Address tax concerns early when owning, investing in U.S. real property
By AdvocateDaily.com Staff
Thousands of Canadians own and invest in U.S. real property, but the issues one couple recently faced when selling their vacation home serve as a cautionary tale on the importance of structuring your investment properly and speaking to a qualified U.S. tax advisor, says Oakville-based U.S. tax attorney Alexey Manasuev.
In the case, says Manasuev, principal of U.S. Tax IQ, husband and wife clients, both Canadians and neither holding U.S. citizenship, approached his firm with a question of whether they were required to file a U.S. tax return as they were selling their vacation home in Arizona.
“They owned the U.S. real property, a vacation home, through a corporation. Initially, because they bought it 10 years ago, they used it for personal purposes, but then in the last four years, they started renting it out. To manage U.S. estate tax exposure, the Canadian tax advisor 10 years ago advised them that they should make an investment through a numbered Ontario corporation. And that's how they held the vacation house.”
As a result, says Manasuev, the firm identified and addressed a number of issues in this particular case.
“First of all, under U.S. tax rules, when you receive U.S. source income — in this case, rental income — you’re required to report it and file a U.S. tax return. No U.S. tax returns had been filed,” he says. Sometimes, even when you are not generating any income, you may still be required to file a U.S. tax return, as you may be deemed to be engaged in a U.S. trade or business.
“More importantly, technically, their withholding agent was required to withhold 30 per cent withholding tax on any rental income coming to Canadian corporations, unless the entity, in this case, the Canadian corporation, made a special net rental income election. That allows taxpayers — Canadians, whether corporations or individuals, for example, who own the U.S. real property — to offset any income from rent with any expenses, such as maintenance, depreciation or property taxes,” adds Manasuev.
The couple also hadn’t been making any rental payments to their corporation for the use of the vacation home, even though the corporation was the owner of the house.
They also did not have proof that they purchased the vacation home from a U.S. person.
“That is significant, because under U.S. tax rules and what is known as the FIRPTA withholding regime, the Foreign Investment in Real Property Tax Act, the buyer is responsible and liable and is considered the withholding agent for any taxes underwithheld or not withheld on any sale or disposition of U.S. real property or U.S real property interests more broadly — subject to FIRPTA withholding — unless the seller provides the buyer with an affidavit of a U.S. person status,” says Manasuev.
“That wasn’t done and there was no respective proof. And of course, after 10 years, you don't have the vital information that is relevant for determining whether or not the seller was a U.S. person. The entity may have been liquidated even. There was no Social Security Number of the prior sellers or current address. When a seller is an entity — such as a corporation or a partnership — an Employer Identification Number (EIN) is required. When somebody buys property from someone, they don’t necessarily stay in touch. So that was another complicated fact and an area of concern. As a result, the Canadian corporation could be on a hook for FIRPTA withholding that was not done at the time of the vacation home original purchase.”
As U.S. tax accountant Brandon Vucen, a U.S. Tax IQ principal, explains, a Canadian corporation would generally receive a foreign tax credit for income taxes paid in the U.S. For example, if it received rental income and then the U.S. withheld 30 per cent, the corporation should then be able to claim a tax credit in Canada.
“The timing of that is critical because there is a three-year statute of limitations on the Canadian tax returns to claim a foreign tax credit. You don't want to be in a situation where four years down the road, this U.S. tax arises and then you may not get a foreign tax credit for it in Canada because the statute has expired. So that's why it's critical to get everything done in a timely manner,” says Vucen.
Another complication in this case, says Manasuev, is that the property was located in Arizona.
“In Florida and California, for example, you have title agents and escrow companies that are familiar with Canadians and the FIRPTA withholding regime, and as a result, when someone would like to apply for an IRS withholding certificate to reduce the withholding tax and to limit the amount of tax payable to the amount of the actual tax liability, they co-operate and follow the IRS procedures. But in this particular instance, we had a really difficult title agent who did not know the rules and who was refusing to follow the IRS guidance. As a result, they improperly withheld 15 per cent of the sale proceeds and remitted the tax to the IRS,” he says.
“In this particular instance, the difference between FIRPTA withholding of 15 per cent of the sales proceeds and the tax liability of the taxpayer was quite substantial. It was over a hundred thousand dollars.”
He says when the U.S. real property is owned jointly by a Canadian couple, they are required to file two FIRPTA withholding certificate applications (for each spouse) and two tax returns (for each spouse), as they are both non-U.S. residents. They also need to apply for Individual Taxpayer Identification Numbers (ITIN) — the taxpayer identification number the IRS issues to foreign nationals who do not qualify for a Social Security Number, but have federal tax reporting or filing requirements.
“Because we are certified acceptance agents, we can apply for an ITIN and certify passports for Canadians,” he says. "That makes the whole process easier."
“In this case, we obtained an Employer Identification Number (EIN) for the Canadian corporation. We applied for the IRS withholding certificate. Because the escrow agent was very difficult, it inappropriately withheld and remitted tax to the IRS. We had to then apply for an early refund with the IRS and were successfully able to accomplish that. Ultimately, the funds were released to the client and we later filed the corporation’s U.S. tax return,” says Manasuev.
This situation shows the importance of addressing these issues ahead of time by being proactive.
“You want to structure your investment properly, and when you do, you need to talk to a qualified U.S. tax advisor,” says Manasuev.
Secondly, he says, make sure your objectives are clear.
“If you want to manage estate tax exposure in the U.S., one structure may be preferable to the others as opposed to you trying to manage income tax consequences. It also depends on your exit strategy, whether or not you can leave with the form of investment that you are choosing. In the case we described, the couple was not able to do so. They made an investment through a corporation. They didn't walk the walk and talk the talk.” That may allow the IRS to disregard the corporation, he says.
Finally, when applying for an ITIN for nonresident individuals, Manasuev says it may be helpful to work with a certified acceptance agent.
“You don't need to send your passport to the IRS. You can have it certified by a certified acceptance agent.”
Because of the recent U.S. tax reform that saw the corporate tax rate fall to 21 per cent, Manasuev and Vucen say that more individuals may consider holding U.S. real property through a corporation, rather than personally.
“Historically, the corporate tax rate was much higher. If in the past people would have been gearing toward holding the real property personally, now, with a decrease in the corporate tax rate, the choice in terms of how you're going to hold that property requires more consideration,” says Vucen. It also puts a corporate solution back on the list of viable investment vehicles for holding U.S. real property.
As Manasuev notes, however, another important consideration in terms of the lower corporate tax rate and holding U.S. real property investments through a corporation is that the U.S. gift tax may apply to certain transfers.
“The Canada-U.S. income tax treaty does not provide any relief from gift tax, only from estate tax. So this is something to be aware of, and usually local advisers are not necessarily aware of that. This is a significant detail that might lead to a huge amount — a 40 per cent gift tax on the fair market value of the property that is being gifted,” he says.