A place in the sun

Canadians love Florida, especially its real estate. According to the U.S. National Association of Realtors, Canadians were the largest single group of foreign residential property buyers last year, accounting for 26% of all nonresident purchases. That’s not surprising when there is a sub-prime lending crisis, house prices remain 40% to 50% below peak levels in several markets and distress sales continue to provide potential bargains for international buyers.

It shouldn’t be all that surprising when an advisor receives a call from a client asking about the implications of a home purchase in Florida, and any other sunny destination, for that matter. Let’s say you field such a call from Barbara a longtime client who’s an independently wealthy retired physician. A recent inheritance had added to her wealth and that got her thinking about sun-drenched days in a comparatively inexpensive but fabulous second home, preferably near a beach, or close to a golf course. She could live there during the winter months and then rent it out the rest of the year, generating income that would help cover her costs. She would be living the snowbird’s dream.

This article won’t focus on the investment merits of the purchase compared to say more traditional investments. Instead, we are going to discuss the tax matters Barbara should consider before she purchases the property. She should pay close attention to two important factors: the length of her annual residency in the U.S.; and the method she uses to report rental income on her new property for tax purposes. The basic information below draws on the above conversation and highlights some of the key tax discussion points to be raised should you receive a similar call from a client asking about the advisability of buying property in Florida or other U.S. states.

The residency test

The Internal Revenue Service determines whether or not you qualify as a U.S. resident for tax purposes by imposing what it calls the substantial presence test. The test sounds a bit intimidating but it’s extremely important for snowbird clients or anyone who spends a significant time in the U.S. to understand it.

Anyone qualifying as a U.S. resident will face much more daunting tax compliance requirements than a non-resident. The objective is to track the days one is present in the U.S. and ensure that those U.S. days are below the threshold, so an individual is not considered a U.S. resident. So how does the substantial presence test work? To qualify as a U.S. resident, you must be physically present in the U.S. for 31 days during the current year and for 183 days in the three years that include the current year and the two preceding years. In calculating these totals you actually get a bit of a break. You count up the days you were in the U.S. in the current year and then add it to one third of the days you were there the previous year and one sixth of the days you were there the year before that.

With all that in mind, Barbara should keep careful track of the number of days she spends in the U.S. to ensure that she remains below the 183 day threshold. For the purpose of this discussion, let’s assume Barbara is considered not to be a U.S. resident.

Canadian taxes

Once Barbara has purchased a U.S. property and begins to generate rental income, she will have to report it on her Canadian income tax return as worldwide income. In doing so, she includes net rental income from the property, that is, gross rental revenue less expenses including property taxes, mortgage interest, insurance, management fees, utilities costs, and repairs and maintenance.

As you can appreciate, there’s a fair amount of record keeping involved in determining net rental income and, as unpleasant as it may seem to some, the effort is necessary. To prevent double taxation, the Canadian tax rules allow a foreign tax credit for U.S. taxes on U.S. property income. However, the foreign tax credit is limited to the lesser of the U.S. or the Canadian taxes on the U.S. property. In cases where a Canadian resident reports rental property income, there’s extra time to file the tax return. The actual tax return isn’t due until June 15, although any taxes owing are still due by the normal deadline of April 30.

U.S. taxes

This is where it gets more complicated for Barbara.

For U.S. tax purposes, there are two ways a U.S. nonresident can calculate and report taxes on rental property income. The first is to follow the general rule that says 30% of gross rental income be withheld and remitted to the IRS. This method is easy insofar as the calculation is simple and no U.S. personal tax return is required to be filed.

Simplicity though comes at a price. A better option is to elect to be taxed at graduated rates on net rental property income, even though this necessitates filing a U.S. non-resident personal tax return. There will be record keeping and paperwork to calculate net rental income; then the nonresident tax filer will have to calculate U.S. tax payable on the net rental income at graduated rates. Generally, a U.S. tax return – and the tax owing – is due on April 15, but in the case of a nonresident return, the deadline for the return only (not the tax owing) is extended to June 15.

Despite the added work and complications, the net rental method saves money. It will almost always result in fewer tax dollars being paid to the IRS than the gross rental method. And remember, the CRA will limit the foreign tax credit to the lesser of the U.S. and the Canadian taxes, where the Canadian taxes are required to be calculated based on net rental income.

A telling example

To see how this works in practice, let’s look at a simplified outline of a hypothetical situation. This client has net taxable income in Canada of about $100,000, and she’s paying Canadian tax at a rate of roughly 30%. The Florida property she’s considering could easily generate annual gross rental income of about $10,000 and net rental income around $5,000. Note that in practice, net rental income is generally less than 50% of the gross, but in this instance the higher number could be correct. In keeping with our initial scenario, Barbara is going to use an inheritance to make the purchase. This way, she’ll avoid taking out a mortgage, but of course that means she won’t be able to claim mortgage interest against gross rental revenue.

If Barbara elects to go with the 30% withholding rate, the simplest approach, she’ll pay $3,000 to the IRS but when she files her Canadian tax return, the foreign tax credit she can claim will be limited to $1,500 (calculated as her Canadian tax rate of 30% multiplied by her net rental income on the U.S. property of $5,000). Overall then, she will be out $1,500, and be a victim of double taxation. This is an outcome all of our clients want to avoid.

If she does the paperwork and files a nonresident return in the U.S., tax will be calculated on net rental income at graduated rates. Almost always, she’ll pay much less to the IRS and still be able to claim the full foreign tax credit on her Canadian return.

Some added complications

Residency and tax filing may be key tax issues for your clients when buying U.S. property, but there are many other considerations. Although residential real estate prices are extremely inviting in Florida and many other states at the moment, it’s important to remember that ownership means maintenance, paperwork and taking care of tenants as well as relaxation in the sun.

My comments have focused on Florida, a state that has no personal income tax, but other states do, possibly adding a U.S. state tax filing obligation for nonresident rental property owners. And I haven’t dealt at all with the tax consequences of an eventual sale or questions of estate tax following an owner’s death. As with any major purchase, your clients should obtain professional advice for their particular situation.

Buying a second home in Florida or elsewhere in the U.S. can be a very rewarding investment. Your clients, like Barbara, just have to make sure that they fully understand the landscape.