DOMESTIC DISTURBANCE: IRS AND CRA DON’T AGREE ON PRINCIPAL RESIDENCE TAX

Canada is experiencing an extraordinary housing boom, causing real estate to appreciate at a breakneck pace. With the substantial rise in real estate values, our team has received inquiries from prospective cross-border clients regarding planning for their principal residence. Most assume that any sale will be tax free, however the tax issues surrounding the ownership of a home as a US person in Canada are complex. Undertaking some planning will help to mitigate this confusing cross-border tax situation.

This edition of WWB explains the planning options that may be available for a US person with a principal residence in Canada. It should be noted that everyone’s situation is different and at Steele Wealth Management we assess our clients’ unique situation before developing a comprehensive financial, tax, and investment plan that includes advice for our client’s specific real estate assets.

Who is impacted by these rules?

Individuals classified as US persons are required to file US tax returns and pay income tax on their worldwide income. A US person includes a US citizen, a dual citizen, a US green card holder or a US resident. In Canada, the obligation to file an income tax return and pay income tax on worldwide income is based on tax residency. Generally, Canadian tax rules base tax residency on permanent home location, personal ties such as the location of family, the location of personal property and economic ties such as the place of employment. The planning options this edition discusses relate to a US person who is a tax resident of Canada and has an obligation to file a tax return in both countries.

CANADIAN TAXATION ON THE SALE OF A FAMILY HOME:

What is the principal residence exemption?

In Canada, most homeowners know that the profit earned when the family home is sold is tax free, but it is actually the principal residence exemption that achieves this outcome. This special exemption, detailed in the Income Tax Act (ITA), reduces or eliminates the capital gain from the sale of a principal residence. The ability to shelter the gain from tax makes this a key strategy in a financial plan.

What qualifies as a principal residence?

According to the ITA rules, any residential property owned and occupied by a Canadian tax resident or their family at any time in a given year, may be designated as a principal residence for that particular year. A home may qualify if it is “ordinarily inhabited” which is based on the facts and evidence in each situation. A property cannot be considered a primary residence if it is used to earn income. A property is designated as a principal residence on a year-by-year basis. A family unit may only designate one property per year. Any property owned and ordinarily inhabited may be designated as the principal residence each year. As a result, there is the possibility of designating a seasonal residence, like a cottage, for the exemption. It may be beneficial to designate the property with the greater average annual accrued gain.

The Canada Revenue Agency requires the sale of a principal residence be recorded on the personal tax return for the year of sale. The principal residence exemption is only allowed where the sale and designation of the principal residence are reported. In most cases, this eliminates the Canadian tax on the sale of the family home.

US TAXATION ON THE SALE OF A FAMILY HOME:

What is the principal residence exclusion?

The US taxation rules are contained in the Internal Revenue Code (IRC) and are quite different from Canadian rules. For many cross-border clients who are capitalizing on the increase in Canadian real estate values, this may be an unpleasant surprise.  For US tax purposes, the principal residence exclusion only provides relief on $250,000 US dollars (USD) of gain from the sale of a principal residence.  For a married couple who are both US persons and file jointly, this exemption is $500,000 USD. Any gain above the exclusion amount is included in income for tax purposes.

To calculate the gain, the proceeds are converted into USD using the spot rate on the date of sale, and the cost base is converted into USD using the spot rate on the date of purchase. This means that any exchange gain or loss is also part of the calculation.

What qualifies as a principal residence?

According to the IRC rules, the exclusion applies only on the sale of a principal residence described as the “main home”. Unlike the Canadian rules, where the taxpayer can choose the home to designate, for US purposes the taxpayer is considered to have only one main home that qualifies for the exclusion at a time. If more than one home is owned and lived in, then there is a "facts and circumstances" test to determine which property is the main home. The facts and circumstances test looks at the address listed for voter registration and tax returns, as well as the proximity of the house to work and recreational clubs or religious organizations of which the US person is a member.

There are three eligibility tests, ownership, residence and look-back, which must be met. If the home was owned for at least 24 months out of the last five years leading up to the date of sale, the ownership requirement is met. A taxpayer who has owned the home for less than two years fails the ownership test. If the home was owned and lived in by the US person for at least 24 months of the previous five years, the residence requirement is met. The 24 months of residence can fall anywhere within the five year period, and do not have to be a consecutive block of time. The look-back requirement is met if there was not a sale of a home during the prior two years. This rule means that the exclusion may only be used once during a two year period.

If the gain on the sale is greater than the exclusion amount, then the sale is reported on the personal tax return for the year of sale. If a taxpayer excludes the entire gain on the sale from income, the transaction is not reported. With the current rapid increase in housing prices, the $250,000 USD exclusion will probably not be enough to cover the entire gain, which may result in substantial US tax on the sale of the family home.

PLANNING STRATEGIES

Structure the Purchase to Avoid the Problem

The easiest way for a US person to avoid US tax on the sale of a principal residence is not to have owned the home in the first place. This works for many of our clients where one spouse is a US person living in Canada married to a non-US person (Canadian). For clients like this, title to the principal residence can be solely in the name of the non-US person spouse. Then on the sale of the residence, this spouse, who is only required to file a Canadian tax return, would record the sale and claim the principal residence exemption to eliminate the entire gain from income. This planning, however, must be implemented at the outset when the home was originally purchased. Note that if the non-US spouse passes away first, there is a risk of provincial probate fees applying to the estate if no other legal planning arrangements have been put in place.

Gift the Ownership to the Non-US Spouse

If the spouse that owns the principal residence either wholly or jointly is a US person, , there is strategic planning that may be taken to avoid the US tax on the eventual sale of the home. The plan involves gifting the interest owned in the home by the spouse who is a US person to the Canadian (non-US person) spouse. The gift may occur without Canadian income tax as a spousal rollover and without land transfer tax.

From a US tax perspective, the gift of the interest in the principal residence to the spouse may not result in US taxes. Similarly, to the spousal rollover on the Canadian side, the general rule in the IRC is that no gain or loss is recognized on a transfer of property between spouses.

Unlike Canada, the US imposes a gift tax. The gift tax is imposed on the donor, and applies to US persons living in Canada, regardless of where the gifted property is located. A gift made to a non-US person spouse qualifies for a special annual exclusion of $159,000 USD (limit in 2021). Therefore, to avoid any gift tax on the transfer, the strategy would be to annually gift a portion of the interest in the home up to the annual gift limit. Over a period of several years, the spouse will be divested of the interest in the principal residence. Subsequently when the principal residence is sold, there are no resulting US taxes that would have otherwise arisen on the sale.

CONCLUSION

It often comes as a surprise to prospective cross-border clients that the sale of their family home is not tax free. There are planning strategies that may be undertaken to mitigate US taxes payable. The Steele Wealth Management team can help cross-border clients to effectively navigate the principal residence tax rules and integrate real estate assets into an overall financial plan.

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