spouse will move to another country, thus avoiding U.S. gift and estate taxes altogether.

Without the availability of the marital deduction, current law permits the first $5,430,000 (adjusted for inflation) of assets to be transferred tax-free. In other words, an inheritance left to a non-citizen spouse is subject to a 40% estate tax after the $5,430,000 lifetime exemption is used up.

So what should you do if you are married to a non-citizen and your estate is above the exemption threshold?

Let’s use our clients as an example. The wife could become a U.S. citizen prior to the husband’s death. Or they could establish a qualified domestic trust (QDOT). A QDOT defers the estate tax until the death of the foreign spouse, and allows for an annual income stream to be paid to her. Moreover, it can buy time for the surviving spouse to acquire U.S. citizenship.

Gifting strategies can also be used to transfer a certain amount of assets to the non-citizen spouse each year (the 2015 limit is $147,000). This will gradually reduce the size of the U.S. citizen’s taxable estate while protecting them from federal gift-tax liability.

Alternatively, if certain conditions are met, our clients can take advantage of the marital credit under the Canada-U.S. tax treaty. This option, however, can’t be used in conjunction with the QDOT deferral.

As our clients learned, there are certain planning strategies and legal structures that, if set up in advance, can help cross-border couples avoid losing up to 40% of their wealth through unnecessary taxes.

If you would like more information about this topic, or to discuss your own unique situation, please contact us today for a confidential consultation.

Americans Exiting Canada: Understanding the Five-Year Deemed Disposition Rule

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American citizens living in Canada for more than five years face an imposed exit tax on unrealized gains.

One of the most common questions we receive from Americans moving to Canada is how to navigate around the Canada Revenue Agency’s five-year deemed disposition rule. Canada assesses an exit tax on any unrealized capital gains inside taxable accounts in cases where the U.S. citizen moves back to the United States after having been a Canadian tax resident for longer than 60 months.

It is important to note that this rule does not apply to any tax-deferred investment accounts or plans.

Some visa holders arrange their date of return to the United States to be 60 months less a day in order to avoid qualifying for this event. But in many cases, this is inconvenient for the corporations that employ them. And it can create personal family hardship, should it occur, for example, in the middle of a school year.

The Canada-U.S. tax treaty requires that non-tax-deferred securities accounts be taxed in the country of the beneficial owner’s residency. Accounts that are transferred to Canada from the United States “in kind” retain their original cost basis (usually the purchase price) for U.S. tax purposes. But a second cost basis—equal to the accounts’ market value on the day the beneficial owner became a Canadian resident for tax purposes—is automatically generated. This can cause confusion, and in many cases erroneous tax reporting, in both Canada and the United States.

Does leaving your accounts in the U.S. help?
In the past, some U.S. citizens would simply leave their U.S. taxable and trust accounts in the United States in an attempt to get around the Canadian five-year tax rule. Prior to 2013, this sometimes worked. The CRA required, but did not rigorously enforce, reporting of unrealized capital gains of all taxable accounts, including those remaining in the U.S.

In 2013, however, the CRA introduced a revamped, more robust version of a form called the T1135 Foreign Income Verification Statement, which is somewhat similar to the IRS’ foreign reporting requirements in the United States through IRS Form 8938 and the FinCEN 114. The CRA T1135 form requires a detailed annual accounting of all foreign accounts (including those in the United States) held by a Canadian tax resident. Failing to file this form leads to penalties. And given the increased information sharing initiatives now in place between the CRA and IRS, taxpayers must be compliant. If an American moves back to the United States after five years, the CRA will have a complete record of all of their taxable investment accounts in both countries. When completing the Canadian exit tax returns, you will be assessed on any unrealized capital gains from the date of when you entered Canada to the date of departure. This is reported on your Canadian exit return through Forms T1161 and T1243.

How do the tax rules work?

  • Let’s use a hypothetical example to illustrate how the rules work. For simplicity’s sake, we will ignore currency exchange. Bear in mind that in real life, currency exchange must be accounted for to determine the proper Canadian basis and ultimate proceed numbers for Canadian and U.S. purposes.
  • You purchase a number of investment securities (stocks, bonds ETFs etc.)in a taxable account that has a U.S. cost basis of $50,000. When you later move to Canada, the account is worth $100,000 ($50,000 of which is unrealized gains). Regardless of where the account is domiciled (Canada or the United States), you now have two adjusted cost bases for tax purposes. The U.S. basis is $50,000. The Canadian basis is $100,000.
  • Five years later, you move back to the United States; the account has now grown to a value of $150,000 ($100,000 capital gains for U.S. tax purposes and $50,000 for Canadian tax purposes). For Canadian tax purposes, you will have an imposed departure gain of $50,000. In Canada, 50% of the gain is taxable at your respective marginal rate. Assuming that you are in the highest marginal rate in Ontario upon exit, your net tax would be 24.76%.

For U.S. tax purposes, you would have to pick up capital gains of $100,000.
The current U.S. long-term capital gains rate of 15% would be applied. However, depending on your filing status and U.S. Adjusted Gross Income amounts, you could be subject to an additional 5% capital gains tax and a 3.8% levy on all net investment income for the tax year. Therefore, it is extremely important to proactively gain a sense of what exposure might exist in Canada and the United States prior to departure or the end of the tax year in order to avoid any unnecessary surprises.

  • On any Canadian tax paid, you would receive a passive foreign tax credit. The credit may be used for U.S. tax reporting purposes under the Canada-U.S. tax treaty—provided that it is properly filed by your accountant. It should be noted that this is a “deemed” sale, and not an actual sale of the securities in the account. For U.S. tax purposes, your original adjusted cost basis is still $50,000.
  • Interestingly, when moving back to the United States, the IRS does not allow for a stepped-up basis to be used for securities bought while living in Canada. Unlike in Canada, where the basis for Canadian tax purposes is calculated based on the market value on the day that the beneficial owner became a Canadian resident for tax purposes, the U.S. will only recognize the original basis. This means that if a security was bought in Canada for $50,000 and it was valued at $100,000 at the time you move back to the U.S., the IRS would consider $50,000 to be the cost basis—it will not allow it to be stepped up to $100,000.

How to minimize the Canadian exit tax
A qualified Canada-U.S. cross-border financial advisor will keep track of both your Canadian and U.S. cost bases, and tax-manage your portfolio accordingly. Actively and prudently employing tax-loss harvesting to offset gains can reduce the amount of exit tax owed. Contact Cardinal Point to learn more about our tax-managed portfolio strategies for Americans living in Canada, and how we personalize our investment process to fit your needs.